CLOs Make Inroads in CRE Capital Markets

Real estate investment and management firm Harbor Group International recently announced its first collateralized loan obligation, or CLO—a collection of bridge loans on multifamily assets across the US in an aggregate deal worth about $558 million.

“The close of our initial CLO marks a significant progression for Harbor Group International as we grow our debt and alternatives investment platform and adapt our business to meet changing market needs,” president Richard Litton said in prepared remarks. “We intend to continue to leverage our deep multifamily expertise to be a CLO manager and bridge lender on a long-term basis.”

Last year, the company created its bridge lending program, “originating senior mortgage loans for multifamily borrowers seeking short-term financing for new construction and value-add assets,” it said. The company currently manages $2.3 billion in real estate debt.

CLOs and commercial mortgage-backed securities have been in use for years as forms of non-recourse financing. Each creates a bond-like financial instrument, with investors paying money for return of principal and interest from the cash flow of loan payments. But there are key differences between the two vehicles that are worth examining, especially as CLOs continue to gain traction in CRE’s capital markets. 

“CLOs provide more flexibility to make modification and adjust loan terms and structure to meet changing asset conditions,” Joseph Iacono, CEO of Crescit Capital Strategies, tells GlobeSt.com. “This makes the CLO appropriate to hold loans on transitional assets versus stabilized assets which tend to go into CMBS deals. CLOs are really a vehicle to finance a lender’s loan portfolio where CMBS tend to take on more sale-like characteristics.”

CLOs aren’t new to CRE. They are essentially a rebranding of the CDO instruments that ran into big trouble during the financial collapse of 2008.

“With CLOs, commercial real estate borrowers can get a cheaper rate because it can be laid off to the investors,” says Brett Forman, eastern US executive managing director for private lender Trez Capital. “The thesis is that the CLO buys time to improve the quality of the real estate until a permanent takeout loan can be obtained. Investors are clamoring for yield because we are in a yield-starved environment, so CLOs are increasingly appealing.”

“Anything multifamily is seeing a lot of CLO financing until the assets are ready to go for agency [like Fannie Mae or Freddie Mac] permanent financing,” Forman says. “We’re even seeing it for industrial and office product. There isn’t amazing upside with CLOs—it’s like a bond yield but a little better. But with the dearth of yield in general, it’s enticing right now.”

But for investors, timing is everything. “The more junior tranches of CMBS securities are impacted by negative survivorship bias as the higher quality mortgage assets pay off earlier in the deal’s life span, thereby skewing the composition of the overall collateral pool toward lower quality mortgage assets as time goes on,” says Dan Vetter, chief investment officer and co-founder of M360 Advisors. On the other hand, a CRE CLO sponsor can actively manage the collateral pool, “allowing the sponsor/manager to ‘cull the herd’” by swapping poorly performing assets with better ones, “maintaining the overall ‘health’ of the collateral pool.”

In the eyes of some, economic conditions are having an impact on an investor’s CLO-or-CMBS decision. “At the current time, there is a high demand for yield, especially for fixed rate products,” says Gary Mozer, principal and co-founder at George Smith Partners. “This has brought spreads down and made CMBS offerings more competitive.”