Lending

Greater Access

CDOs offer small investors financing options.

After an extended period of worry-free financing thanks to low interest rates, the lending environment finally is beginning to tighten. Rising interest rates have ushered in a new mindset among lenders and investors, yielding such factors as downward pressure on prices and an overall compromise in underwriting practices. As a result, many traditional capital sources, such as credit companies, now virtually have disappeared from the market, significantly diminishing the availability of bridge financing options.

The commercial mortgage-backed securities market, one of the greatest success stories of the commercial real estate market, also is beginning to feel the pressure. CMBS lenders have lowered their debt coverage ratio from 1.20 to 1.15, and while most of the CMBS lenders have nearly doubled their volume, they have experienced a decrease in profit.

Financing Options

While the days of “can’t miss” transactions and deep pools of available capital now are mostly in the rearview mirror, there remains good reason for cautious optimism.

Despite a falloff among traditional bridge lending sources, the capital markets still are flush with money as a staggering number of new sources continue to enter the market. This is the direct result of the growing significance of commercial real estate as a viable investment option.

This has prompted Wall Street to take a much more active role in the industry. While CMBS historically has been the main offering available for commercial real estate finance, the changing market requires a more versatile option that addresses a broader array of product types and is not limited solely to the senior portion of the loan. After several years of introduction and refinement, the collateralized debt obligation appears to be the perfect solution.

CDO Capabilities

Similar in principal to a CMBS loan, a CDO is a securitized collection of real estate debt instruments employed to provide financing for a commercial real estate transaction. However, CDOs provide a much more versatile means of financing commercial real estate.

CDO assets remain on the holder/issuer’s balance sheet, in contrast to CMBS where the loans are sold. Typically, the issuer retains the most junior piece of the debt and the below investment-grade-rated bonds, which typically total 10 percent to 20 percent of the security’s capital structure. The collateral may include first mortgages, B-notes, bridge loans, mezzanine loans, CMBS, residential mortgage-backed securities, and trust preferred stock.

One of the largest advantages to the CDO is its ability to leverage higher risk levels. Prior to the CDO’s advent, Wall Street was unable to leverage successfully against the inherent risk associated with nontraditional product types. Instead it chose to focus primarily on the office, industrial, and retail markets. CMBS, for example, generally aims to create a homogenous pool of cash-flowing mortgages, often diversified by product type and geographic location. CMBS loans also primarily are connected to senior debt from first mortgages and almost solely rely on cash-generating assets.

Conversely, CDOs represent the first securitized means of providing non-recourse debt against the inherent risk associated with unstable transactions, such as land, empty buildings, single-tenant buildings, or value-add plays. As investors now actively seek investment opportunities via nontraditional product types, the need for a more versatile financing option is finally being met.

CDOs also are capable of providing stability amidst changing market dynamics. The assets in a CDO may be both floating-rate and fixed-rate debt instruments, while the bonds may be floating-rate or a combination of floating-rate and fixed-rate bonds. Interest rate swaps can provide the issuer with protection against interest rate movements.

New Options

The CDO strategy provides a number of unique advantages previously unavailable in real estate finance by diversifying the risk in pools and allowing for better execution. CDOs also provide bond investors with a more diversified profile of lending sources that encompasses capital from banks, life insurance companies, credit companies, and additional lenders.

Another key advantage is CDOs’ ability to provide a “one stop shop” for financing. In the past, obtaining higher leverage required the investor to obtain senior debt from one source and mezzanine debt from another. CDOs are capable of writing both the senior and mezzanine debt in one loan and selling the risks off to various investors.

Finally, CDOs work to small investors’ advantage by providing them with non-recourse financing that previously was unavailable. Institutions primarily are interested in larger transactions and rarely display an interest in anything below the threshold of $25 million. However, CDOs are capable of providing financing for middle-market transactions in the area of $7 million, which historically was difficult to find.

As CDOs continue to grow in influence, they are expanding their capacity and lowering their capital costs, resulting in a number of benefits to the borrowing community.

Gary Mozer

Gary Mozer is managing director of George Smith Partners, a real estate investment banking firm in Los Angeles. Contact him at gmozer@gspartners.com.

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