Demand for apartment bridge loans is pushing CRE collateralized loan obligation issuance to heights not seen since 2021. Investors bought up $40.2B worth of the debt in the first 10 months of the year, up 66% from last year by dollar volume, according to data from Trepp provided to Bisnow.
But volatile debt markets have left some issuers waiting on the sidelines for now, which is likely to weigh on fourth-quarter issuance.
“I think there's a number of issuers who could have come to market in Q4 but instead are acting a little slower and looking to bring their deals to market in January,” said David Henschke, managing director and head of capital markets at Benefit Street Partners, an alternative credit asset manager and CRE CLO issuer.
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Henschke forecasts a modest level of new CRE CLO issuance through the end of the year, and he suspects the total will fall short of the $45.4B record from 2021. Investors are struggling to divine the direction of interest rates and are waiting to deploy capital until after the Federal Reserve votes at its meeting in December, he said.
“We'll see what the Fed does there, and then you'll have some of that uncertainty kind of behind you,” he said.
It’s that same uncertainty that is driving up CRE CLO issuance in the first place. Underlying loans bundled into CRE CLOs are typically bridge or transitional debt with two- or three-year terms.
The majority of CRE CLOs today are made up of loans being used to refinance existing mortgages, but the capital is also used by developers as a transitional loan for a newly completed project on its way to full occupancy and by buyers looking for short-term acquisition financing before securing a longer-dated mortgage.
“What the CRE CLO market is designed to do is be a bridge facility, and that’s what it’s doing,” said Andy Boettcher, who leads research at Trepp. “It’s bridging new product that hit during a supply wave that didn’t hit its lease-up target, and it just needs time.”
The CRE CLO market was built for these transitional market phases, where there’s a sudden glut of new development as the U.S. saw during the pandemic era, he said. The loans are typically floating-rate debt, which leads to higher borrowing costs when interest rates climb, and the debt has been the fastest-growing segment of the nonagency CMBS market this year, according to Morgan Stanley.
Multifamily loans make up nearly three-quarters of all CRE CLO debt issued this year through October, and 57% of assets underwritten for CRE CLOs were built within the last five years, according to Trepp.
The makeup is a shift away from the retail and office assets that were being pledged as collateral in the recent past, Morgan Stanley analysts wrote in a September research note. Office exposure made up as much as a quarter of CRE CLO collateral prior to 2020 but shrank to just 2% of issuance through this August, according to the investment bank.
Some owners with maturing debt are looking at a landscape where the 10-year U.S. Treasury yield climbed above 5% before retreating and are opting to take the shorter-term CRE CLO debt as a way to effectively bet on lower debt costs within a few years.
“The cost of equity, getting new equity in from somewhere else on one of these deals that has to be refinanced, is more expensive than three years of building the lease roll, stabilizing the occupancy, stabilizing the rent roll, and saying, ‘I now have a bigger value than I had going in,’” Boettcher said.
But there are signs that the marketplace is itself being strained by the elevated rate environment. The CRE CLO distress rate jumped from 19% in July to 28% in August, the sharpest one-month move of any deal type this year, according to Cred iQ. Single-asset, single-borrower CMBS loans, by contrast, held flat near 22%.
While climbing, the CRE CLO distress rate is concentrated in a handful of large deals, not widely dispersed. Five deals account for 38% of all of the CRE CLO special servicing balance. The distress traces to loans originated in 2021 and 2022 that now account for $3B worth of CRE CLO loans in special servicing, according to Cred iQ.
Investors have shaken off the rising delinquency rates because they're concentrated in a handful of loans and because investment-grade bondholders in the segment have rarely seen real losses, Henschke said. The structure typically leaves sponsors holding the first-loss position, aligning issuers with investors, making it the most conservative structure in the CMBS market, he said.
Owners opting for the shorter-term debt that comes with a CRE CLO are hoping that the interest rate environment will look better when the debt comes due in a few years. Many of the assets could refinance today with a traditional mortgage, but owners are instead taking a higher interest bill today for the prospect of greater savings in the years ahead.
“You have assets that probably could go fixed-rate in today's market; they're not really bridging anything to change at the property. It's really a bridge for potentially market conditions to change,” Henschke said.
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