Investors are snapping up commercial real estate collateralized debt obligations (CDOs) in ever greater numbers. Issuance volume more than tripled last year, from approximately $6.5 billion in 2004 to more than $21 billion in 2005, according to Wachovia Securities.

Like a commercial mortgage-backed security transaction (CMBS), a CDO is essentially a collection of debt instruments. The CDO issuer converts the pool of loans to bonds offering varying levels of risk and rewards, and sells those bonds to investors who receive regular returns from the cash flow of loan payments. The pool of assets in a CMBS deal is generally limited to senior mortgages, but the more versatile CDO can include almost any form of debt that generates a cash flow.

“CDOs are becoming the preferred way to finance floating-rate loans on the balance sheet,” says Tad Philipp, managing director of the CMBS group at Moody's Investors Service.

What's propelling CDOs?

Last year's record CDO issuance is astounding for a financing method that only became available to the industry in 1999. In fact, the real surge in commercial real estate CDO issuance has been in the last two years following key CDO structural changes the industry adopted in 2004. Specifically, many new CDOs feature revolving transactions that enable a fund manager to buy replacement collateral as debts in the pool are paid off.

Before CDOs, CMBS was the only securitization option available for real estate debt, and CMBS transactions were typically limited to the senior portion of first mortgages. The subordinate portion of those loans, called B-notes, were left out of the CMBS deal and either held on the lender's balance sheet or sold to one of a small number of buyers.

The first commercial real estate CDOs were a way for buyers of subordinate interest in CMBS loans to arrange financing, and most involved static pools of fixed-rate, long-term notes. As in a CMBS transaction, the pooled CDO assets lessened the impact of individual defaults, while tranching enhanced credit quality.

With the introduction of revolving transactions, CDOs were able to securitize a range of real estate debt including mezzanine loans, construction loans and other obligations with short terms or with a strong likelihood of being paid off early, since that collateral could be replaced to maintain cash flow from the pool.

“There was this whole set of untapped commercial loan assets, all these B-notes and mezzanine debt, that no one could securitize before,” says Brian Lancaster, head of structured products research at Wachovia.

The more liberalized CDO structure couldn't have come at a better time, coinciding with a surge in demand for secondary financing on commercial real estate.

Although property values have appreciated recently, owners of commercial real estate are often restricted by conditions of their CMBS loans from obtaining a second mortgage or refinancing. In order to liquidate their increased equity in such cases, owners may take out a mezzanine loan, which is secured by a pledge of the owner's equity rather than the real estate asset. Where the first mortgage prohibits a mezzanine loan, owners may issue preferred equity, which is a senior interest in the entity that owns the property.

Global opportunities

With much of the world's investment capital seeking placement in commercial real estate, lenders are eager to help property owners liquidate portions of their equity and refinance through CDOs.

“Bond investors have made it clear there's a market for greater risk and higher yield,” says Gary M. Tenzer, co-founding principal at real estate investment banker George Smith Partners Inc. in Los Angeles. “The CDO is just a means to liquefy the higher risk tranches.”

The commercial real estate CDO has given the world access to a market that was previously the purview of a handful of players with the expertise to evaluate B-notes, bridge loans or mezzanine debt, Wachovia's Lancaster says. In addition to providing a more efficient means of financing for lenders, the CDO has enabled buyers with limited real estate expertise to rely on rating agency assessments of the top tranches in a CDO.

The variety and complexity of CDO structures make comparison shopping difficult, even for the institutions that purchase most of these instruments. Investors must remember that the commercial real estate CDO market lacks a track record. For that reason, each deal needs to be evaluated individually, taking into account the quality of the asset manager and of the underlying collateral, according to Joe Chinnici III, managing director of the structured products group at KeyBanc Capital Markets. “There are no cookie-cutter deals.”