Wall Street Returns to Property CDOS in Yield HuntSarah Mulholland
What’s old is new again on Wall Street as banks tap into soaring demand for commercial real estate debt by selling collateralized debt obligations, securities not seen since the last boom.
Sales of CDOs linked to everything from hotels to offices and shopping malls are poised to climb to as much as $10 billion this year, about 10 times the level of 2012, according to Royal Bank of Scotland Group Plc. Lenders including Redwood Trust Inc. are offering the deals for the first time since transactions ground to a halt when skyrocketing residential loan defaults triggered a seizure across credit markets in 2008.
The rebirth of commercial property CDOs comes as investors wager on a real estate recovery and as the Federal Reserve pushes down borrowing costs, encouraging bond buyers to seek higher-yielding debt. The securities package loans such as those for buildings with high vacancy rates that are considered riskier than those found in traditional commercial-mortgage backed securities, where surging investor demand has driven spreads to the narrowest in more than five years.
“Investors are willing to go further afield in their quest for yield,” Ed Shugrue, Chief Executive Officer of Talmage LLC, who oversees $2 billion of commercial property debt in New York. “With demand rich, Wall Street is scouring the cupboards to find anything with a cash flow that can be securitized.”
The deals could help borrowers owing more than their properties are worth who would otherwise be unable to refinance, said Richard Hill, a debt strategist at RBS in Stamford, Connecticut. About $450 billion in debt that was arranged before markets tumbled in 2008 matures through 2017 and commercial property values are still 22.4 percent below the 2007 peak.
CDOs pool loans or bonds into new deals with varying levels of risk and return. In the residential market before the credit crunch, that included securities backed by subprime home loans, which helped inflate the U.S. housing market and fueled more than $2 trillion of losses and writedowns at financial institutions globally.
Commercial real estate CDO issuance peaked at $65 billion in 2006 before the market collapsed in 2007. While CDOs tied to commercial mortgages typically fared better than those linked to residential, certain types performed better than others, according to Hill.
“There is no doubt that CRE CDOs were abused prior to the crisis,” Hill said. “If done appropriately, CRE CDOs provide a very valuable financing tool.”
Redwood, which has also led a revival in selling securities tied to home loans without the backing of the U.S. government, sold $172 million of bonds linked primarily to commercial mezzanine loans in November, the first sale of its type in five years.
The transaction, arranged by UBS AG, includes 30 loans on buildings ranging from the Gansevoort Hotel in Manhattan to the RiverTown Crossings shopping mall in Grandville, Michigan, according to data compiled by Bloomberg. Mezzanine debt is repaid after the first mortgage and can bridge the gap between how much a landlord owes and how much the property is worth.
The deal “increases our ability to make additional investments in commercial real estate in an industry where there is more capital needed than there is capital” available, Michael McMahon, a managing director at Redwood, said in a telephone interview.
The Mill Valley, California-based firm kept the so-called subordinate tranche, which is first in line to incur credit losses. “We are certainly standing behind the deal which is consistent with Redwood’s strategy as a credit investor,” he said. Redwood this month sold bonds tied to $398 million of so-called jumbo mortgages, following six sales last year that packaged almost $2 billion of the loans, according to data compiled by Bloomberg.
NorthStar Realty Finance Corp., a New York-based commercial-property lender and investor, issued $351 million of securities linked to so-called transitional properties in October. The mortgages were taken out on the expectation that income from the buildings will increase, with vacancy rates as high as 40 percent, according to deal documents.
At the Cherry Hill mall in Cherry Hill, New Jersey, the value of the property is forecast to climb to $115 million by December 2014 from $100 million as of June, the documents show.
Representatives from NorthStar didn’t respond to e-mails and phone calls seeking comment.
Firms aren’t marketing the new deals as CDOs, Hill said, even as the securities contain the same type of collateral found in CDOs completed prior to the crisis. Some are seeking to label them collateralized loan obligations, which are typically linked to corporate loans often used to fund leveraged buyouts.
Issuers are attempting to draw greater distinctions between different types of offerings, said Tad Philipp, an analyst at Moody’s Investors Service.
“During the boom, CDO was the umbrella term for everything,” Philipp said in a telephone interview. “That’s not the case now.”
Bond buyers are latching on to the debt as property values stage an uneven recovery across the U.S., with large cities such as New York and San Francisco recording the biggest gains, according to Moody’s Investors Service. Commercial real estate prices have climbed 27.7 percent since bottoming in November 2009, according to the Moody’s/RCA Commercial Property Price index.
Traditional CMBS sales are poised to climb 50 percent in 2013 to $60 billion as demand soars, according to Deutsche Bank AG, and lenders are set to issue $8 billion in deals this month, the highest monthly volume in five years. The $550 billion market shut down in 2008 after a record $232 billion was sold in
Money managers putting new investment mandates to work this year have contributed to increased trading and a “sharp tightening in spreads,” Barclays Plc analysts Keerthi Raghavan and Aaron Haan wrote in a report last week.
“Cash inflows into fixed income funds have remained elevated over the last year and despite the significant tightening, CMBS remains attractive” compared with similarly rated assets, such as corporates, they wrote.
The extra yield investors demand to own top-ranked commercial-mortgage bonds rather than Treasuries has narrowed to 1 percentage point from 2.23 percentage points at the end of 2011, according to a Bank of America Merrill Lynch index, about the narrowest level since July 2007.
Shrinking yields on CMBS are pushing investors to look for higher-yielding assets, said Hill of RBS. “CRE CDOs are the next frontier.”
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