Real estate CDOs: One size fits all?


Louise Bowman
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Taking the successful US CRE CDO model and simply applying it to the European CMBS market is unlikely to work.

Despite a fair degree of scepticism in many corners of the market, insiders are confidently predicting that one (maybe even two) commercial real estate CDOs will close in Europe by the end of this year. These structures pool a wide range of real estate assets such as CMBS bonds, whole loans, B notes and mezzanine loans and have been popular in the US since the late 1990s. The relative immaturity of the CMBS market in Europe (particularly at the junior part of the capital structure) has always been considered a barrier to their use there. However, enthusiastic pioneers are now talking up the prospect of the product jumping the Atlantic.

The first CDO backed by commercial real estate assets appeared in 1999, and transactions backed by actively managed pools of assets appeared in 2004. The US market grew by 50% the following year to reach $14 billion at the end of 2005.


In Europe, Fortress Group’s Eurocastle vehicle is the closest thing the market yet has to a commercial real estate CDO. This is a Guernsey-based investment vehicle that was set up to invest in the equity pieces of primarily German CMBS transactions. It was an early precursor of the listed residual income funds that have sprung up in the market over the past year. The fund now has €36 billion assets under management in a REIT-like structure. It differs from traditional arbitrage CRE CDOs in that the former tend to retain the equity and subordinated debt where Fortress does not. It is a financing rather than an arbitrage vehicle.

The first and overriding challenge to structuring a CRE CDO in Europe is the formation of the collateral pool. Rating agencies want to see transparency and diversity in asset pools, something that European real estate lending is not known for. “Europe is still essentially a large loan market,” observed James Hart, debt portfolio manager at Fortress Investment Group, at a Commercial Mortgage Securities Association (CMSA) forum on the topic last month. “Just putting the word ‘conduit’ at the end of your programme does not make it a conduit.” CMBS conduits in the US routinely top 100 loans in the asset pool, whereas in Europe they still tend to be dominated by two or three large loans and whatever else the originator happens to have to hand. Because there are fewer, larger loans in Europe, access to collateral – particularly in the mezzanine space – will be a problem. “It is hard to get a good allocation,” says Hart. “On the B note and mezzanine side it is still a question of being invited – most B notes are still not syndicated.” It is simply not possible to go out and buy small B loans at, say, €10 million a pop. “The number of people that can do this [undertake a CRE CDO in Europe] can be counted on the fingers of one hand,” says Hart.

Recent research published by Barclays Capital indicates that the European market will go through an early phase of “trial” deals to test both rating agency treatment and investor reception. It emphasizes that the wide variety of national legal and tax rules in Europe, the high levels of prepayment in the CMBS market and the diverse and mostly limited background of originators all present a challenge.


If the market takes to heart the advice of Robert Foley, CFO at Gramercy Capital Corporation, growth will be glacial indeed. “We would not recommend anyone to do a CRE CDO who has not done one before,” he warned at the same meeting. The investment banks will certainly be hoping that this advice is ignored, and are busily warehousing assets for potential issuers. But apart from the difficulties of actually sourcing the assets themselves, nagging questions remain about whether or not CDO technology should be applied at all to pools of these types of assets.

Ronan Fox, managing director at Standard & Poor’s, explains that some market participants consider that CRE CDO structures with only B-notes are “one step too far” in financial engineering of real estate capital market transactions. Aside from credit quality and diversity concerns, B note spreads in Europe have fallen from above 400 basis points to below 200bp in five years – they now routinely price more tightly than double-B rated debt. Leverage levels in Europe are higher than those in the US, asset pools in CMBS are dynamic and prepayments are rampant. “Rating debt secured on static pools of European CMBS with fewer than 20 loans is not particularly easy,” notes Fox. “Rating CMBS debt secured on evolving pools of assets adds further challenges. Expressing a rating opinion on an ever-changing pool of junior debt is, frankly, very difficult.”

But the match funding benefits for managers of doing CRE CDOs are substantial. They have traditionally financed their business using repo lines, which are short-term recourse lending that has to be marked to market. CDOs provide longer-term finance and eliminate the mark-to-market risk. This is why there is such momentum in Europe to get the product off the ground. One solution to the problem of sourcing collateral is for originators to pool their resources. “When the US was still a large loan market we saw various partnerships with people combining collateral,” says Gramercy’s Foley. “This is how the market achieved the kind of diversity that the rating agencies want to see.” It certainly makes no sense to go to the market with a 20-loan CRE CDO.


As with any new product, the temptation for potential issuers is to sit on their hands and let someone else take the pain of doing the first deals. “Anyone looking at doing a European CRE CDO in the next 12 months is going to have a tough time,” observes Fortress’s Hart. Those likely to step up to the plate are going to be large, existing players in the CMBS space that are able to aggregate the collateral and can exploit the opportunity that CRE CDOs represent. On the investor side, buyers that are comfortable with the risks that the structure encompasses will be champing at the bit to buy into the first few deals because they will likely offer good protection to debtholders at a very attractive spread. But as with any managed CDO, investors will be buying into the manager’s ability to extract maximum value out of the portfolio. A strong track record in European real estate and – most important – local knowledge will be important factors in determining which CRE CDO managers succeed and which fail. But the hurdles on this front are not insurmountable. As Blackrock’s Chris Milner observed at the same meeting: “You do not have to have the same number of offices as CB Richard Ellis to be an effective and thoughtful investor in real estate.”

Do the maths
Deal economics of a sample CRE CDO
Assets Liabilities
Type PortionSpread* Tranche Size Spread
B-Notes50%275AAA 35% 35
Mezz. debt20%475AA 15% 55
Whole loans10%130A 20% 100
CMBS18%250BBB 12% 225
REIT debt2%113NR 18%
Average spread293bp to Treasury68bp (excluding NR) to 1mL
Average ratingB2/B3
Weighted average rating factor  3500                           
* All spreads are indicative levels as of January 2006.
Source: Nomura Securities International, Bloomberg