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It is fair to say that there is not only a lot excitement about the arrival of CRE CLO technology in Europe, but also a heightened level of interest when it comes to some of the structural features that this new asset class could embrace. In this vein, it is fair to say that one of the marquee features of a CRE CLO is that the underlying collateral is not necessarily confined to a static pool of loans (as is the case with CMBS), but instead can comprise a dynamic pool of loans, the composition of which evolves as new loans are acquired and existing loans are sold or redeemed. In order to finance this churning of loans, capital will take the form of either recycled funds from prepaid or sold loans, or fresh capital accessed from either a day one reserve or a tap issuance taking place later down the line.
Ostensibly having a dynamic pool of collateral makes a lot of sense in situations where you have loans that are prone to early prepayment or simply of a short term nature. When it comes to CMBS and CRE CLOs, prepayments are rarely regarded as a positive thing for the structure. From an investor’s perspective prepayments are certainly not welcome, especially if they lead to redemptions taking place soon after issuance. Equally, from a structurers point of view, prepayments can create a structural nightmare in terms of devising how principal should be applied. This is especially true if a securitisation features multiple loans of varying quality, a difference in interest rates and a wide geographical spread of underlying properties. Certainly in European CMBS 1.0, the modified pro-rata application of principal repayments really went through the structuring mill, which manifested itself with some hugely complex CMBS structures as the structurer sought to ensure that principal was applied in such a way to ensure that credit enhancement erosion for the senior notes was limited, that the weighted average rate on the notes was kept in check whilst at the same time ensuring that the class X would not be adversely impacted.
A neat solution to alleviate prepayment pain from investors and structurers alike, is to have a dynamic pool of loans where prepayment amounts are recycled with the acquisition of new CRE credit. Investors, instead of receiving early redemption proceeds, will be instilling confidence in a collateral manager who will be responsible for managing the collateral pool over the passage of time, and more specifically charged with the task of managing the constant risk of credit quality drift as the nature and type of underlying collateral changes as a result of prepayments and the acquisition of new loans.
The existence of a dynamic pool of loans can be considered a desirable and immensely flexible feature that would be greatly welcomed by sponsors of CRE CLO’s, which will be especially true if this technological feature actually enables them to use the CRE CLO to fund the origination of fresh loans following issuance. Investors will welcome it if it means that they are not suddenly subject to an early redemption. As for underlying borrowers, if this structure will ensure that they receive less arduous prepayment fees then this can be construed as a clear positive of having a lender house their loans in a CRE CLO.
Ultimately, having a CRE CLO product that is collateralised by a dynamic pool of loans can only be a good thing and in many respects a “must have” as the European market not only grows and develops, but does so in the face of a storm of rising interest rates and with it the inevitable risk of heightened loan prepayments.