The word “CLO” may conjure dark memories of the Great Financial Crisis, when another financial abbreviation wreaked havoc on the American economy.
CRE CLO (Commercial Real Estate Loan Obligation) is the successor to CDO and is not a typo. This is a new and improved debt tool and is supposed to be different from another real estate acronym, CMBS.
real deal The Deconstruct Podcast interviewed Dechert attorney and CLO expert Stewart McQueen to break down CLOs and explain their importance in the real estate industry, particularly in the multifamily sector.
First, what is a CLO? Collateralized loan debt is a debt product that allows lenders to finance commercial real estate loans.
“This is primarily a de facto leverage tool for non-bank lenders,” McQueen said. These non-bank financial institutions include companies such as Arbor Realty Trust, LoanCore Capital, Rialto Capital, and Ares Management.
Lenders sell CLO bonds to investors, and as the borrower pays off the debt, the investor is also repaid. On the surface, it shares some similarities with CMBS and even his CDO. However, there are some important differences, including the types of assets supported.
McQueen said CLOs are typically designed for transitional properties, meaning properties that need some work done. CMBS loans, on the other hand, typically guarantee a more stable property.
Meanwhile, CDOs typically consist of “subordinated assets,” as banks sought to mitigate risk by pooling vast amounts of high-risk assets, McQueen added.
However, there are also significant differences in how lenders use these tools.
“The people who originate the loans that are used in CMBS transactions are looking to remove exposure from their balance sheets. They use CMBS vehicles to do that,” McQueen said. “CRE CLOs, on the other hand, are primarily utilized by bridging lenders looking to fund, for lack of a better term, balance sheets or assets.”
CLOs have been around for more than a decade, but only really started to gain popularity in 2018. However, CLO issuance boomed in 2021 as new multifamily investors, many of whom lacked access to institutional capital, discovered the debt tool. It was perfect for them.
Lenders issued $30 billion in CRE CLO bonds in 2021, $24 billion of which went to multifamily investors.
There are also differences in CLO lender-borrower relationships, primarily driven by the transient nature of the ancillary assets.
“These are assets where the borrower, the manager and the CLO are constantly communicating and having a dialogue to ensure that the loans continue to be made,” McQueen said. They may also be more willing to accept loan modifications.
Many of those apartment complexes are currently facing difficulties due to rising interest rates on their floating rate debt and problems with finalizing their debt. However, the rise in non-performing loans highlights important differences between CLOs and CDOs.
CLOs are typically structured so that the lender becomes a junior partner in the investment. If the assets backing the debt are in jeopardy, they will be the last to receive compensation. This structure allows lenders to ensure that investments run smoothly and investors receive compensation.
Unfortunately, many CLO-backed multifamily properties are currently not doing well, with borrowers facing foreclosures across their portfolios. His GVA, one of his major syndicators, defaulted on his $600 million debt.
Still, there are ways for lenders to protect investors in these situations. CLO lenders can replace distressed loans in a CLO pool when they have defaulted or are at imminent risk of default. They accomplish this by buying up bonds in favor of investors.
So far, most of these CLO lenders have been able to successfully avoid problems arising from defaults. Some are less successful. Ready Capital, one of the GVA lenders, suspended interest payments to some investors following a default.
The company is set to face a multibillion-dollar CLO maturity wall this year, potentially putting some lenders and junior CLO investors at risk.
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