FEATURE ARTICLE, OCTOBER 2007

IS YOUR DEAL RIGHT FOR A CDO?
Structured finance offers new choices to developers seeking options beyond traditional construction financing.
Daniel Walsh

Stabilized cash flow in a commercial real estate development and repositioning was once a prerequisite to having choices in financing options. Without cash flow in place, financing that a local lender kept “on its books” was the traditional option for getting real estate projects redeveloped. CMBS (commercial mortgage-backed securities) and most other structured debt vehicles were designed for financing real estate projects with proven cash flow — i.e., leases in place and signatures on the bottom line. However, the increased sophistication that has come to the real estate capital markets during the last several years has brought choices to borrowers seeking to finance non-stabilized properties. Structured financial solutions, including non-recourse loans ultimately securitized in CDO (collateralized debt obligations) structures, provide a venue for experienced and financially sound developers to obtain potentially lower-priced financing for qualifying redevelopment projects.

Rising Demand for Securitization

Just in the last few years, CDOs have joined CMBS as a mainstream vehicle to securitize commercial real estate debt. As CMBS rose in popularity since the 1990s, both investors and borrowers began to demand a new form of commercial real estate security: one that would satisfy investor demand for higher returns (and risk), and a securitized platform for borrowers that would accommodate projects with credible potential, but with limited cash flow generated by the property.

Both CMBS and CDOs are real estate capital markets bond structures that securitize pools of commercial real estate loans. A typical CMBS offering consists of stabilized assets and is traditionally considered lower risk than a CDO, while CDOs offer financing for non-stabilized assets. At their most basic, both types of securitization offer financing for real estate projects by drawing in capital from investors in the real estate debt capital markets. The process of securitization includes loans being selected, pooled and used as collateral for the issuance of securities. Credit risk is moved off the original lender’s balance sheet and diversified into the capital markets, with bond-buying investors assuming both the risk and the yield. Either way, the borrower seamlessly receives capital to finance their project.

By the Numbers

Since 2005, CDOs reached legitimate skyrocketing status. At the beginning of the decade, commercial real estate CDOs represented less than $3 billion of market volume per year and barely registered as a percentage of commercial real estate securitizations, according to Commercial Mortgage Alert. In fact, the $40 billion volume in 2006 is a rise from approximately $20 billion in 2005 and from less than $10 billion in 2004. While the 2007 volume will most likely not reflect a similar percentage rise in popularity due to the movement of the bond markets, it is expected that the CDO market will continue to thrive as a commercial real estate security.

Many potential borrowers and investors in CDOs were taken aback this year, as doom-and-gloom headlines during the first half of 2007 concerning real estate CDOs flooded the market. These scenarios were due to the fact that CDOs are only as stable as the assets that are allowed into their collateral pool. Unfortunately, some CDOs were backed by subprime home mortgage loans, residential mortgage-backed securities, weak single-family home loans and other assets with default risk that created volatility in the capital markets. However, the long-term viability of CDOs as a stable vehicle for financing is expected to remain strong.

Inside CDOs: Understanding the Vehicle

It is important to understand why a developer should consider CDOs as opposed to other financing options. Many times, a loan headed for a CDO issuance will offer the borrower favorable terms, much like a CMBS loan is often a favorable option to other forms of permanent finance. CDOs represent an investor-backed financial solution that will finance assets “in transition,” meaning non-stablized, while CMBS loans require stabilized cash flow — i.e., completed projects with signed leases in place. Such a product has been an important step forward for developers of all commercial properties including retail, industrial, office and multifamily properties.

A commercial real estate CDO can consist of a wide variety of assets including whole loans, B-pieces, mezzanine debt, preferred equity, CTLs (credit tenant leases), trust preferred notes and more. The pool of assets is rated by the rating agencies and divided into separate tranches of bonds based on the credit worthiness of each tranche starting with AAA credit rating, moving down in the capital structure to the non-investment grade tranches at higher leverage levels. Capital is raised by the sale of the tranches of bonds to third-party investors. The income from the underlying loans is used to pay the holders of the bonds. After payment of all of the superior bondholders in a CDO securitization, excess income is paid to the owner of the most subordinate class of the CDO bonds. CDOs have a fixed maturity and are designed as buy-and-hold investments.

Historically, CDO bonds have paid a higher return than similarly rated CMBS bonds, thus explaining their popularity with commercial real estate investors. CDOs also allow investors access to asset classes that would otherwise be unavailable directly to them — the non-stabilized assets that do not qualify for CMBS. The bonds offer a yield to compensate investors based on a combination of considerations including the possibility of default on the underlying assets because of their transitional nature, liquidity of the bonds and possible price volatility. Investors can choose the level of risk and return that suits their requirements by investing in the different bonds with different risk tolerances issued by a CDO.

