Finance  ·  Analysis

Cracks Appear in Once Sturdy Market for Collateralized Loan Obligations 

No one thinks it'll be a repeat of what happened ahead of the Global Financial Crisis, though

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Soaring interest rates have created turmoil for a flavor of financing favored by owners of Class B apartments and other types of speculative assets.

In recent months, commercial real estate collateralized loan obligations, or CRE CLOs, have flashed warning signs. In one example, Moody’s Investors Service reports that CLO loan impairments soared from just 0.3 percent in the second quarter of 2023 to 2.9 percent in the first quarter of 2024.

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While CLOs conjure bad memories of the dark days of 2008 and 2009, no one expects the distress in this particular corner of commercial real estate finance to drag the industry — much less the wider economy — into crisis this time around. But the problems illustrate one more way that jumps in interest rates in 2022 and 2023 have roiled the property sector.

“These are story loans. They’re a little bit higher risk, they’re shorter term,” Stephen Buschbom, research director at data firm Trepp, told Commercial Observer. “If something is going to break, the conventional wisdom will say that’s where we’re going to see it first.”

About two-thirds of CLOs issued comprise loans on apartment projects. Nationally, more than half of CLO-funded multifamily projects operate with negative cash flow, he said. 

In some metro areas, the signs of distress are “staggeringly high,” Buschbom said. In the Denver market, 95 percent of apartment CLOs aren’t generating enough revenue to cover their debt service. In the Washington, D.C., metropolitan area, the figure is 90 percent. Even in the comparatively healthy apartment market of Miami, 60 percent of CLO properties have debt service coverage ratios below 1, Trepp data show. 

“We’ve got more distress to come,” Buschbom said.

Mike Haas, founder and CEO of valuations tracker CRED iQ, is similarly wary. He began seeing warning signs last summer, as the Federal Reserve neared the end of a round of 11 rate hikes that boosted the central bank’s policy rate from zero to more than 5 percent. “August marked the beginning of a trend of substantial distress in the CRE collateralized loan obligation arena,” Haas wrote in a column for CO.

Before that breaking point, just one or two loans a month were sent to special servicing. In August, 31 CRE CLO loans went to special servicing, followed by 41 such moves in September.

In July, just 1.7 percent of CRE CLO loans were 30 days delinquent or in special servicing, according to CRED iQ. That share had soared to 8.6 percent as of January.

CLOs are backed mainly by short-term, floating-rate loans for properties in transition or undergoing renovations. Most CLOs are tied to multifamily properties, many of them “value-add” Class B and C properties built in the 1970s or 1980s.

Typically, an owner buys one of those dated properties and overhauls it, upgrading the kitchens, adding amenities such as in-unit washers and dryers, or sprucing up the swimming pool.

Given the ongoing shortage of affordable housing nationally, renovating lower-priced apartments would seem a winning strategy.

But Mark Neely, director of alternative investments at money management firm GenTrust, said the post-pandemic apartment market hasn’t been kind to investors. “There’s a bunch of different headwinds, and they’re all coming at the same time,” Neely said.

The most obvious challenge is the sharp rise in interest rates since early 2022. To combat soaring inflation, the Fed raised the federal funds rate by a range of 525 to 550 basis points in 2022 and 2023, creating sticker shock for borrowers who have to refinance at today’s higher rates.

Another factor: The once-hot apartment sector has cooled. While occupancies and rental rates remain strong overall, many developers who bought multifamily properties in 2021 and 2022 were banking on a continued surge in rents. Instead, rents plateaued — a pause that’s good for tenants but an unexpected hit for CLO loan borrowers.

As rent growth cools, properties no longer fetch the rich capitalization rates of 4 percent to 4.5 percent that they commanded during the apartment boom, Neely said. Instead, cap rates are more like 5.5 percent to 6 percent, meaning property values have fallen.

Other challenges come from rising insurance bills, still-high construction costs and the newfound caution of lenders, who are demanding loan-to-value ratios as low as 50 percent, compared to the standard of 65 percent a couple of years ago, Neely said. As a result, investors who need to refinance might also have to bring a hefty equity check to the closing table.

“A lot of these guys are like, ‘I don’t have $20 million to recapitalize the property. I can’t make this math work,’” Neely said.

The soaring cost of interest rate caps as the Fed raised rates was a final wild card. Deryk Meherik, senior vice president at Moody’s Investors Service, pointed to an example of a three-year cap at 3 percent for a $100 million loan: In 2019, the cap cost just $98,000. By 2023, the same protection cost nearly $3.5 million.

“The price of these caps was astronomical,” Meherik said. “Combined with slowing rent growth in certain markets, that really put a lot of stress on these floating-rate loans.”

From late 2020 through early 2022, investing in apartments seemed a can’t-miss proposition. Now, though, as CLO loans mature, growing numbers of borrowers are struggling to pay.

“What’s bringing this all to a head now is all those loans are coming due,” Neely said. “2024 and 2025 will be active refinancing years.”

The problems have already hit Arbor Realty Trust, a major issuer of CRE CLOs. As its delinquencies have increased, short sellers have gravitated toward the stock — about 40 percent of shares were selling short as of late February. Arbor Realty Trust declined to comment.

Not everyone thinks a reckoning is nigh, though. In a March 1 earnings call, Lauren Basmadjian, CEO of Carlyle Credit Income Fund, which specializes in CLOs, downplayed the turmoil.

“In the fourth quarter of 2023, many banks predicted a significant increase in defaults and lower CLO issuance for 2024,” she said. “We think this is likely incorrect and are only expecting a small increase in defaults this year.”

While others aren’t so sanguine, no one predicts that this CLO crisis will cause a contagion like the one seen during the Global Financial Crisis more than 15 years ago.

“I think it’s completely manageable,” GenTrust’s Neely said. “It’s going to cause a decent amount of pain in the CRE markets. But is it another 2007-08 event? No.”

CLOs pool loans of differing credit quality, and the highest-rated debt in CLOs is performing well. Meanwhile, issuers have been working with troubled borrowers by modifying the terms of loans. In some cases, borrowers must put more capital into their deals to keep their loans current — and increasing the pain should the borrower default.

“The optimistic side of me says it won’t get too bad,” said Trepp’s Buschbom. “There’s a lot of equity in these projects.” 

Jeff Ostrowski can be reached at jostrowski@commercialobserver.com.