F E A T U R E CDOs

Understanding Commercial Real Estate CDOs and

As the U.S. commercial real estate (CRE) mortgage market approaches $3 trillion, securitized commercial real estate loans, commonly referred to as commercial mortgage-backed securities (CMBS), have become a major force in the new-issue market and attained a 26 percent ($675 billion) market share, up from only 6 percent ($60 billion) a decade ago. With the explosive growth of the CMBS industry, a new investment class consisting of subordinate debt, including mezzanine loans, B-notes, and subordinate CMBS (collectively, subordinate debt), has emerged as a new and permanent component of the modern CRE capital structure. In connection with this new subordinate debt class, which is dominated by private equity funds, mortgage REITs, and other sector-specific investment vehicles, an innovative form of permanent financing has been created through the CRE collateralized debt obligation (CDO) market. From virtual nonexistence five years ago, the CRE CDO market is expected to have annual issuance in excess of $30 billion in 2006 and approximately $75 billion of total outstandings by year-end 2006. The availability of cost-efficient and term-matched funding provided by CRE CDOs to buyers of subordinate debt has revolutionized and fundamentally altered real estate finance, its participants, and market pricing. This article outlines the origins of the CRE CDO market, the drivers of its development, how CRE CDOs are constructed, the major issuers, and the long-term implications for commercial real estate finance.
Edward L. Shugrue III Guggenheim Structured Real Estate

A
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How They Are Revolutionizing Real Estate Finance

A once single-tiered market ... evolved into a two-tiered market ... into a multi-tiered market.
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which has further evolved

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F E A T U R E CDOs
A Brief History Although the CRE CDO market officially began in 1999 with three 1st Synthetic CDO 1st Trust-Preferred CDO 1st Managed CDO securitizations that provided financing for static portfolios of fixed1st B-Note/Mezzanine CDO 1st CDO 1st Whole Loan CDO rate CMBS and REIT debt, the modern CRE CDO market be1999 2000 2001 2002 2003 2004 2005 2006 gan in 2004 (Exhibit 1) with the introduction of the floating-rate, actively managed CDO. This new structure accommodated the Mix of Arbitrage and Financing Transactions Mostly Financing-Driven Transactions many different forms of subordinate debt created by the growing CMBS market and, more important, provided issuers with a flexPrimarily Static Primarily Actively Managed ible term-matched funding tool with the ability to actively manage Sources: Citigroup Global Markets Research, Industry Data Sources: Citigroup Global Markets research, industry data their loan portfolios. Notwithstanding the explosive growth of CRE *credit tenant lease CDOs in the last two years, during which time new issuance has exceeded all prior issuance (Exhibit 2), the CRE CDO market is Exhibit 2: Historical CRE CDO Issuance still immature when compared to the $1 trillion global CDO mar$80 $35 ket (Exhibit 3). In addition, as the CMBS market continues to grow $70 $30 and evolve, so too will the CRE CDO market. $60 $25 The major factors contributing to the need for CRE CDOs are $50 Annual Cumulative $20 $40 the overall growth of the CRE debt market and the increasing im$15 $30 portance of CMBS. The CRE debt market has nearly tripled in size $10 $20 since 1995 (Exhibit 4), and over the same period, CMBS have ex$5 $10 $0 $0 panded from a 6 percent market share ($60 billion outstanding) to 1999 2000 2001 2002 2003 2004 2005 2006* a 26 percent market share ($675 billion outstanding), more than a Sources: Commercial Mortgage Alert, industry data tenfold increase. Moreover, CMBS issuance continues to increase at *based on year-end estimates record-breaking levels, approaching $180 billion of new issuance for 2006, and CMBS lenders are increasingly relying upon subordinate Exhibit 3: Cumulative CDO Issuance by Sector debt investors to complete the debt capital structure for their borrower ($1 Trillion Estimated Through Year-End 2006) clients (Exhibit 4). Synthetic / The evolving CMBS market has led to increased capital tranching, Other greater sophistication, and new subordinate debt investment products. 14% CRE A once single-tiered market (with loans typically provided by a bank or a 8% Balance Sheet / life insurance company prior to 1995) evolved into a two-tiered market Market Value (mezzanine and CMBS), which has further evolved into a multi-tiered 15% market (Exhibit 5, p. 58). Although the total loan proceeds are viewed by the real estate owner/borrower as a single integrated loan with an overall blended coupon, the loan has actually been broken up into an investment-grade A-note (typically securitized in a CMBS trust) and Structured Finance below-investment-grade notes that may include any or all of the follow29% ing: rake bonds (subordinated CMBS certificates), B-notes (subordiHigh Yield nated mortgage interests), and/or mezzanine loans (loans secured by a 34% pledge of the borrowers equity). These new subordinate debt products Sources: Credit Suisse research, industry data are primarily being funded by private equity funds, mortgage REITs, and other specialized investment vehicles.
Key Events in Exhibit 1: the History of CREin the History of CRE CDOs Key Events CDOs 1st CTL* CDO

