The assets that collateralized loan obligations purchase are likely to become riskier as the lending cycle heats up. For now, however, they comprise mostly newly originated junior debt, and the intent of companies such as Redwood and Arbor is much more straightforward: achieving higher yields.
Mike McMahon, a managing director at Redwood, said the Mill Valley, Calif.-headquartered real estate investment trust had made approximately $290 million in mezzanine-type loans that were sitting on its balance sheet. Seeking additional financing, it decided to split the debt into a $170 million senior tranche to sell to investors while keeping a $120 million junior tranche on its books.
The large subordinated portion prompted Moody’s and Kroll Bond Rating Agency to give the senior bonds investment-grade ratings of Baa3 and BBB-minus, respectively. McMahon said the underlying mortgage loans yielded roughly 10% on average, and the senior bonds priced for a coupon of 5.62%.
“That increased the yield on the junior bonds to north of 13%,” McMahon said, adding that there were “half a dozen institutional money managers in the deal.”
McMahon also said that most, if not all, of the loans in the securitization were made in conjunction with a senior lender, such as a bank, insurance company or CMBS lender. “Those lenders generally made the 65% LTV loan, while we made the next approximately 10% in the form of a mezz loan, and the borrower put in 25%,” McMahon said. “The plan was to get some permanent, structured financing on our portfolio [of loans], so we could increase the return on our retained piece.”
The CLO also provides an attractive source of financing to Redwood. Steven DeLaney, director of special finance research at JMP Securities, said in a Nov. 29 client note that the deal’s leverage of 1.5 times enables Redwood’s commercial mortgage subsidiary to originate a CRE loan portfolio as big as $750 million, comprising $300 million in equity and $450 million in senior financing.
“With a huge CRE loan refinancing pipeline of over $1.5 trillion over the next five years, Redwood should have plenty of opportunities for additional middle market CRE lending where loan yields have held up much better than in other debt or fixed-income markets,” DeLaney wrote.
He added that Redwood’s all-in funding costs will likely be more than 6% when issuance costs are included, but it should still earn a net interest spread of about 3% on the levered portion of the portfolio.
“[Redwood] will receive fresh cash to continue to grow and diversify its CRE portfolio and will boost the return on equity through the application of modest leverage,” DeLaney said.
UBS Securities led the transaction and Wells Fargo Securities acted as co-manager. The private placement was secured by a portfolio of 30 collateral interests tied to 76 underlying properties comprising multifamily, office, hospitality, retail, self-storage and mixed-use properties.
The Arbor deal, split into a $87.5 million senior portion sold to investors and a $37.5 million equity portion retained by the REIT, comprises 18 whole loans and A-notes on multifamily properties. Placed by Sandler O’Neill, the notes priced at 339 basis points over one-month Libor, excluding fees and transaction costs, and for two years the deal allows the principal proceeds from repayments of the collateral assets to be reinvested in qualifying replacement assets.
The Arbor offering didn’t securitize loans defined as mezzanine. However, said Philipp, from Moody’s perspective a portion of the securitized loans carried LTV ratios above the level that typically marks straightforward debt. He added that some transactions are more clear cut because there is a loan carrying a 70% LTV, and the next 10% is a mezzanine position.
That distinction does not exist in Arbor’s transaction, but when securities exceed an LTV of 70% they begin to exhibit equity-like characteristics, and the loans in the REIT’s securitization fit that mold. “Some rescue or gap loans are leveraged enough where a portion appears to be crossing into the equity zone—they’re not technically equity, but they’re beginning to get to that area in terms of risk,” Philipp said.
Another benefit of CLO funding is that traditional lenders such as banks are typically unwilling to fund debt securities with LTVs higher than 70%, and if they do the restrictions tend to be significant. In addition, those lenders will likely want recourse to the property.
“CLO technology allows you to fund at close to the same amount of leverage—maybe not quite as much—but the costs may be less, and it’s nonrecourse,” said Rodgers. He added that because the issuer holds on to the junior portion of the deal and absorbs first losses, “the sequential structure allows bondholders to choose lower leverage over recourse.”
In addition, financing from banks may carry a different term than the CRE CLO’s underlying loans, so that if rates jump there may be a mismatch between those loans’ cash flow and the financing rate. “One of the reasons portfolio lenders like CRE CLOs is they lock in matched-term financing. If the weighted average life of their loans is three years, the weighted average life of their securities issuance is also three years,” Philipp said. “So for lenders who are looking to finance their portfolio, it takes a lot of capital markets risk off the table.”
Investors are heavily protected in the Redwood and Arbor offerings, but the deals nevertheless represent a willingness to consider more complicated and potentially riskier deals as today’s low rates push them in search of yield.
Clancy noted CMBS spreads have rallied furiously since June and benchmark rates remain at historical lows, allowing issuers to save hundreds of basis points even at the triple-A level.
“That forgives a lot of sins,” Clancy said, adding that market participants assumed that many of the loans done in 2006 and 2007 would never be refinanced and would have to be worked out in bankruptcy. Now, property values have rebounded for many marginal properties and are nearly in the black, making refinancing—especially with the help of mezzanine lenders—a real possibility.
“With rates so low, borrowers who were on the ropes before are much more willing to say, ‘Let me stay in this deal and try to recapitalize the property,’ as opposed to two or three years ago when they were ready to turn in the keys or have the property foreclosed on,” Clancy said.
The other trend, he said, is that CRE investors are becoming more confident and willing to move beyond the “class A trophy properties in the 24-hour cities—even a bit ‘frisky’.” Clancy pointed to a recent $27.3 million, 10-year CRE loan made to Detroit’s One Kennedy Square that priced at 5.15%.
CRE-CLOs aren’t the only example of deals in which investors are expanding into more complex and potentially riskier terrain. Goldman Sachs recently completed a CMBS deal securitizing cash flows stemming mostly from billboard licenses in Times Square, and a few months ago JPMorgan completed the first of a couple of deals securitizing nonperforming commercial loans—not seen since before the financial crisis.
Rodgers said it’s “only a matter of time before we see B-piece re-REMICs,” or deals securitizing the most subordinate tranches of other CMBS deals, another type of CDO.
Philipp acknowledged that B-piece securitizations may arrive at some point, given B-piece investors must also finance themselves. When those buyers pursued b piece securitizations that were highly leveraged prior to the market collapse, “that was viewed by most market participants as the beginning of the end, when the risk buyers cashed out,” Philipp said.
“We’re 90% back to the playbook of peak of market–not in terms of credit quality deterioration but rather the types of deals being done,” Philipp said.
Indications of a frothy CRE market, including higher LTVs and debt service coverage ratios, and pro forma loans that essentially speculate on future cash flows, have yet to emerge in any meaningful way. “We’re nowhere near the LTV levels done in 2006 and 2007, when A notes were done at 80% and B notes and mezzanine took you up to 98%, leaving 2% equity in the deals,” Clancy said.
Rather, the recent CRE market collapse appears to still be weighing heavily on credit decisions by investors and especially the rating agencies, keeping deal terms and structures conservative.
Nevertheless, spreads on CRE-related paper still provide a premium over alternatives, prompting investors to snap up the bonds. “Between tightening spreads and the current Treasury curve, and improved confidence in CRE, it’s just a perfect storm for borrowers right now,” Clancy said.
(Second of two parts.)
