Property owners and operators have been tapping Wall Street and private real estate investment funds in ever increasing numbers to finance unstabilized or outside-the-box deals. An unrelenting push by institutional investors to deploy more capital into commercial real estate has added fuel to the fire, driving financing to record volumes. It's clear why many observers believe the stunning growth of highly structured real estate lending via commercial mortgage-backed securities (CMBS) conduits is a performance that won't be repeated.

Some mortgage bankers and financing providers point to extremely favorable terms — maximum loan proceeds at low interest rates and with flexible repayment schedules — as the potential undoing of the hot commercial real estate sector. This has become a widely-held opinion among analysts, as lenders continue to push the credit quality and leverage envelope in order to win new funding business.

Market observers also believe that many of these risky deals will eventually go bad, and that they have the potential to plunge the commercial real estate marketplace into a period of losses much like the late 1990s. However, since the advent of the commercial real estate collateralized debt obligation (CDO) product, the pipeline of available funds for risky deals appears to have recently been turned on.

New global capital sources, as well as institutional investors who have long been around the commercial real estate business, have now set their sights on more risky property transactions to achieve higher investment yield. Their objective is to bolster what has become meager real estate returns in recent months. At the head of the table are private mortgage real estate investment trusts (REITs), pension investment funds, private equity investors and analytics-driven hedge fund traders.

Burgeoning investment vehicle

CDOs, which have long existed in the corporate and asset-backed debt marketplace (including residential mortgages and credit card debt), are an emerging method for high-yield investors to buy commercial real estate assets. A lower investment grade than its CMBS cousin, the product allows owners to secure flexible short-term financing for unstabilized properties.

CDO issues include loans for condo conversions, construction, substantial rehabs, and acquisitions of properties that need to be leased up. As a result, year-to-date issuance as of early September was more than $23 billion — easily eclipsing the $20.5 billion issued in the entire previous year (see chart above).

“Going forward, you can expect to see a record amount of investment capital continuing to be directed at the U.S. commercial real estate market, and you can bet that the bulk of that capital will be directed at the CDO space,” predicts Robert Ricci, managing director of Wachovia Securities, one of the emerging leaders in the issuance of these new securities. Ricci's assessment came recently during the first conference on CDOs organized by the Commercial Mortgage Securities Association (CMSA).

This capital-markets product has grown in such popularity that it is now the subject of new conferences and discussion modules at trade conventions — including the first such meeting recently organized by the Mortgage Bankers Association (MBA).

CDOs vs. CMBS

Borrowers who have benefited from favorable loan terms that CMBS conduit lenders offer have also discovered the painful limits such attractive financing programs can bring. When a loan is closed and pooled into a CMBS issue, the borrower must abide by the strict rules and guidelines of that loan for its life or (more probable) for a specific period.

These loans have strict prepayment penalties and yield maintenance requirements to lending institutions or bond investors. They also place restrictions on what the property owner can do with the real estate asset during the life of the loan.

Because of these limits, borrowers have had to employ a rather expensive method of prematurely exiting CMBS loans — the loan defeasance process. Defeasance is a form of paying off a CMBS loan without violating the terms of a securitization agreement. To defease a loan, the borrower must replace that loan with a similarly yielding asset that has little potential for losing its value over time.

The CDO product, however, was designed to take this sting out of capital markets structured financing for property owners and managers. It allows borrowers to maintain flexibility in the operation of a real estate asset, while that asset remains in a securitized pool.

For one thing, the CDO structure allows the collateral manager (the person or organization responsible for the administration of the pool of assets in the structure) to pull a loan out of a pool, if that loan/borrower fails to perform as expected. For this reason, CDOs — unlike CMBS structures — can include borrower obligations backed by unstabilized real estate, or mortgages that are junior liens in an asset.

“Until recently, originators of loans for unstablized assets would have had to fund these high-risk deals out of their capital accounts, or funds provided by high-yield investors,” says Ricci. “But now these originators can deploy funding directly from CDO issuers on a timely and orderly basis.” Borrowers benefit from the instrument because it allows them to get funding for difficult deals, obtain high leverage, and close deals faster.

To be sure, while the ultimate destination of a loan into a CDO structure is transparent and of no real consequence to a borrower, it is important to note that the financing terms can sometimes be close to those of conventional term lending. The investors who provide the funding, on the other hand, are happy with these deals because they provide access to highly profitable real estate transactions, while being adequately compensated for the additional risk they take on.