Cumulative Issuance (in Billions)

Exhibit 4: U.S. Commercial Mortgage Market

1995 $1.0 Trillion
Savings & Loans 11% Other 14%

Annual Issuance (in Billions)

2006* $2.7 Trillion

Other Savings & 9% Loans 7% Agency & Govt. Pools 5% Life Insurance Cos. 10% Banks 43%

Agency & Government Pools 7%

Banks 43%

Life Insurance Cos. 19% CMBS 6%

CMBS: $60 Billion

CMBS: $675 Billion

CMBS 26%

Sources: Federal Reserve, industry data *estimate 

CRE Subordinate Debt: The Building Blocks of the New CRE CDO Commercial real estate debt finance has evolved significantly from a onetiered product to a multi-tiered product, allowing investors to precisely select the level of risk (and compensation) they wish to acquire within the capital structure. In addition to fundamental real estate diligence (asset cash flows, property valuation, market fundamentals, etc.) regarding the investors acquisition decision, other material factors when analyzing a subordinate debt investment include legal structure, subordination (credit enhancement), pricing, and funding.

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F E A T U R E CDOs
Exhibit 6 illustrates the CRE CDO process. An issuer will aggregate a diversified portfolio of subordinate debt investments from which it can create a CRE CDO. Following are brief descriptions of the most typical CRE CDO building blocks. n First Mortgage Loan: A senior mortgage loan secured by an individual property or a portfolio of properties. First mortgage loans for CRE CDOs tend to represent transitional or specialty assets, which may or
Exhibit 5: The Evolution of CRE Capital Tranching
Equity 80% LTV* Equity Mezzanine Equity Preferred Equity Jr. Mezzanine Sr. Mezzanine B-Note 50% LTV Senior Debt Senior Debt BBB/BB CMBS Senior Debt (CMBS) Current Subordinate Debt

Traditional

Early Phase

Source: Guggenheim Structured Real Estate (GSRE) Source: Guggenheim Structured Real Estate (GSRE) *loan to value

Exhibit 6: Building a CRE CDO

Aggregate Subordinate Debt Jr. Mezzanine Contribute to CRE CDO Issuer Equity Distribute CRE CDO Bonds BBB

may not include subordinate financing in the form of a B-note or a mezzanine loan. A first mortgage loan can be tranched in a senior/junior and/or in a pari-passu fashion. Typically, first mortgage loans, or the senior portion thereof, are securitized in the CMBS trust. n CMBS: Interests in investment-grade and below-investment-grade classes of fixed- and floating-rate commercial mortgage-backed securities, including collateralized debt obligations and rake bonds, which are certificated junior participations in individual mortgage loans held inside a CMBS trust but for the sole benefit of the rake bond holder. n B-Note: A subordinated participation in a first mortgage loan, where the A-note has typically been securitized. A B-note is typically immediately subordinate to the investment-grade (and securitized) component of a first mortgage loan and is senior to a mezzanine loan. B-notes can be multi-tranched. n Mezzanine Loan: A loan secured by a pledge of an owners equity interest in one or more properties. A mezzanine loan is typically subordinate to a B-note and is senior to the owners equity. In some instances, a mezzanine loan will reside immediately subordinate to the investmentgrade component of a first mortgage loan (like a B-note). Mezzanine loans can be multi-tranched. n Other Investments: Other investments that may be found in a CRE CDO include (all relating to commercial real estate) bank loans, synthetic or reference obligations, REIT debt, and trust-preferred securities.