Static CDOs are based on pools of assets that, once purchased, do not change — hence the name. The alternative is a managed CDO that pays the collateral manager to actively manage the underlying portfolio of assets and maximize returns for investors while assets move in and out of the collateral pool in compliance with existing bond covenants to ensure stable cashflow to the bondholders. In many cases, 20 percent or more of the underlying collateral pool can change each year driven by loan payoffs as assets achieve stabilization. The manager acts as an experienced advisor to work with the investment bank and rating agencies to structure the initial portfolio and to validate the chosen credits as the portfolio evolves over time. The manager will pay close attention to the portfolio, will respond to changes in the credit environment and will try to minimize defaults in the CDO. Investors in actively managed CDOs are investing as much in the experience of the collateral manager and their access to future collateral as they are in the existing asset base.

From the borrower’s point of view, their loan will be a temporary member of the collateral pool of a CDO whether it joins the pool at the outset of the CDO issuance or as a replacement property for a completed development transitioning into a different financial vehicle via a refinancing program.

Looking at the Transactions – and at Your Deal

CDO loans are typically non-recourse and offer the choice of a floating or fixed rate. They offer flexible loan terms and negotiable pre-payment. Furthermore, they offer competitive pricing and a streamlined closing process. Most loans are warehoused on a bank’s balance sheet until the bond issuance, so the closing process resembles traditional processes and documentation. Like a mutual fund, CDO collateral changes over time, so borrowers and investors alike should keep track of exactly who is managing their CDO.

What Lenders Look For

As you consider CDO financing for your deal, you should consider the features that lenders will look for in a project that could become a member of a CDO collateral pool. The importance of lender discretion in choosing collateral has increased proportionally with the upheaval in the capital markets: to attract investors to a CDO, the issuer must make the case that the collateral (i.e., borrowers) has been judiciously selected and the chosen assets will cause the pool to perform as expected, providing revenue that then become investor returns.

Lenders look for developers that are experienced not only in the product type of the project in question, but also those with strong development teams in place. The ability of the developer to successfully deliver the project on time and on budget becomes paramount, which means that a development team experienced in working together (i.e., developer with contractor, architect and key subcontractors) will be strong candidates for this type of financing. Also related to successful project delivery is the importance of due diligence: a fully executed due diligence program in place is critical to a transaction’s approval as a CDO-ready deal. The market also must provide a fertile ground for tenants to provide cash flow supporting the business plan. The stronger the market and demographic data supporting the project, the better. Finally, a successful historical relationship between borrower and lender and a strong credit history also contribute positively to a deal’s attractiveness as a member of a CDO collateral pool.

Choice is Critical

Choice in financial solutions is at the heart of the viability of CDOs as a construction finance vehicle. As an increasing percentage of the commercial real estate market volume becomes securitized, CDOs will likely continue to grow, along with the many other financial products from which borrowers and investors may choose. To determine whether your deal is right for CDO financing, talk to your lender, and explore all the options available to you.

Daniel Walsh is managing director of KeyBank Real Estate Capital Private Equity Group.

Subprime Mess’ Effect On Southern California Market Bauer With subprime lenders filing for bankruptcy faster than movie stars are getting DUIs, it is natural to wonder how the negative mortgage trend will affect the Southern California office market. Will the market direction lead to office vacancies of 18 percent like the days after the dot-com implosion earlier this decade? Prior to this financial hiccup in fourth quarter 2006, the office vacancies in Los Angeles, Orange and San Diego counties averaged 6 to 10 percent. This low vacancy spurred the construction of approximately 7.9 million square feet, including 3.4 million square feet in Orange County. This new construction represents 2 percent of the 347 million square feet of total inventory in these markets. This is not a large percentage statistically; however, the percentages should cause some concern because most of the space under construction is speculative with little or no pre-leasing. In mid-2007, the financial market fallout increased in velocity with subprime lenders, such as New Century and Ameriquest, filing for bankruptcy and releasing more than 1 million square feet back on the office market. Despite that, new construction is still underway with the majority of the space unspoken for. Given all this bad news, how is office space going to fare? Amazingly, the impact is projected to be localized in specific areas such as Orange County, where the majority of the subprime lenders were headquartered. As it turns out, the impact may be less than expected due to the fact that housing-related companies in general occupy less office space, compared to the professional, pharmaceutical and medicine, computer and technology sector. For example, in 2005, 48 percent of all housing-related jobs were in construction, 26 percent were in professional and business services, and 13 percent in trade and financial activities. Consequently, only 39 percent of all the housing jobs require office space. Construction jobs that account for almost half of the total are project-related and have no office requirement. An additional 13 percent of housing-related jobs — title insurance, real estate agents, etc. — are in industrial or retail space. In contrast, 39 percent of all technology jobs were part of professional and business service sectors, 31 percent are manufacturing, 25 percent information and 5 percent in wholesale trading. This results in 64 percent of all technology jobs requiring office space. Typically the leading indicator for office occupancy has been job growth in management, financial services, technology, telecommunication and the various sectors enumerated earlier. At present, the job growth for these sectors in California is expected to decline by 1 percent or remain static until mid-2008.  The weak job growth along with completion of the 7.9 million square feet of office space under construction will tend to increase vacancy. What does this all mean? The slowdown of the housing market and implosion of the subprime lending sector in specific areas such as Orange County will add additional pressure to office vacancy. However, in contrast, the impact should be negligible in other western markets, correlating with the area’s general job growth. John Bauer is a senior director for Tremont Realty Capital in Newport Beach, California.

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