“You can expect to see more high-risk loans like mezzanine deals finding their way into these structures in the coming months,” predicts Robert Foley, chief financial officer of New York-based Gramercy Capital Corp., an issuer of CDOs, and manager of pooled assets. Foley says that in addition to loans that can't make it into ordinary CMBS deals, mezzanine loans will become a major commodity in new issues.

Jenny Story, a managing director at Fitch Ratings in New York, says that as short-term and unstabilized loans go into CDO issues, the investors who eventually buy these products look for assurance that collateral managers are capable of working with property owners and operators to ensure acceptable performance of these assets. Story is head of a new commercial real estate CDO ratings group at Fitch, and predicts that the sophisticated players on Wall Street will eventually find a way to develop risk assessment standards for borrowers, issuers and investors.

“If there is one thing that Wall Street is good at doing, it is finding and eradicating inefficiencies in structured products,” says Ricci. “The rating agencies — which are the ultimate gatekeepers of risk for investors who buy CDOs — will certainly be looking at these developments in order to do an acceptable job of separating the good deals from the bad ones.”

Borrower beware

While CDO issuers represent an excellent source of direct funding for high-leverage, impaired or otherwise unstabilized properties, owners and managers must be aware of the risk of substantial loss. It is not unusual for a property owner to experience a 100% loss if an asset fails to perform to the satisfaction of high-risk lenders and investors.

“Collateral managers, unlike typical CMBS master servicers, are usually experts at loan workouts, or have deep enough pockets to buy a bad deal out of a collateralized pool and bring it to a quick resolution,” says Ricci. “Remember that most of the players who manage these pools of loans are the experienced B-piece players of old from the CMBS space, and they already have a history of loan workouts or otherwise resolving bad deals.”

Ricci's comments imply that collateral managers — who usually retain the highest amount of risk in a structured security issue — are trained to protect the investment of their shops by taking over the asset in the event of a borrower's default. This also suggests that owners and managers must be on target with their real estate performance projections, particularly those that include lease-up or other asset-repositioning activities.

Since these loans are usually tied to a future event such as condo conversion unit sales or the lease-up of a rehabbed property, borrowers must be certain they can reach their projected results. High-risk loan managers rely heavily on owners and managers to understand the nature of their unstabilized assets well enough to make CDO investors comfortable with these transactions.

The ultimate risk to a borrower is that in the event an asset fails to meet its projected target, the collateral manager will step in and take control of the asset and let the chips fall where they may.

W. Joseph Caton is based in Connecticut.

CDOs raise real estate ownership stakes

A more sophisticated level of market efficiency has emerged in the commercial real estate ownership world, requiring today's real estate manager to take the business to the next level, or run the risk of being taken out of commission. The recent rash of leveraged buyouts of publicly listed REITs is the quintessential example of what happens to real estate managers who don't perform at the next level.

That next step, say capital market observers, is being driven by the collateralized debt obligation (CDO) space. For instance, CharterMac, a mortgage real estate investment trust based in New York, has made an unprecedented move into the commercial real estate CDO market through its recent acquisition of ARCap REIT Inc. ARCap is a high-yield mortgage investor renown as one of the elite high-risk commercial mortgage-backed securities (CMBS) players that are commonly called “B-piece” buyers.

CharterMac's surprising acquisition gives it direct access to the real estate asset management business. Properties that are part of commercial real estate CDO issues represent an area that traditional real estate owners and managers must seriously consider as the fast track for taking their business to that desired next level.

“In 2007 and 2008, we expect to see a lot of high-risk commercial real estate loans mature,” says Bryan Carr, CFO of ARCap. “With those significant events, we also expect to see a real spike in maturity defaults.” Carr's comments were directed toward commercial real estate lenders gathered in New York for a conference organized by the Commercial Mortgage Securities Association (CMSA).

Carr noted that property owners are used to the flexibility of short-term deals and high-leverage loans, and cautioned that these lending products were designed in an environment of rising property values. He says that once loans mature and property values are no longer rising as sharply as in the past, there will be fallout that the CDO marketplace will have to contend with as collateral managers.

Investment managers who have traded out of properties at healthy internal rates of return must compete in a capital-rich marketplace to buy new assets. That's more difficult than many had anticipated, causing traditional real estate pros to consider buying access to real estate through structured products like CDOs.

CharterMac has long been known as a capital provider, rather than a real estate investor. But if traditional property investors are to remain competitive, they must own portfolios of real estate, as well as portfolios of investment- and non-investment-grade CDOs, CMBS, and even synthetic real-estate related securities.
W. Joseph Caton