With CRE CLO issuance gaining in popularity following Blackstone Mortgage Trust’s USD 1bn deal late last year, and with others following suit or considering it, it might seem like CLOs are back and here to stay. But the current enthusiasm for the once-maligned debt vehicle is likely short-sighted, especially for smaller players, said Jeff DiModica, President of Starwood Property Trust.
“Until late last year, it was significantly cheaper to use CLOs and unsecured [high yield debt]” to finance many commercial real estate assets, he said, than to use a warehouse line of credit. Warehouse lines had, of course, become the loan of choice for mortgage REITs in recent years.
But in the last few months, high-yield spreads have widened related to fears that corporate debt is overleveraged. And while CLOs remain cheaper than warehouse lines, the nature of their structure often means some issuers will face significant risks as interest rates rise, DiModica said yesterday, speaking on the sidelines of the 2018 KBW Mortgage Finance Conference in New York.
The CLO market’s quick growth is poorly timed for smaller players, he said, because the warehouse lines or repo loans major players such as Blackstone and Starwood use to create leverage are bound to become less expensive over the next year, with pricing set to dip to Libor+ 100bps or so for select borrowers. Perhaps ironically, part of what will compress spreads on warehouse lines for banks is the competition from CLOs.
Cheaper leverage for larger players, however, means they reap comparatively higher yields, and hold a significant advantage over their smaller brethren—who may not even be large enough or have the relationships to take warehouse lines, and who could pay as much as 60bps more for them if they do. The already staggering advantage of being a massive lender and borrower could be further magnified.
Those less established issuers could also find themselves at a significant disadvantage in terms of prepayment risk. First, as rates rise, floating-rate loans pay off earlier, and those payouts wipe out the highest (and cheapest) tranches of the CLO. And then, because those issuers have likely been urged to have a more diversified asset pool by ratings agencies, there are more individual properties in the CLO—and more prepayment risk.
On top of that, as CRE executives consistently say, the US real estate cycle is in its “final inning.” Even the Starwood President, whose firm may stand to gain from an overabundance of CLO issuance, doesn’t want it. “It will get worse for everybody if [CLO issuance] is too active,” DiModica said on a panel at the KBW conference. “For small shops… it might not end so well.”
by Guelda Voien