FEATURE ARTICLE, DECEMBER 2006

CDO'S: WHAT YOU NEED TO KNOW
It pays to know the structure and benefits of this popular real estate financing vehicle.
Mark Strauss

Collateralized Debt Obligations (CDO) were introduced as a financing vehicle for real estate in 1999 and have had great acceptance and phenomenal growth since then. How are these securities structured? What benefits do they hold for the issuer? How do they benefit the borrower? In these answers lie the basis for the rapid expansion of commercial real estate CDO originations. Finally, what cautions should be exercised when considering this rapidly expanding financing vehicle?

CDO Structure

There are various types and structural combinations of CDOs — static, managed, cash and synthetic. This article will primarily address static and managed CDOs where assets are pledged to a trustee to back the debt for the benefit of the investors. Not unlike CMBS, CDOs are really about repackaging and transferring credit risk.

CDOs evolved from static funds invested in fixed-rate loans into managed portfolios which invest in CMBS, B Pieces, B Notes, mezzanine notes and preferred equity. Commercial real estate (CRE) CDOs are similar to mutual funds that buy corporate bonds. However, CRE CDOs purchase subordinated and sometimes unsubordinated real estate debt obligations. CDOs do not sell shares but sell privately placed securities backed by real estate debt obligations, which are tranched based on credit risk characteristics and the maturity of the underlining loans. These tranches, in which the principal and interest cash flows are allocated based on the collateral seniority, can range from A Rated (investment grade) debt backed by B Notes and mezz notes to B Rated (non-investment grade) debt backed by preferred equity.

The basic concept of CDOs continues the trend toward an actuarial approach to lending as opposed to a borrower or bricks-and-mortar view. The idea is that a pool of defined financial assets will perform in a manner that can be reliably forecast and can be financed in a way that captures the arbitrage between the interest received on the CDOs assets and the interest paid on the securities issued to finance them. Fitch, Moody’s and Standard & Poors have developed CDO criteria and statistical models to determine the level of credit enhancement required to issue credit ratings for the pool of CDO securities. CRE CDOs will allocate interest and principal of such pools on periodic distribution dates according to Collateral Quality Tests (CQT), which are typically an over-collateralization ratio and an interest-coverage ratio.

Tranching creates more than one class of debt within a given structure. Junior investors provide credit enhancement for senior investors. Investors in subordinated classes enjoy a higher coupon but have higher risk to their initial principal investment. The subordinated debt holders agree to absorb losses before the senior debt holders. The more certain the payment the higher the credit rating and lower the return. The less certain the payment, the lower the credit rating and the higher the return.

A CRE CDO life ranges from 5 to 10 years. Some offerings are fully invested in loans at inception, others consider the first year as a ramp-up period when the portfolio manager invests the proceeds from the sale of the fund’s securities. During the next 3 to 7 years in a managed CDO, the portfolio manager actively reinvests cash flows, buying and selling assets. During the final 2- to 5-year phase of the CDO’s life, the portfolio manager no longer reinvests cash but uses the proceeds to amortize the underlining collateral and repay the investors.

The Benefit To The Issuer

Managed CDOs typically lend themselves to the bridge-loan lender, focused on transitional real estate, who has been using bank and repurchase lines to raise its capital. (If assets have fixed long-term, stable or predictable cash flows, then a CMBS execution is probably better. But not everything fits into a REMIC. Currently, REMIC tax rules still prohibit making modifications to the property, loan amounts and the cash flow.) CDOs offer structural as well as cost advantages to the issuer: (1) CDOs offer longer terms — 10 years versus 1 to 3 years for bank lines; (2) There is no mark to market risk and margin call provisions, therefore insulating the issuer from liquidity and valuation issues during volatile times in the credit markets; (3) Advance rates tend to be higher; (4) As opposed to the subjective third-party gatekeeper typical in line lending, CDOs have objective collateral quality tests; (5) The capital is non recourse; (6) Pricing pick-up — bank and repo lines typically run between 125 and 250 basis points over LIBOR while CDOs execute after fees and costs at plus or minus 75 basis points over LIBOR.

Rates have been kept low even in the face of significant issuer increases because the CDO is a rated liquid instrument with an active market that will pay more than buying like-rated CMBS bonds, agency securities or corporate bonds. The investor is getting more yield for an equivalent risk. Furthermore, there has been a ready acceptance of the investment by the European community as evidenced by the subscriptions from Irish, French and German investors in several of the recent offerings. Anecdotal evidence indicates that European institutions have tended to prefer floating-rate instruments with intermediate terms of 5 to 7 years, which matches the CDO profile. Also, the Europeans seem to be more comfortable underwriting the collateral manager and the agency credit ratings versus domestic insurance companies, which still tend to be more asset oriented. That said, the life companies have acquired static CDO, CMBS B Pieces, which are fixed rate and have longer-term maturities.

The Benefits To The Borrower

For the conduit borrower, the proliferation of CDOs has been advantageous as it has given B Piece buyers a less expensive methodology for refinancing their positions and therefore allowing some of the benefits to be passed through to B Piece pricing in CMBS deals. The old adage “garbage in, garbage out” has changed in some circles to “garbage in, credit out.” Sub-investment-grade B Pieces go into static CDO pools and, through diversity and structuring, come out carrying a high rating, providing the B Piece buyer a lucrative arbitrage position and cheaper money to go back and buy more B Pieces.

For the value-added transitional real estate borrower, CDOs have created a much broader playing field. Where there used to be a handful of non-recourse, non-hard-money lenders for transitional assets, there are now twice as many. At the same time, floating-rate spreads are 50 to 75 basis points inside where they were a year ago. Loans at full leverage levels are available on assets classes that have historically been hard to finance. Furthermore, CDO financing can offer flexibility in the modification of loan terms to take advantage of market opportunities and changing business plans for an asset. Such flexibility includes additional funding or various prepayment options.

Where Are The Concerns?

Another adage goes like this: “The worst loans are made in the best times.” Where is the discipline in the marketplace? The issuers to some extent are relying on the rating agencies to bring discipline and monitor the market by changing their approach to issues and ratings in an attempt to normalize for real estate supply and demand market dynamics. In fact, the marketplace has experienced some of this discipline with a pull back in land finance issues. But rating agency discipline should not be a substitute for lender underwriting discipline.

The collateral manager should be an issue for both the borrower and the CDO investor. Today’s rising-value real estate market has led to very low default rates across all asset classes and financing structures. The test of the CDO structure and of the collateral managers will come when the markets are put under stress. It is not difficult in today’s market for talented originators to lay off pools of loans. But both borrowers and investors will be well served to focus on the collateral manager’s capital resources, the experience and quality of their personnel, their understanding of real estate fundamentals and the ability to manage properties, their experience in asset classes, their systems and infrastructure, CDO covenant compliance, reporting and investor relations.

It is evident that, to date, CRE CDOs have effectively allocated risk, return and benefit, creating a real win for the issuer, the CDO investor and the real estate ownership community. With a formula like that, the market growth is easily understood.

Mark Strauss is the managing director for Cohen Financial in Newport Beach, California.

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