Back to the CDO Playbook


The much-maligned collateralized debt obligation (CDO) appears to be set to play a crucial role in the refinancing of maturing commercial mortgages and the recapitalization of the recovering commercial real estate (CRE) market. Only no one is calling these deals CDOs.

CRE values have made an unexpected, yet uneven, comeback from the depths of the recession, leaving many property owners still owing too much to hold on to their shopping malls, office buildings, hotels and industrial buildings--unless new capital is introduced.

The Moody’s/RCA Commercial Property Price Index (CPPI) for October—the most recent available before ASR went to press—shows prices overall have climbed 27.7% since the November 2009 trough, but they remain 22.4% below the December 2007 peak.

Boston is the market that is closest to regaining its peak, at 1% below that level, according to the September report, with Washington, D.C., and New York are off by 5.7% and 7.5%, respectively. Los Angeles and Chicago lag, at 22.9% and 18% below their peaks, and many less-than-major markets are still struggling. (A geographical breakdown of the October data was not available as ASR went to press.)

As these loans mature, borrowers can’t rely on traditional first-lien lenders to refinance all of their debt. They either have to pay it down, bringing loan-to-value (LTV) ratios back to a level that banks are comfortable with, or obtain some kind of “rescue” financing, a catch-all term for mezzanines or other debt with equity-like characteristics, to combine with a smaller first-lien mortgage.

Rescue financings are initiated in a variety of ways. Banks may contact providers of mezzanine or other equity-like securities to play a roll in a recapitalization, or vice versa. Or the property owners themselves may instigate the transactions. Given the high property values at which CRE owners locked in financing before the financial crisis, an ever increasing and potentially vast flow of rescue or “gap” financing is likely in the offing.

“There’s likely a three-to-five year window of these transactions to come; we’re seeing the leading edge of CRE recapitalization,” said Tad Philipp, director of CRE research at Moody’s Investors Service.
Such financings may be necessary, if, for example, a $70 loan is made against a $100 property, the property’s value falls by 20%, and its LTV increases to 87.5%. If the first-lien lender requires an LTV of 70%, then the lender will only provide $56 million in debt, and to refinance the property a $14 million gap must be filled. Mezzanine and other equity-like securities can fill that gap.

Rescue capital must be financed, however, and that’s where securitization appears likely to play a vital role. Philipp pointed to $170 million and $87.5 million securitizations respectively completed recently by Redwood Trust and Arbor Realty Trust as early templates for the types of financing vehicles that are almost certain to play a key part in the recapitalization of the CRE market. Other providers of rescue capital said to be considering similar deals include H/2 Capital Partners, Prime Capital Advisers, Blackrock, and MFS Investment Management.

The Redwood and Arbor deals were marketed not as CDOs but as commercial real estate collateralized loan obligations (CRE CLOs). A CLO is a kind of CDO, and the term “CLO” can describe deals backed by corporate loans with a senior claim on an operating company’s assets. In the CRE market, however, the CLO structure has typically been used to securitize loans with a subordinated claim on a property, such as mezzanine and preferred equity. By comparison, commercial mortgage-backed securities (CMBS) have mostly pooled first-lien loans.

Market participants are careful to avoid using the broader “CDO” term, which in the past has included transactions backed by much dicier collateral. Philipp noted that the performance of CRE CLOs was superior to that of other types of CDOs during the crisis.

David Rodgers, principal at Park Bridge Financial, which advises on CRE lending issues, said that the CMBS deal structure is more efficient at securitizing standard, fixed-rate mortgages, whereas the CLO structure is much more flexible, allowing a wider variety of securities, such as mezzanine and B-notes, to be included in the pool of collateral. “If you have higher risk loans or more transitional floating-rate loans, then you can use CLO technology to finance these positions,” Rodgers said.

“These CLOs are riskier investments. You have to be real estate investor looking very closely at these loans,” he said.

Park Bridge specializes in this type of due diligence. Rodgers said that on future CLO transactions the firm plans to compete for assignments as the operating adviser, which oversees the activities of the special servicer and in some cases issues quarterly reports updating investors about the status of each loan in the pool.