Why Don’t (Enough) Investors Like CRE CLO? | Dechert LLP

Why don’t enough investors like CRE CLO securities? They all really should, and it would be terrifically helpful to the market if more of them did so. (Okay, terrifically helpful to me.)

We hit $45 billion in CRE CLO production in 2021 and the market for secondary trading in CRE CLO securities is maturing. 2022 has been a challenge. Absent inflation that was supposed to be transitory, an uncertain and conflicted Fed and that pesky little war in Europe, we surely would have been on pace to exceed that level in 2022. Now we have to reset expectations for 2022, as we’ve lost the better part of 2 months of issue. Everyone “took a break.” The path ahead had become uncertain and no one wanted to look stupid, right? But, as I pen this, it seems like we’re starting to turn a corner (hopefully we’re not on a circular track) and we should see the market begin to reliquefy. It may not be great year, but it should put in a bottom for 2023.

Why do I think we’re about to turn the corner? In the first instance, and perhaps most importantly, we have become inured to the multiplicity of early spring crises that bedeviled our market. As always happens, yesterday’s crisis metamorphizes into today’s new normal. The US real economy seems to have broadly shrugged it off (a certain nauseating volatility in the equity markets aside). As I write this, last week’s Jobs Report showed strong growth in employment and wages. GDP growth was slightly negative in Q1, but the Fed sees positive growth for the rest of the year and that seems right. The data keeps coming in to the positive side. Unless something new goes wrong, a not completely implausible thing, we should be back to playing the cards we got dealt. It doesn’t matter how starting a crisis, the passage of time always brings ennui. I’m good with ennui right now.

Also driving the market back into a semblance of health, non-bank lenders simply need access to the capital markets. Perhaps in the days before the modern CRE CLO when cell phones were still made of wood, non-bank lenders managed their balance sheet in other ways. However, once the CRE CLO drug was broadly available, non-banks simply can’t do without it. Earlier this spring every non-bank lender in the space toddled off to its warehouse lenders with an ingratiating mien to tell them what terrific business partners they were and couldn’t I have a bit more, please? While that strategy has worked to a certain extent, it’s soon to have run its course. Warehouse lenders are full and getting fuller. They do not represent an endlessly deep well of liquidity. Further, no lender can afford a pause in lending while awaiting its capital and cash flow to be refreshed. Lenders cannot come and go from the primary lending space while bloated repo exposures are worked off. To do so is to risk losing one’s place on the mortgage bankers’ speed dials and no longer getting first looks from key relationships.

You’ve got to lend; you’ve got to warehouse and you’ve got to refresh the warehouses on a regular basis. That’s the reality of the way this market is constructed today. Non-banks today cannot be effectively managed and grown on the back of equity and traditional bank repo warehouses.

Then there is the continued hunt for yield by investors. There remains a vast amount of uninvested capital yearning for exposure to commercial real estate. In addition to the robust US domestic bid, just look at the investment dollars pouring into the United States from around the world, largely and somewhat shockingly, notwithstanding our inflation. Funny how investors and shareholders get annoyed by undeployed capital. No fund manager can tolerate that for long.

So, where are our investors? We need more investors to retain and build upon the vibrancy of the CRE CLO market. Is the problem that the CRE CLO market is still new and shallow? Is this the financial equivalent of vaccine hesitancy? Is the float too small to make investors really happy with liquidity? Ok, the market is still not large, but it’s only getting bigger and will continue to do so. It is certainly reasonable to see, across cycles, an annual run rate in the $40-60 billion range.

It can’t be performance. Over the past several years, this technology has performed extraordinarily well. The data makes the case that the CRE CLO is a well-performing, safe technology. DBRS just last week took a deep dive and was positive on the space. Defaults are low, assets in forbearance (or with some form of relief in place) are a small fraction of the total. Delinquencies in the CRE CLO space are considerably lower than other structured finance spaces and a fraction of delinquencies in the conduit CMBS space. Low delinquencies in this marketplace are a meaningful tell. A combination of good underwriting by folks who really have to eat their own cooking and structural features in the technology that permit assets to be removed to fix a problem or for refurbishment is very positive for investors.

Perhaps the CRE CLO still retains an unjustified odeur from the midden heap of the late and unlamented CRE CDO? It’s been almost 15 years since the last Frankenstein’s monster of a CRE CDO slouched into Bethlehem. Those mistakes have precious little to do with the state of the CRE CLO market today, but folks have long memories, don’t they, when bad things imperil careers. Is there concern that there’s something poisonous and secret buried in the current version of the CRE CLO technology? (Spoiler alert – I would know, and there is not.)

Is it just unfamiliarity? Gadzooks! Could it be that simple? I think that might be it! (Bear with me here.) Let me try and fix that.

First and foremost, this is the structured finance space where there is the best alignment between investors and deal sponsors. Even after Dodd-Frank’s truly annoying and largely ineffective risk retention regime went into effect, a 5% first loss piece can simply be priced to the deal. In other asset categories there is considerable use of the vertical risk retention structure, which really is sort of like kissing your grandmother through a screen door in terms of alignment of interests. Not so in the CRE CLO; it’s horizontal all the time.

