Wall Street Engineers Awaken CDOs in Real Estate Deals

Wall Street’s financial engineers are getting creative again.

Commercial real-estate investor H/2 Capital Partners bundled a hodge podge of its holdings -- from bonds tied to skyscrapers and malls to junk-rated bank loans -- into about $400 million of securities. The deal, similar to the pre-crisis transactions known as collateralized debt obligations, included one portion that Moody’s Investors Service gave its highest rating of Aaa.

The investment firm is seizing on a revival of the types of transactions that fueled the property boom in 2006 and 2007, showing the lengths to which investors are going to bolster skimpy yields across credit markets. Such offerings are giving commercial-property investors a wider range of options to fund acquisitions, according to Richard Hill, a debt analyst at Morgan Stanley.

“Investors are willing to take on more risk in the hunt for yield,” the New York-based analyst said in an interview this week. Such deals “in the right hands can be a very powerful and productive tool, but in the wrong hands they can be destructive.”

Sales of CDOs tied to commercial real estate are accelerating after the market lay dormant for five years. While anticipation started building three years ago that they would reemerge, the first post-crisis offering wasn’t completed until September 2012, Morgan Stanley data show.

Market Peak

About $3 billion of securities in 15 deals have been sold since, with six of the offerings brought to market in the second half of 2013, Hill said. He’s predicting that other investment firms will offer similar deals this year.

Issuance surged to a record $50 billion in 2006, before coming to a halt the next year as credit markets started seizing up. H/2 Capital issued about $482 million of similar debt in August 2006, according to Moody’s, before the worst excesses of the property boom began to surface. The deal paid off without taking a loss last year.

“There is potential for supply to increase going forward,” JPMorgan Chase & Co. strategists led by Edward Reardon wrote in a March 28 report.

In H/2’s latest offering, about 20 percent of the total collateral that will be linked to the securities hasn’t yet been selected by the firm, Moody’s said in a March 21 statement. The ratings company didn’t disclose the yields paid by the privately issued debt.

More Yield

The most-senior AAA pieces of commercial real-estate CDOs issued last year were sold to yield an average of about 1.75 percentage points more than the one-month London interbank offered rate, the JPMorgan strategists said in their note last month. The borrowing benchmark, which is the rate at which banks say they lend to one another in dollars, was set at 0.153 percentage point yesterday.

That compares with an average of about 1.5 percentage point more than Libor on similarly rated deals tied to bank loans, according to Morgan Stanley data.

The H/2 deal, which was managed by Wells Fargo & Co., enables the firm to boost returns on its real estate holdings by issuing long-term debt against them. It’s different from other recent transactions in that it’s linked to loans as well as commercial-mortgage bonds, according to two people knowledge of the deal who asked not to be identified because the transaction was private.

Representatives of H/2, Wells Fargo and Moody’s declined to comment.

About 37 percent of the deal is backed by commercial-mortgage securities, including a speculative-grade slice of a $775 million deal linked to hotels and issued by Deutsche Bank AG last year, one of the people said.

Speculative-grade, or junk, debt is rated below Baa3 by Moody’s and less than BBB- by Standard & Poor’s.

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