Managed CRE CDO v. CMBS: Is One Better For A Borrower?

By Jonathan Shils

Until recently, commercial real estate owners had little or no reasonfor weighing the relative merits of obtaining a first mortgage loan to be contributed to a Commercial Real Estate Collateralized Debt Obligation trust (“CRE CDO”) against aloan to be included after originationin a pool ofcommercial real estate mortgage loans supporting commercial mortgage-backed securities (“CMBS”). The real estate mortgage investment conduit (“REMIC”) structure has efficiently provided debt capital to U.S.commercial real estate borrowerssince the mid-1990s and continues to do so to date. CMBS domestic issuance in 2006 exceeded $200,000,000,000. As a result of this influx of capital to the U.S. real estate debt market, acommercial real estate owner may choose among numerous CMBS loan programs competing with one another to provide first mortgage financing for a stabilized, cash flowing property. CMBS should continue to represent a significant portion of U.S. commercial real estate financing by offering highly efficient pricing and proceeds to borrowers.

Prior to 2004/2005, CRECDOs were terra incognita – and deservedly so – to most commercial real estate borrowers. Before those dates, CRE CDOs almost always were comprised solely of REIT debt, and, importantly,unrated and below-investment-grade rated CMBS tranches known as first loss pieces (“B-Piece”), providing long termfinancing to B-Piece buyers,thereby adding liquidity and providing a degree of risk sharing to the CMBS process. But in 2004, B-Notes, mezzanine loans, credit tenant leases, loans and debt-like preferred equity were included with B-Pieces and REIT debt in CRE CDOs. And then in 2005, first mortgage commercial real estate loans – “whole loans” – started becomingcollateral assets in CRE CDOs. Of 81 CRE CDOs issued between 2001 and 2005, only one (Wrightwood CDO2005-1)was comprised entirely of whole first mortgage commercial real estate loans.[1] However, the rapidly changingCRECDOstructures,the evolving composition of managedCRECDOcollateral assets and the recent increase in CRE CDO issuance volume, while still a small fraction of CMBS issuance,indicate that commercial real estate borrowers might now consider obtaining mortgageloans to be included in managed CRE CDOs as an alternative mortgagedebt source for commercial real estate borrowing.

The important“pass through” treatment of the paymentsa REMIC receives under U.S. tax laws comes at a price.[2] Any commercial real estate loan held by a REMIC which does not comply with the REMICstatutory tax schememay cause the entire REMIC to lose its “pass through” taxtreatment. The core motivation of the REMIC tax-rule drafters was the undying fear that the pooled mortgages in a REMIC, meant to constitute a “static” pool of assets, would be used as a forum for active trading or refinancing of existing loans. Strict rules on prepayments and modifications therefore were enacted. Post securitization changes to a CMBS loan held by a REMIC (outside of the narrow parameters of permitted post securitization changes to REMIC held mortgages) jeopardize this “pass through” tax treatment with potentially devastating tax consequences to the holders ofREMIC bonds.

As a general rule, after securitization,a CMBS borrower is not permitted to obtain modification ofa performing loan, obtain discretionary releases of property collateral, encumber the property with junior secured debt, obtain loan advances for the property other than for property protection advances, make optional prepayments in whole or in part during the REMIC two year “lockout” period and usually for most of the loan term, or take any other action requiring the consent on behalf of the REMIC ifthe action requested is notspecifically permitted by the loan documents or completed prior to the loan’s securitization.[3],[4] Additionally, economics of the CMBS bond structure dictate relatively strict call protection, generally now requiring the use of loan defeasance as the singular prepayment option for CMBS borrowers. As a result, a CMBS borrower may incur substantial costs for defeasance. The REMIC’s pooling and servicing agreement controlling both the master and special servicer adds additional restrictions on a borrower’s ability to accomplish post-securitization changes to a REMIC held loan. Additionally, over the past several years,the Financial Accounting Standards Board has considered changes to FASB’s accounting rules which, if ever adopted, may further limit discretionary changes to REMIC-held loans.

The emergence of CRE CDOswhich include commercial mortgage loans may now provide additional access to the global real estate capital debt markets for commercial real estate borrowers requiring flexibility in their loans not presently afforded by REMICs. For example, a loan secured by a property with unstabilized cash flow as a result of the property being “repositioned” in the market would be a candidate for inclusion in a CRE CDO. As described on the following chart comparing CRE CDOs to CMBS REMICs, CRE CDOs, organized as CaymenIsland entities,areclearly more flexible as to the types of real estate loans and the variety of collateral assets they maycontain.[5] Unlike a REMIC, a CRECDO is not required to treat real estate mortgages as “static” assets without detriment to bond holders. Mortgage loans with floating rates, maturities shorter than 10 years, or with future funding commitments as well as other real estate loans not otherwise suitable for or permitted to be held by a REMIC can be included in a CRE CDO.

Active management of the pool of collateral assets is a distinctive CDO feature. Additionally, specific CRE CDO loans often require a higher degree of servicer attention due to their “unstatic” features. For example, aCRECDOmay hold a construction loan with future advances funded through the CRECDO, an impossible task for a REMIC. Unlike a REMIC held loan, a performing loanin a managedCRE CDOcan be modified, have collateral released on a discretionary basis, or even be withdrawn from the CRECDOpool and sold. Another loan may be substituted in its place. Prepayments and other funds may be used to reinvest in replacement assets for the managedCRECDO.[6] The CRECDO structure does not perse prohibit loan prepayments since call protection is not an essential feature.

