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CRE Finance World, Summer 2014

New Generation of CRE CLOs Find their Stride A publication of Summer issue 2014 sponsored by CRE Finance World Summer 2014 17 Moody’s Investor Services’ Tad Philipp, Director of Commercial Real Estate Research, and Deryk Meherik, Vice President and Senior Credit Officer, spoke with Christina Zausner of CRE Finance Council about how the new generation of CRE CLOs are gaining a following. here is little doubt that the commercial real estate (CRE) sector has been safely delivered to the recovery zone from the trough several years ago. Low interest rates and improving macroeconomic conditions, such as employment and GDP, point to continued profitability in the sector. As long as cap rates and other real estate specific factors do not fly too close to the sun, CRE should broadly continue its recovery and expansion. It is this robust environment, say Moody’s Investors Services’ Tad Philipp and Deryk Meherik, that has set the stage for the return of CRE Collateralized Loan Obligations (CRE CLOs). While its big brother market, Commercial Mortgage Backed Securities (CMBS), is primarily dedicated to providing long-term fixed-rate financing for stabilized properties, CRE CLOs are frequently used to finance short-term floating-rate loans or participations in loans backed by non-stabilized properties. TP: “Given where we are in the cycle, a lot of properties still need to be re-capitalized or re-positioned, and there is a wave of maturing pre-crisis loans right behind them.” DM: “Today we are seeing CRE CLO deals backed almost entirely by floating-rate whole loans and senior participations. What we are not seeing is CRE CDOs, in which some of the collateral is debt obligations involving additional layers of leverage such as subordinate CMBS securities.” “In 2013 and so far in 2014, whole loans and senior participations account for nearly 100% of CRE CLO collateral and it is likely to remain this way for the foreseeable future.” Deal Structure is Key Clearly the investors are back, and there is more drawing them to the table than the simple fact that the pools are cleaner and transparency has improved. Specialty lenders with expertise in commercial real estate re-positioning and development are bringing transactions backed by portfolios of loans on such properties to market. DM: “They understand how to structure bridge financing for transitional properties. Maybe the collateral suffered from the departure of a large tenant, but the borrower has a re-leasing plan and the lender can make additional proceeds available in the form of future funding to execute the plan.” Both experts also point out that the specialty finance companies are staying involved throughout the life of the deal, typically in the capacity of collateral manager and by retaining the non-sold equity portion of the transaction. This adds stability to the credit profile of this asset class. TP: “The specialty finance companies typically keep the junior bonds and equity portions, which makes the CRE CLO more of a portfolio finance vehicle than a trade.” DM: “The specialty finance companies expect to hold credit risk for the life of the loan as it can provide attractive equity returns if the transaction performs as expected.” Investment Grade Investor Role While generally true that the collateral in the CRE CLOs is riskier than in CMBS, the senior investors have some advantages over a CMBS structure. TP: “CRE CLOs are controlled from the top down (the senior bond holder is in the control position), whereas CMBS is controlled from bottom up (the B-piece investor can replace the special servicer). The senior investors have a lot of say in how the deal is managed once certain performance triggers are tripped, and in such cases they may receive additional proceeds to reduce their exposure to the deal.” Collateral quality and leverage levels vary more widely in CRE CLOs than in CMBS, and consequently subordination levels vary more widely as well. Aaa/AAA subordination levels for CRE CLO’s tend to run between 40% and 50%, roughly twice that of CMBS. T Deryk Meherik Vice President and Senior Credit Officer Moody’s Investor Services Tad Philipp Director of Commercial Real Estate Research Moody’s Investor Services Christina Zausner VP, Industry and Policy Analysis CRE Finance Council


CRE Finance World, Summer 2014
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