The CDO Stands Out

In order to gain market share, lenders are working aggressively to take deals off the street and in doing so are actually assuming some deal risk. For instance, conduit lenders are using their balance sheets to warehouse deals not ready for securitization. Lenders capable of warehousing loans for extended periods of time are closing on transactions for an array of properties, from well-stabilized assets to those in need of repositioning. By utilizing their strengths, conduit lenders in particular have been able to capture more business and borrowers are able to take advantage of existing long-term, fixed-rate debt earlier than they might have otherwise.

Lenders are also taking advantage of positive operating fundamentals, which are prevalent across most major commercial property types. Capital sources are heartened to see rent growth across most product categories and in most markets. It affords underwriters the ability lower debt service coverage requirements. While it has not been unusual to see debt service coverage ratios reduced to 1.10 and below for class A assets, debt coverage ratios are moving to those levels for class B and C product as well. Underwriters justify this aggressive approach on rent growth of 5% to 10% depending on the market and product. Measurable rent growth instills faith in leery lenders and allows borrowers to use future revenue (pro forma) to negotiate current debt levels.

The CDO (Collateralized Debt Obligation) Emerges on the CRE Scene

While CDOs are not new, their use in the commercial real estate arena is. Commercial real estate CDOs were introduced in 1999 and used in to finance CMBS B-piece and unsecured REIT debt. Since then, they have moved into the mainstream to finance bridge and structured finance transactions. Typically, the property being financed needs some form of restructuring or repositioning. The CDO platform can be used in such a circumstance because it offers a great deal of flexibility.

Once a niche play, we expect the commercial real estate CDO market to approach $40 billion by year-end 2006. In fact, the evolution of the CDO in the commercial real estate marketplace has been quite significant. Over the past year, spreads on bridge loans and other structured debt fell from 225 to 300 over Libor to 175 to 225 over Libor for an 80% leveraged transaction. In addition, transactions structured at 90% are not uncommon.

As with all complex structured transactions, lenders typically trust borrowers to understand the product, know the market, have a well devised plan and hopefully have a successful track record. In today's market, borrowers are looking for transactions with sound exit strategies. Most would like to use a refinance strategy as the exit, some are willing to consider a sale strategy, but in either instance the strategy needs grounding supported by a proven plan.

As if their presence in structured and bridge products wasn't enough, CDOs are starting to emerge as vehicles for fixed-rate permanent debt. A number of new programs offer 10- year fixed rates with significant interest-only periods; in most instances five years and in some cases, 10-year interest only periods. Underwriting is accomplished using debt cover ratio of 1.2 to 1.25 on the interest-only payment; 1.05 on the amortized payment. If you need leverage, this is the way to get it and at only an incrementally greater cost; 30 to 40 basis points over standard CMBS underwritten deals. Because of the CDO legal structure the product offers the potential for substitution of collateral, greater pre-payment flexibility and the addition of supplemental loan dollars.

The CDO has given some additional flexibility to the marketplace. In addition, it has forced traditional players, which are typically commercial banks, to compete with a whole new capital source. Only time will tell how the CDO will evolve and how much of the market it will capture. Without question, it has great momentum and could change the way investors look at commercial real estate.

William E. Hughes is a senior vice president and managing director of Marcus & Millichap Capital Corp., based in Irvine, CA. The views expressed in this article are the author's own.