These real-estate loan securities are growing in number, requiring strong, fundamentals-based analysis.
Over the last few years commercial real estate (CRE) collateralized loan obligations (CLOs) have moved from the fringes of the securitization market and now are entering the mainstream. Following a record year for issuance in 2018, issuance is 29% higher year to date (YTD) in 2019 and poised to continue that growth trajectory following what is expected to be a light calendar through Labor Day. This couldn’t have come at a better time for some investors, as the issuance of traditional pooled commercial MBS (CMBS) transactions (conduit) has failed to meet expectations given that 2019 YTD total issuance is running behind las year’s pace and is 35% lower than the 20132015 average. As a result, this emerging subsector now represents 20% of all private-label commercial mortgage issuance this year (Exhibit 1), and Western Asset expects issuance to continue growing.
Exhibit 1: CRE CLO Issuance Continues to Grow
Source: J.P. Morgan and Commercial Mortgage Alert. As of 26 Jul 2019. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
Although this growth has been an important theme for the broader market, the complexity of the sector and its emergent status require increased scrutiny. This has led some investors including Western Asset to approach the space with an abundance of caution. In essence, these transactions borrow “technology” from the corporate bank loan market that has a long and established history and cross it with small- and medium-balance transition commercial mortgages. Before the great financial crisis, these types of loans were either held on balance sheet by originators/investment banks or they were securitized as small portfolios/included in collateralized debt obligations (CDOs). Although structurally these deals are CLOs, there are a number of differences between them and corporate CLOs, most of which are detailed in Exhibit 2.
The two most important differences are the respective sizes of the markets and the motivations for including the loans in a securitization. The size of the outstanding CRE CLO market is approximately 5% of its corporate cousin, which—although the former is growing strongly—does pose challenges to the transparency and liquidity of the securities in the secondary market and is a concern for Western Asset. However, the rationale for securitizing these assets in the first place and the differences in structure are skewed more positively in favor of CRE CLOs. For example, most CRE CLOs are issued by loan originators looking to diversify their funding sources and to lengthen the duration of their funding. On the other hand, corporate CLOs are issued primarily as arbitrage vehicles when market conditions accommodate. That is also one of the reasons why the amount of structural leverage in the CRE CLO transactions is on average less than half of what is found in corporate CLOs. Despite the differences in motivation, the credit enhancement levels for investment-grade rated bonds is nearly twice that of similarly rated CLO securities.
Exhibit 2: CRE CLOs vs. Corporate CLOs
Source: J.P. Morgan and Markit. As of 26 Jul 2019. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
Western Asset’s Mortgage and Consumer Credit Team carefully monitors the issuance market in this growing sector, including the credit, structure and anticipated liquidity of these transactions on a programmatic basis. Now more than ever, the growth and complexity of this sector demands careful analysis and scrutiny.
Collateralized loan obligations (CLO) are the same as collateralized mortgage obligations (CMOs) except for the assets securing the obligation. CLOs allow banks to reduce regulatory capital requirements by selling large portions of their commercial loan portfolios to international markets, reducing the risks associated with lending.
Collateralized mortgage obligations (CMO) are securities backed by a pool of pass-through securities, which consists of several classes of bondholders with varying maturities. The principal payments from the underlying pool of pass-through securities are used to retire the bonds on a priority basis as specified in the prospectus.
A Commercial Mortgage-Backed Securities (CMBS) is a type of mortgage-backed security that is secured by the loan on a commercial property.
A Mortgage-Backed Security (MBS) is a type of asset-backed security that is secured by a mortgage or collection of mortgages.
Collateralized debt obligations (CDO) are a kind of asset-backed security, holding a pool of collateralized debt, such as mortgages and auto loans, that may be subdivided into various tranches representing different levels of risk.