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.
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.
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.
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
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.
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.