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Commercial real estate

When speaking to market participants about the intricacies and benefits of CRE CLO technology, more frequently than not the first point that I have found myself explaining is the difference between a CRE CLO and CMBS. It is certainly a fair question, as ostensibly both products are the same given that they both feature loans secured by commercial real estate and the resultant investment piece is a rated debt instrument.

However if you peel off the label and take a more forensic analysis of the structure, it is clear that CRE CLO’s and CMBS are distinct products. For starters with the former, the sponsor of the securitisation retains a large percentage of the first-loss notes, where as in a CMBS this retention amount is likely to be limited to the bare minimum required to comply with the orginators regulatory requirements, and even then in lieu of the first loss piece they may elect to retain a vertical slice of the issued notes.

In terms of control, in a CRE CLO there is a day one operating adviser (or collateral manager) that not only has certain modification rights with respect to the collateral but also has extensive consultation rights when it comes to material actions. In the case of CMBS though such control is limited to consultation rights and the operating adviser is not a day one issuer appointment but instead a noteholder appointment which only really takes place at times of distress.

Finally (and quite literally), a further redeeming feature of CRE CLO is the existence of note protections tests. These are financial covenants which, if breached, cut-off distributions to the equity and sets off alarm bells signifying distress. CMBS has no equivalent early warning system, although payments to the Class X are switched off following the occurrence of certain credit events.

The upshot of these attributes is that CMBS is an ideal structure for the securitisation of loans backed by more stabilised assets, and therefore a perfect pricing arbitrage tool for those banks adopting the originate-to-distribute business model when it comes to financing CRE. On the other end of the spectrum, CRE CLO’s are better suited for loans backed by more challenging transitional types of CRE, and given that debt funds have colonised this lending space following the retrenchment of the banks, CRE CLO technology can be viewed as a balance sheet financing tool for such funds.

Although on a superficial level CMBS and CRE CLO’s could be two peas in a pod, when you sharpen the focus it becomes evident that they have very different and distinct personalities. As the European CRE CLO evolves, adapts and embraces some of the features of its more developed US cousin, the personalities of these two asset types will become increasingly apparent.