In the CRE CLO space, most of the transactions are structured as Qualified REIT Subsidiaries (QRS) requiring the sponsor to retain all of the non-investment grade securities issued by the related securitization. And it cannot be sold. Depending upon underlying asset quality, this is a retention of 15-25% of the capital stack. Now that’s alignment!

Let’s just take a look at the key credit positive structural features of a CRE CLO. (Yes, I said credit positive.)

First let’s start with the fact these transactions are actively managed. What? I thought active management was bad! No, not true my good personal friends. Active management by a sponsor with around 20% of the bottom of the capital stack is actually credit positive. Look at a straw man comparison to conduit CMBS. Many have observed that securitization of long-tenured commercial real estate assets with stable cash flows are safer. That’s high-minded amphigory. Does anyone actually think that commercial real estate properties are stable over a 10-year time horizon? I don’t know about you, but my level of certainty begins to tail off after lunch. So, I would argue that as all commercial real estate is dynamic and fundamentally unstable, it’s better to have active management protecting my bonds than not.

The CRE CLO is going to have one sponsor, one seller. How much better risk alignment is there between one sponsor and one set of underwriting criteria and one set of origination protocols than in a pool that has multiple sellers? Collective responsibility, as we know, often means no responsibility. As Henry Kissinger famously said, “Who do I call if I want to talk to Europe?” Oh sure, multiple sellers can work just fine, but net/net, I would rather figure out if one counterparty knows its stuff and stays around to eat its own cooking.

The CRE CLO is featured by significant overcollateralization. Note protection tests which are typically set very tight to day-one performance, can result in significant cash being turboed to the senior bonds in the event of distress. The sub-bonds in the CRE CLO PIK create the equivalent of a fortress balance sheet at the top of the capital stack. Kind of cool, right?

The deals are shorter in duration. Transition assets usually max out around 5 years and generally speaking, loans prepay far before that. There is no existential prepayment penalty baked into transitional loans in recognition of the dynamism of most CRE assets. Peering into the crystal ball for 5 years instead of 10, is hardly the stuff of a sure thing, but it’s a bit easier, isn’t it? In fact, CRE CLOs generally have a real effective life of around 2 to 4 years (the longer tenure for the actively managed structures) and that’s something investors should appreciate. Between optional redemption at around 2 years and cleanup calls at 10%, you can reasonably expect these deals to pay off during a time horizon when the level of certainty is considerably better than other long-tenured securitization structures.

In dynamic deals, loans aren’t added willy-nilly. In onboarding loans, the sponsor must comply with detailed and prescriptive eligibility criteria, both as to the performance of the pool and the loans that are added to the pool. In many cases, what’s added to the pool are the non-pooled portions of loans that have already been participated into the pool and therefore do not represent a change of the credit composition of the transaction. If entirely new loans are added by a manager with real skin in the game, one might reasonably conclude that’s a good thing.

Consider one of the newest features in the marketplace that has attracted some attention, is the so-called criteria modification or “SIG MOD.” These rights allowing the collateral manager to modify loans provide a significant enhanced flexibility to the sponsor. Some have viewed this harshly from a credit perspective and that’s not a fair assessment. As Coach Corso would say, “Not So Fast!” The exercise of these rights is highly consistent with what a portfolio lender would do with its own portfolio. That’s the point. Investors ought to like that. If a portfolio lender thinks a criteria modification should happen and owns 20+% of the bottom of the capital stack, it’s probably a pretty good decision on behalf of all the investors as a collective whole.

It’s really important, Mr. Investor, to take on board that a CRE CLO is essentially a leveraged device for a portfolio lender. You’re backing a manager of its own assets. If you don’t have faith in the manager, don’t invest in the structure. The sensibilities of the sponsor reflect that. The decision of a sponsor when making decisions about the pool of loans, reflect that.

The servicing standards are consistent with other CRE securitization structures and the information flow to the investors is robust. (Okay, not perfect but robust or on its way to robustness.) CREFC is continuing to work with investors, servicers and sponsors to improve the quality of the data as we have repurposed conduit IRPs for this new asset class and we haven’t quite caught up yet (not for lack of trying). We have added borrower business plans to the disclosure material to give investors better visibility into the future performance of transitional assets. That’s good. The industry is working hard to increase the comparability of Annex As to facilitate comparison across sponsors as well. These are good things. The fact that they’re being worked on is not an indication of prior failure but an industry committed to increasing safety and soundness.

For heaven’s sake, even the NAIC said the CRE CLOs are “attractive” And in a market where there’s a potential for ongoing material inflation, there’s something awfully attractive about well-structured, relatively low LTV floating rate loans.

Our current cohort of loyal investors are benefiting from the fact that other investors haven’t yet figured this out and this lack of demand is supporting outsized returns. So, for you folks who are already active in the space, apologies for this, but for the rest of you, it’s time to get into the pool. The water is fine and they’re serving Mai Tais at the bar.

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