Commercial Real Estate CDOs Not As Low-Risk As They Seem?
Collateralized debt obligations backed by commercial real estate may not be quite as low-risk as their holders assume, according to CreditSights.
Following up its two-part analysis of potential risks in the commercial real estate market, CreditSights provides a helpful rundown of the CRE CDO market that highlights changes in the ways these instruments are funded.
CreditSights noted in Bubblenomics - Hunting for the Next Subprime in Commercial Real Estate (Part 1) and (Part 2) articles that total returns on commercial real estate holdings are set to hit an all-time record high this year in real terms. However, the turmoil in US residential real estate likely bodes ill for the US economy in general and commercial property in particular.
CreditSights says issuance of CRE CDOs has exploded in the past three years and now represents roughly 10% of all CDO issuance. A reason often cited for the success of CRE CDOs is that the rating agencies are excessively conservative in their estimates on property valuations when rating commercial mortgage-backed securities (CMBS), CreditSights says.
“Despite prices surging in recent years, the rating agencies tend to assign lower values to commercial property than the market, which reduces the proportion of the entire mortgage that can be funded by CMBS. This has forced property owners to look for other avenues to borrow additional money subordinate to the CMBS-eligible A-notes.”
CRE CDO ratings are also benefiting from a supposed diversification, since they hold a larger number of smaller-sized commercial property-related assets than CMBS, CreditSights says.
“But given that all the assets are in commercial real estate, which like residential property is no doubt more correlated now than it was 20 years ago in the last property collapse, the diversification might not equate to low correlation in defaults in the event of a commercial property downturn.
If commercial property conditions turn nasty then senior tranche investors who no doubt are under the impression that they are invested in low-risk or zero-risk assets may find that because the whole capital structure is backed by low quality real estate debt, even those senior tranches could be at risk.
CreditSights points out that roughly one quarter of all US commercial and multifamily residential lending - by value - is now provided by the capital markets via CMBS - $700 billion of the $3.1 trillion market. Ten years ago, just 7% was repackaged as CMBS.
CRE CDOs: A Diversified Collection of Low Quality Mortgage Debt? includes a history of the evolution of the commercial mortgage and a handy definition of terms.
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