How a CRE CDO Works: CRE CDO Construction Once a CRE CDO issuer has aggregated sufficient collateral for a CDO (CRE CDOs typically range from $300 million to $1 billion), the issuer A Sr. Mezzanine will work to shape a CDO. In its most basic form, a CRE CDO is to CDO Bonds AA a real estate lender what portfolio financing is to a real estate owner. By B-Note aggregating a diversified portfolio of real estate loans, just like aggregatAAA BBB/BB CMBS ing a portfolio of diversified real estate properties, the issuer/borrower is able to access more favorable financing. A CRE CDO is typically rated Source: GSRE by two or three rating agencies, including Moodys Investors Service, Standard & Poors, and Fitch Ratings. After assigning shadow ratings Exhibit 7: Typical CRE CDO Pool-Wide Tests and Reinvestment Parameters to each of the underlying collateral assets, a capital Pool-Wide Tests Property Limitations (Maximum) structure is developed for the portfolio based upon Maximum Term: 7 years Retail: 50% various loan and underlying asset criteria and conReinvestment Period: 5 years Multi-Family: 50% centrations (Exhibit 7). Optional Redemption: 2 years Office: 50% In a typical revolving CRE CDO structure, the Weighted Average Rating Factor: 2200 (B+) Industrial: 50% issuer will have the flexibility to make collateral Weighted Average Spread: 2.50% Hospitality: 40% substitutions over the term of the financing. This Maximum Obligor: 10% Other: 10% Herfindahl Score: 15 substitution ability allows the issuer to replace loans Minimum Recovery Factor: 25% that have been repaid, subject to specified criteria, Interest Coverage Test (min.): 115% keeping the CDO fully invested and thereby more Overcollateralization Test (min.): 110% efficiently amortizing its up-front financing costs (typically 1.5 percent of the transaction amount for Geographic Limitations (Maximum) Asset Limitations (Maximum) banking, rating agency, legal, administration, and acCalifornia: 40% First Mortgages: 50% counting fees). The CDO liabilities are then packaged New York: 40% Mezzanine Loans: 50% and sold to third-party, fixed-income investors, such Texas: 30% B-Notes: 50% Florida: 30% Bank Loans: 50% as foreign and domestic banks, insurance companies, Nevada: 30% CMBS: 25% money managers, and other CDO issuers or strucAny other individual state: 20% Other: 10% tured vehicles.
Sources: GSRE, compilation of recently completed transactions 0 PREA Quarterly, Fall 2006

