A Practical Guide to Investing in CRE CLO

Collateralized loan obligations (CLOs) are a short-term financing option within commercial real estate. These can be a valuable vehicle for both property owners and loan investors who have a time frame of 3 to 5 years.

What are CRE CLOs?

CRE CLO stands for commercial real estate collateralized loan obligation. These are investment vehicles composed of short-term commercial real estate loans.

The loans are pooled together to mitigate risk, and the pool is usually actively managed by an asset manager. Management fees and distributions are paid for from the cash flow that the loan payments provide.

Since diversifying risk is a significant reason to include multiple loans, CRE CLOs often have a mixture of retail, office, multi-family, and other properties in their portfolio.

Most CRE CLOs are managed with a 5-year horizon, after which capital may be withdrawn or reinvested. Many loans included in these vehicles are 3-year loans with floating interest rates. Both fund and individual loan specifics can vary, though.

CRE CLO Structure

A typical CRE CLO structure separates loans into different tranches or layers. Each tranche has a distinct risk and return level.

The most senior tranches usually comprise primary-positioned loans, albeit still short-term loans of a few years. Mezzanine and other loans may make up junior tranches, depending on specific risk and return targets. Equity tranches have the lowest repayment priority but may offer the highest interest rates.

Individual loans are managed within each tranche to meet the tranche’s specific risk and reward targets. Tranches are managed within the fund to meet the overall risk and reward targets.

Understanding Different CRE CLO Tranches

The tranches in a CRE CLO are rated from AAA (highest quality) to BB or lower, reflecting their risk and return profile. In general, tranches and ratings correspond as follows:

• Senior tranches may be rated AAA and AA
• Mezzanine tranches may be rated A, BBB, and BB
• Equity tranches are usually unrated

Investors should review a fund’s overall rating and the rating of its individual tranches. Conservative investors might want to target funds that have a lot of senior tranches that are rated AAA and AA and perhaps some of the better Mezzanine tranches (AA and BBB). Those willing to accept substantially more risk may be willing to work with lower ratings. A rating of BB+ is often considered the bottom of investment grade, however.

Benefits of CRE CLOs

Like any real estate loan, CRE CLOs have their place within lending and investing. They can offer benefits for both parties.

For Investors

• Diversification: CRE CLOs offer exposure to a diversified pool of real estate loans, mitigating the risk associated with any property, borrower, or loan type.
• Yield Optimization: The tiered structure allows investors to select tranches aligning with risk tolerance and return expectations.
• Liquidity: Compared to direct real estate investments, CRE CLO securities can be more easily bought and sold, providing investors with liquidity.

For Borrowers

• Access to Capital: CRE CLOs provide real estate companies with access to financing beyond traditional bank loans and for durations many loans don’t offer.
• Flexibility: The structure of CRE CLO loans can offer more flexibility in terms of loan covenants and repayment terms compared to conventional financing options.
• Funding: Many CRE CLO loans are used to finance transitional properties, such as those with high upcoming tenant turnover, a major planned renovation, or something similarly significant. Loans for these properties may otherwise be limited.

Risks of CRE CLOs

Despite their benefits, CRE CLOs carry inherent risks that investors must consider.

• Credit Risk: The performance of CRE CLOs is closely tied to the creditworthiness of the underlying borrowers. Defaults can lead to losses, particularly for junior and equity tranches. It’s essential to have an experienced and knowledgeable asset manager for this reason.
• Market Risk: Real estate market conditions can affect property values and rental incomes, impacting the cash flows available to pay investors.
• Interest Rate Risk: Fluctuations in interest rates can affect the interest income from floating-rate loans in the pool, impacting returns.

CRE CLOs vs CMBS

Commercial mortgage-backed securities (CMBS) are perhaps the most common way to invest in real estate loans. These and CRE CLOs are substantially different.

• Loan Type: CRE CLOs primarily consist of short-term financing used during a transitional time, often until permanent financing is obtained. CMBS pools predominantly feature long-term loans.
• Interest Rate: The loans included in CRE CLOs tend to have variable interest rates that can increase and decrease over the loan term. Most of the loans in CMBS investments have a fixed rate.

• Flexibility: While both investments are usually managed by an asset manager, CRE CLO structures are typically much more actively managed. The loans in a CRE CLO will likely change over, whereas those in a CMBS will be fairly static.
• Risk and Return: CRE CLOs often target higher-yielding, riskier loans than CMBS, reflecting a different risk/return profile.

Wrapping Up

Investing in CRE CLOs presents an opportunity for those looking to diversify their portfolio and tap into the commercial real estate market. Specifically, they offer access to shorter-term, higher risk, and higher yield targets than other options. At the same time, these vehicles offer diversification and active risk management.

If these features are within your overall investment portfolio, a CRE CLO may indeed have a place within your investments.