Commercial Real Estate CLOs: Features That Make Them an Attractive Asset Class

Abstract

In the world of securitization and structured finance, a new hybrid asset class—commercial real estate (CRE) collateralized loan obligations (CLOs)—has appeared on the scene, boasting the most attractive structural and underlying collateral features of its parents: the commercial mortgage-backed securities (CMBS) securitization transaction and the standard CLO transaction. The CRE CLO structure is one that can be used as a means of potentially averting financial loss in advance of the “maturity wave” (also known as the maturity wall, CMBS refinancing risk, and CMBS balloon risk), a lurking phenomenon wherein a number of CRE mortgage loans, including balloon loans and anticipated repayment date (ARD) loans, constituting more than one trillion dollars of the underlying collateral in CMBS securitizations from vintages of 5 to 10 years ago, are going to be coming due in 2015–2017. CRE CLOs may create appealing opportunities for lenders, because shorter-term financing can be used to refinance these legacy-maturity CRE mortgage loans into the more stabilized product that CRE CLOs offer. Also, CRE CLOs contain CLO structural features absent in a standard CMBS securitization, including a reinvestment period, a ramp-up period, various collateral quality tests, and an active management feature that empowers CRE CLO collateral managers with the ability and discretion to substitute poorly performing collateral in the CRE CLO’s underlying CRE mortgage loan collateral pool with “new” collateral that satisfies certain rigorous criteria. Moreover, today’s CRE CLO’s collateral is more resilient than CRE mortgage loan collateral from yesteryear because of the following: 1) more stringent lending and underwriting guidelines are in place today for CRE mortgage loans compared with those in place in 2007 at the height of the CMBS market and 2) today’s CRE CLOs do not contain split loans, mezzanine loans, or B-pieces; instead they contain only as collateral CRE senior mortgage whole loans with much shorter durations than the CRE mortgage loans from the pre-2008, CLO 1.0 era. Additionally, a CRE CLO may offer higher yield than other structured products because the collateral manager has “skin in the game” tied to the CRE CLO’s overall performance and payment waterfall, and therefore the collateral manager’s interests are more closely aligned with those of the investor. From a relative-value and performance perspective, investors looking to maximize their yield can thus find comfort investing in a lower tranche in the capital stack without potentially as high a risk exposure for non-payment as if they invested in a lower tranche in a CMBS securitization transaction. Finally, from a regulatory compliance perspective, the CRE CLO’s hybrid structure enables it to fall under certain exemptions under the Investment Company Act of 1940—including the “qualified purchasers” exemption under Section 3(c)(7) and the real estate mortgage loan exemption of Section 3(c)(5)(C)—and to fall under the Volcker Rule’s carve-out for securitization of loans, all of which enable a CRE CLO to escape “covered fund” status under the Volcker Rule.