F E A T U R E CDOs
As illustrated in the hypothetical capital structure in Exhibit 8, the weighted average spread over LIBOR of the various classes of issued liabilities is 50 basis points. The true cost to the issuer, however, includes amortized costs and therefore will include a premium of approximately 30 basis points (1.5 percent of transaction costs amortized over a fiveyear expected life). In this example, the CRE CDO has a total funding spread of 80 basis points, which translates into an all-in rate of 6.1 percent in todays market (1-month LIBOR of 5.30% + 80 bps). Who Are CRE CDO Issuers and What Are Their Motivations? Historically, non-CRE CDOs have been issued by asset managers seeking to increase assets under management (or to manage balance sheet risk) and by structured investment vehicles seeking to create managed baskets of specific risk or to arbitrage credit spread anomalies. In both instances, the issuers frequently retain little or no equity (in fact, the equity is often sold to third parties) and the issuer/collateral manager is simply paid a collateral management fee. CRE CDOs are more typically issued by dedicated real estate debt investors who are using the CRE CDO as a permanent financing tool for their portfolios of loan assets. Importantly, and representing a significant distinguishing feature, most CRE CDO issuers retain all the first-loss equity in their CDOs. The retained equity is typically approximately 15 percent of a CDOs notional value (for example, $75 million for a $500 million CDO). The equity investment by the issuer/collateral manager closely aligns its interests with the interests of the bond investorsa particularly important feature for an actively managed structure. There are more than 30 CRE CDO issuers/sponsors that can generally be broken down into three broad categories, which all use the CRE CDO as a financing tool: private equity debt investors, mortgage REITS, and other institutional lenders, such as banks, hedge funds, and asset managers. According to
Exhibit 8: Typical CRE CDO Capital Structure Securities Issued AAA AA A BBB+ BBB Total Offered Bonds Retained Equity Total CRE CDO Principal (in Millions) $275 $45 $40 $35 $30 $425 $75 $500 Credit Enhancement 45% 36% 28% 21% 15%

Commercial Mortgage Alert, private equity funds that have taken advantage of CDO financing include G2/G3 Opportunity Funds, ARCap, Guggenheim, and a number of other recognizable industry players. Given the composition of typical CRE CDO issuers as long-term investors, as noted above, it is not surprising that their primary motivation for issuing a CDO is to obtain non-mark-to-market, term-matched financing for their loan portfolios. Furthermore, the actively managed CRE CDOs that have dominated the landscape for the past two years afford the issuer/sponsor significant flexibility regarding asset substitution/replenishment within pre-specified guidelines. Through asset replenishment, the issuer is advantaged by maintaining an even cost of capital; likewise, the bond buyer is advantaged by maintaining duration at pre-agreed-upon ratings levels with various ongoing compliance tests, ratios, and covenants. Relative Value in CRE CDOs Although this article has primarily focused on the creation and evolution of CRE CDOs and their use as a financing tool for CRE debt investors, there is an active and growing primary and secondary market for CRE CDO debt as an asset class. Historically, the majority of CRE CDO buyers have been made up of traditional CMBS buyers; however, as issuance, research, and trading (liquidity) have increased in the sector, the investor universe has grown significantly domestically and overseas for buyers seeking diversified CRE debt exposure at a slight liquidity discount to traditional CMBS (Exhibit 9). Conclusion Commercial real estate finance has evolved more significantly during the past six years than in any other period. During this time, CMBS have been established as a leading and competitive form of mortgage financing. Commensurate with the growth of the CMBS market, a robust and multi-tranched subordinate debt market has developed, allowing investors to precisely select a level in the capital structure that meets their Coupon* unique risk-reward objectives. In connection with L + 30 bps L + 40 bps the growth of the subordinate debt market, the L + 55 bps CRE CDO market has evolved, though it is still in L + 110 bps its early stages of development. The primary use L + 175 bps for the CRE CDO has been as a financing tool for L + 50 bps dedicated subordinate debt buyers to acquire their loan portfolios with attractive non-mark-to-market, match-funded financing, allowing them to compete effectively for real estate loans with traditional capital providers, such as banks and life insurance companies. Over time, the CRE CDO market should continue to evolve and encompass new products, as it has recently to accommodate entire pools of whole loans (first mortgages) and trust-preferred securities to real estate companies. Given the historical trend lines and growth rates of the CMBS and the CDO markets, the CRE CDO sector should continue to experience significant growth and innovation. n

Source: GSRE, compilation of recently completed transactions *L=LIBOR (London Interbank Offered Rate)

Exhibit 9: Comparison of CDOs and CMBS* Securities Issued AAA Spreads BBB Spreads Investment-Grade Subordination Market Size (est. through 12/06) CRE CDOs 30 bps 140 bps 15% $70 billion CMBS 10 bps 80 bps 3% $675 billion

Sources: Commercial Mortgage Alert, industry data *assumes mid-market pricing and subordination levels 2

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