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JAN 14, 2013 10:04am ET

Wall Street Returns to Property CDOs in Yield Hunt

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What’s old is new again on Wall Street as banks tap into soaring demand for commercial real estate debt by selling collateralized debt obligations, securities not seen since the last boom.

Sales of CDOs linked to everything from hotels to offices and shopping malls are poised to climb to as much as $10 billion this year, about 10 times the level of 2012, according to Royal Bank of Scotland Group Plc. Lenders including Redwood Trust Inc. are offering the deals for the first time since transactions ground to a halt when skyrocketing residential loan defaults triggered a seizure across credit markets in 2008.

The rebirth of commercial property CDOs comes as investors wager on a real estate recovery and as the Federal Reserve pushes down borrowing costs, encouraging bond buyers to seek higher-yielding debt. The securities package loans such as those for buildings with high vacancy rates that are considered riskier than those found in traditional commercial-mortgage backed securities, where surging investor demand has driven spreads to the narrowest in more than five years.

“Investors are willing to go further afield in their quest for yield,” Ed Shugrue, CEO of Talmage LLC, who oversees $2 billion of commercial property debt in New York. “With demand rich, Wall Street is scouring the cupboards to find anything with a cash flow that can be securitized.”

The deals could help borrowers owing more than their properties are worth who would otherwise be unable to refinance, said Richard Hill, a debt strategist at RBS in Stamford, Conn. About $450 billion in debt that was arranged before markets tumbled in 2008 matures through 2017 and commercial property values are still 22.4 percent below the 2007 peak.

CDOs pool loans or bonds into new deals with varying levels of risk and return. In the residential market before the credit crunch, that included securities backed by subprime home loans, which helped inflate the U.S. housing market and fueled more than $2 trillion of losses and writedowns at financial institutions globally.

Commercial real estate CDO issuance peaked at $65 billion in 2006 before the market collapsed in 2007. While CDOs tied to commercial mortgages typically fared better than those linked to residential, certain types performed better than others, according to Hill.

“There is no doubt that CRE CDOs were abused prior to the crisis,” Hill said. “If done appropriately, CRE CDOs provide a very valuable financing tool.”

Redwood, which has also led a revival in selling securities tied to home loans without the backing of the U.S. government, sold $172 million of bonds linked primarily to commercial mezzanine loans in November, the first sale of its type in five years.

The transaction, arranged by UBS AG, includes 30 loans on buildings ranging from the Gansevoort Hotel in Manhattan to the RiverTown Crossings shopping mall in Grandville, Mich., according to data compiled by Bloomberg. Mezzanine debt is repaid after the first mortgage and can bridge the gap between how much a landlord owes and how much the property is worth.

The deal “increases our ability to make additional investments in commercial real estate in an industry where there is more capital needed than there is capital” available, Michael McMahon, a managing director at Redwood, said in a telephone interview.

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