Hearing the term “CLO” may conjure up dark memories of the financial crisis, when another financial acronym wreaked havoc on the U.S. economy.
CRE CLOs (Commercial Real Estate Backed Loan Obligations) are the successor to CDOs, and that's not a misnomer. They're considered a new and improved debt tool, and are distinct from CMBS, another real estate acronym.
The Real Deal's Deconstruct podcast spoke with Stewart McQueen, attorney and CLO expert at Dechert, to analyze CLOs and explain their importance in the real estate industry, specifically the multifamily sector.
First, what are CLOs? Collateralized loan obligations are debt securities that allow lenders to fund commercial real estate loans.
“This is essentially a leverage tool for primarily non-bank lenders,” McQueen said. These non-bank lenders include firms such as Arbor Realty Trust, Loancor Capital, Rialto Capital and Ares Management.
Lenders sell CLO notes to investors, who get repaid when the borrower repays the debt. On the surface, they have some similarities to CMBS and CDOs. But there are some key differences, including the types of assets they support.
CLOs are typically designed for properties in transition, meaning they need some renovation, McQueen said, while CMBS loans are typically secured by more stable properties.
CDOs, on the other hand, are typically created from “subordinated assets” and banks seek to reduce risk by pooling together large amounts of risky assets, McQueen added.
But there are also significant differences in how lenders use these tools.
“The people who originate the loans that go into CMBS transactions are looking to eliminate exposure on their balance sheets, and that's why they use CMBS vehicles,” McQueen says, “whereas CRE CLOs are primarily used by bridge lenders looking to fund their balance sheets, fund their assets, if that's not the right way to put it.”
CLOs have been around for more than a decade and really started to take off in 2018. But CLO issuance has really surged in 2021 as new multifamily investors, primarily syndicators without access to institutional capital, discovered this debt tool was a perfect fit for them.
Lenders issued $30 billion in CRE CLO debt in 2021, of which $24 billion went to multifamily investors.
There are also differences in the lender-borrower relationship in CLOs, driven primarily by the transitional nature of the ancillary real estate.
“It's an asset where the borrower, manager and CLO are constantly communicating and interacting to ensure the loan performs,” McQueen said. This could also make borrowers more willing to approve loan modifications.
Now, many of these apartment complexes are struggling because of rising interest rates on floating-rate debt and problems completing the transition.But the rise in problem debt highlights an important difference between CLOs and CDOs.
CLOs are typically structured so that the lenders are junior partners in the investment. If something goes wrong with the assets backing the debt, the lenders are the last to get paid. This structure gives the lenders an incentive to make sure their investment goes smoothly and that investors get paid.
Unfortunately, many apartment complexes secured by CLOs are not doing well right now, with borrowers facing foreclosure across their portfolios. One of the larger syndicators, GVA, has defaulted on $600 million.
Still, there are ways that lenders can protect investors in such situations. CLO lenders can replace problem debt in a CLO pool if there is a risk of default or imminent default. They do this by buying out the debt in favor of investors.
So far, most of these CLO lenders have been able to successfully avoid problems arising from defaults, but some have been less successful. One GVA lender, Ready Capital, suspended interest payments to some investors following a default.
Billions of dollars in CLOs are expected to mature this year, putting some lenders and junior CLO investors at risk.
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