Since 2004, overall management of the pool of commercial real estate assets through a collateral asset manager has become more prevalent. The collateral asset manager in a managed CRE CDO makesthe key decisions regarding the composition ofthe CRE CDO including investment and reinvestment of CRE CDO funds. The experience and reputation of the collateral asset manager plays an important part in the decision of an investor to purchase managed CRECDO debt since the pool is active, not static. The collateral asset manager’s role and approach to asset management is important to the borrower. Rating agencies also pay close attention to the identities of the CRE CDO’s master servicer and special servicer. Among the companies which have emerged as significant CRE CDO collateral managers are Capital Trust, Inc., Gramercy Capital Corp., Guggenheim Structured Real Estate, NorthStar Realty Finance Corp. and Capmark Investment LP. Major CMBS master and special servicers are or expect to be active in the CRE CDO market in the near future.

The forces driving the recent increase in issuance of managed CRE CDOs – balance sheet management, increasing assets under management, providing sophisticated investors access to complex debt products – are not the focus of our discussion here.[7] Comparisons of pricing, proceeds or investment risk between the two structures are also left to others. Rather, this discussion briefly compares an evolving source of real estate debt financing to the current CMBS model and describes features of CRE CDOs which may provide borrowers with a degree of flexibility not presently permitted to a borrower by the REMIC structure. The following chart, prepared by Wachovia Securities LLC, provides a side by side comparison of features of both structures.

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CDO

1.Issuer: CaymanIsland Trust

2.Able to hold non-mortgage assets:

  • Unsecured debt (e.g. REIT debt)
  • Mezz, Preferred equity (Qual REIT sub)
  • Derivatives (e.g. swaps, caps, CDS)
  • Real Estate Operating Company Debt (secured or unsecured)
  • Unfunded construction loans

3.Structure can issue any bond class as fixed or floating rate

4.First, second or multiple re-securitization of assets

5.Able to fund future advances

6.Ability to manage assets (e.g. static vs. managed, mixed sector, ability to take views on credit), may or may not be fully ramped at closing

7.Call optionality

8.Collateral Quality Tests (if managed)

9.Excess spread goes to equity

10.Structural Protections:

  • Subordination levels
  • Over Collateralization and IC Triggers (no principal write-downs; P&I become fungible)
  • Collateral Quality Tests

11.Offers ongoing management fees

12.Global buyer base

13.First loss class: (Manager)

  • Excess cash flow class
  • No principal write-downs
  • Cash flow can turn on, and off and back on

14.Controlling Class: Senior most class has control

15.Motivations: Mostly financing, occasionally Assets Under Management

16.Servicing: typically retained

CMBS

1.Issuer: Real Estate Mortgage Investment Conduit

2.Trust may only hold mortgage loans:

  • No unsecured debt
  • No derivatives contracts
  • No unfunded real estate loans

3.Generally issues debt of similar basis as assets (external balance guarantee swap, mostly on AAA)

4.First securitization of assets

5.Not capable of funding future advances

6.Staticloan pools, pool 100% set at closing, no ability to manage the pool or substitute loans

7.No call optionality (except % clean up call)

8.No Collateral Quality Test

9.Excess spread sold as Interest Only bonds

10.Structural protections:

  • Only subordination (principal write-downs; P&I have discrete waterfalls

11.No ongoing management fees

12.Primarily U.S. buyer base (fixed rate)

13.First loss class:

  • Fixed coupon
  • Principal write-downs via:
  • Appraisal reductions, Realized losses
  • Cash flow terminates upon 100% write-down

14.Controlling Class: Junior most class (“B-piece” buyer)

15.Motivations: Most frequently arbitrage

16.Servicing: typically sold[8]

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[1]The Evolution of Commercial Real Estate (CRE) CDOs, Nomura Securities, Jan. 4, 2006, at 1-18, available at

[2] Sally Gordon, The CMBS Process; Build-A-Bond; The CMBS Market, inThe ACREL Papers Spring 2004, 10, 11-26.

[3]Joseph P. Forte et al., Matrix of Issues that Matter in Negotiating Real Estate Loans − What’s Really Required by Lenders and Rating Agencies and What an Acceptable Middle Ground May Be, in The ACREL Papers Fall 2001,1,1-62

[4]Mark A. Hill & Richard D. Jones, A Miranda Warning for Potential Conduit Borrowers (or a Checklist for Loan Officers), 3 CMBS World, 6, 6-9 (2001).

[5]Brian P. Lancaster, Understanding Managed CRE CDOs: An Analysis of Their Collateral, Structures, Opportunities, and Risks, 7 CMBS World, 26, 26-33 (2005).

[6]Nicholas Levidy, Moody’s Approach to Reinvestment Criteria in CDOs Backed by Commercial Real Estate Securities, 7 CMBS World, 34, 34-37 (2005).

[7]Thomas F. Kaufman, Collateralized Debt Obligations: Innovation or Fad The Impacts on Real Estate, in The ACREL Papers Spring 2007,277, 277-83

[8]Robert Ricci, CMBS Investors Conference—Commercial Mortgage Securities Association, 1- (CRE CDO 101 2007)