Wall Street Journal – Investors show an appetite for higher-yielding debt and an expectation that business properties will rebound after Covid-19 shutdowns
Sales of securities backed by riskier commercial real-estate loans have surged to a record, highlighting investors’ demand for higher-yielding debt and expectations for a recovery in business properties.
Commercial real-estate collateralized loan obligations are created by private real-estate investors. In these deals, lenders sell debt and equity to make short-term loans to borrowers that renovate business properties, particularly multifamily housing. Money from interest payments and principal from the pool of bridge loans goes to bondholders, while any residual cash goes to equity holders.
Bridge loans are typically made to properties in flux, such as empty or outdated apartment buildings, and the renovations they finance can fail to pay off as quickly as expected, leading to delayed repayments and defaults. As a result, CRE CLOs offer relatively high payouts at a time many investors continue to expect commercial properties to rebound further from the pandemic.
Firms including Benefit Street Partners and TPG Capital sold $24.5 billion of CRE CLOs this year through July 31, according to Trepp. That is already a full-year record for data going back to 2014, beating 2019’s previous $19 billion peak.
This year’s record sales are a reversal from 2020, when shutdowns related to the Covid-19 pandemic caused some loan borrowers to delay renovations or skip interest payments, increasing default rates. Issuance of new commercial mortgage-backed securities fell to its lowest total since 2017, around $65 billion.
Sales of other floating-rate debt have also surged. Some analysts and investors say that strong U.S. economic growth and high inflation, which erodes the purchasing power of conventional bonds’ fixed payments, will prompt the Federal Reserve to increase rates sooner than expected. That is fueling record issuance of floating-rate corporate bonds and CLOs that buy low-rated corporate loans.
Sales of CRE CLOs have for the first time exceeded issuance of what investors call conduit commercial mortgage-backed securities, which are backed by a more diverse portfolio of bank loans, typically to properties with more-stable cash flows. That is notable because conduit commercial mortgage-backed securities make up the largest source of supply in the mortgage-bond market. This year’s conduit CMBS sales totaled $17.3 billion through July 31, according to Trepp.
“I can’t think of a period this far into the year where the CRE CLO market has had a lead over conduit, let alone one of this magnitude,” said Darren King, head of commercial mortgage-backed securities at Trepp.
The discrepancy between these two assets reflects the mixed recovery in U.S. commercial real estate, analysts said. CRE CLOs typically mature in three years, and about half of the loans are tied to multifamily housing. A housing boom has pushed home prices to records and investors such as Blackstone Group Inc. to bet billions on buying and renting homes.
By comparison, conduit CMBS sales are backed by fixed-rate loans with longer maturities to hotels, offices and retail. The pandemic has made investors more cautious toward longer-dated loans to such properties, said Simon Deery, co-head of structured products at Payden & Rygel Investment Management.
“That has pushed people away from conduit, and then makes the CRE CLO look more interesting,” he said.
Institutional investors, including insurance companies and pensions, have sought out high-yielding, investment-grade-rated debt with short maturities to match shifting liabilities and park cash.
The median extra yield, or spread, investors have demanded to hold triple-A-rated CRE CLO bonds sold this year was recently around 1.13 percentage points over the London interbank offered rate, or Libor. The three-year Treasury note traded Monday at roughly 0.32%.
CRE CLO debt isn’t without risk. About 2.5% of borrowers on more than $80 billion of underlying loans tracked by Kroll Bond Rating Agency Inc. have missed payments since June 2013. When including maturity extensions or other loan modifications, that rate rises to 7.8%.
Recent data suggests that broader CMBS impairment rates have improved with the economy in recent months. The Trepp CMBS delinquency rate fell for the 12th straight month to about 6.1% in June, the lowest level in over a year. Loans in special servicing dropped to about 8.2%, around pre-pandemic levels.
Some real-estate fund managers are taking advantage of low rates and demand for floating-rate debt to reduce reliance on bank credit, says Jade Rahmani, an analyst at Keefe, Bruyette & Woods Inc. That is because those credit lines tend to come with margin requirements, meaning banks can ask investors to put up extra cash when markets are volatile.
“In the CRE CLO space, there’s not that same margin-call feature,” he said.
CRE CLO managers typically keep some equity in their deals, pushing them to reduce debt costs and finish projects.
Mortgage lender Ladder Capital Corp. raised $650 million through its first managed CRE CLO sale earlier this year. Investor demand was so strong that the company increased the sale by $250 million, while the final interest rate fell below original expectations. Chief Executive Brian Harris said during the company’s July earnings call that other lenders are probably looking for new loans to bring more CRE CLO deals.
“I think a lot of the originators in the country are targeting assets for the CLO market,” he said.