“Sales of securities backed by bundles of risky corporate loans are hitting records, lifted by a recovering economy and demand from yield-starved investors. Issuance of new collateralized loan obligations… totaled over $59 billion as of May [this year], according to data from S&P Global Market Intelligence’s’ LCD. That is the highest ever figure for that period in data going back to 2005.” – Sebastian Pellejero, Wall Street Journal
What, exactly, are commercial real estate collateralized loan obligations (CLOs)?
Collateralized loan obligations are complex investments mainly used by larger institutional investors. Commercial real estate (CRE) CLOs are a hybrid of traditionally leveraged bank loans and commercial mortgage-backed securities; they are structured as CLOs but have CRE loans as collateral. A CLO is a single security backed by pooled debt, often corporate loans with low credit ratings or loans taken out by private equity firms to conduct leveraged buyouts; this kind of debt is a company loan rather than a mortgage. Investors receive scheduled repayments from the underlying loans, often assuming the majority of the risk in the event of default. Obviously, the upside of greater risk is higher returns.
How Collatreralized Loan Obligations Work
Loans to companies rated below investment grade are sold to CLO managers who then bundle perhaps 150 to 250 loans together and manage the consolidation. They may then fund the purchase of new debt by selling stakes, called tranches, in the CLO to outside investors. Each tranche is a piece of the original CLO; the tranche dictates who will be paid out first and who will be paid last, therefore taking on a higher risk of default.
“CLOs purchase a diverse pool of senior secured bank loans made to businesses that are rated below investment grade. The bulk of CLOs’ underlying collateral pool is comprised of first-lien senior-secured bank loans, which rank first in priority of payment in the borrower’s capital structure in the event of bankruptcy, ahead of unsecured debt.” – Guggenheim Investments.
Debt tranches vs equity tranches
Debt tranches are mezzanine debt that offers specified repayments comprised of a combination of interest and principal in a similar way to debentures and corporate bonds. Equity tranches do not produce scheduled cash flows; instead, they offer shares in the CLO if or when it is sold.
Why are CRE CLO sales surging?
Commercial real estate values were mostly stagnant in 2020 as government stimulus programs such as the CARES act protected tenants, enabling them to meet their obligations, therefore allowing property values to rebound during 2021. The expectation that business properties, at least in some sectors, will continue to rebound strongly following the pandemic shutdowns is encouraging investors to acquire higher-yielding debt vehicles. Lenders sell a combination of debt and equity to borrowers needing short-term bridging loans for renovations to existing commercial property or to expedite closings on new deals. Institutional investors, including managers of pension funds and insurance companies, may seek high-yield debt with short maturities to balance safer – but lower-yielding – investments in their portfolios.
What Are the Expectations for Sales of Bundled CLOs as the Market Begins to Recover?
The US commercial real estate market is poised to take off in the coming months due to pent-up demand from investors sitting on spare capital and wanting to complete CRE deals. While the pandemic has affected the various sectors of CRE differently, multifamily buildings, in particular, have weathered the storm better than most. By the end of 2020, CBRE Group Inc. was already predicting around 33 percent growth in the first two quarters of 2021.
Following a period when many landlords lost income due to tenants deferring rent and governmental restrictions on evictions during the pandemic, the current situation looks optimistic due to a large pool of prospective renters, including many millennials currently locked out of the housing market. Vacancy rates are currently low, with suburban properties, particularly, being in demand as the high cost of living in cities, combined with the growing work-from-home trend, means renters – in search of more space – are abandoning city centers for the suburbs. Long Island and the New Jersey suburbs have been among the biggest benefactors, as have suburbs of sun-belt cities.
This ties in with Forbes’ predictions for 2021, as reported by Dan Dokovic, including the
- Interest rates to remain low throughout 2021
- Population to decline in major US cities and increase in the suburbs
- Affordable housing to continue to be an issue
- Increased focus on sustainable living
- Mainstream rise in alternative investments
Assuming the continuation of current trends, even riskier loans look likely to be relatively safe. While obviously not without risk, default levels are still low and confidence in the recovery rate of the commercial property market is fueling high levels of investor demand with some lenders needing to increase their sales to satisfy that demand. Given the desire for portfolio diversification and the need to balance safer investments with higher risk/higher yield options, it seems unlikely that this increased demand will wane any time soon.