CDO positioned to be dominant capital source for funding.

Commercial Mortgage Backed Securities (CMBS) transactions continue to grow exponentially as borrowers take advantage of highly leveraged, fixed rate, permanent debt offered by securitized lenders.

In fact, according to the third quarter "CMBS Quarterly Insights" report from Standard & Poor's, new issuance of CMBS has reached record levels: CMBS issuance in September 2006 was $23.3 billion--double the issuance of the previous year.

However, stringent underwriting guidelines required by CMBS lenders have made it difficult for many borrowers to attain financing for unconventional deals.

Generally, CMBS lending is geared towards financing traditional, stable multifamily, office, retail, or industrial properties. Additionally CMBS lenders often punt on conventional, yet slightly complicated deals, because of the scrutiny from B-piece buyers. If any of the individual mortgage loans pooled together by the lender for securitization deviate from CMBS standards, the B-piece buyer will want that loan removed from the pool. Consequently, the loan remains on the lender's balance sheet thereby increasing their risk exposure.

CMBS financing has matured over the years. Lenders have developed an appetite for deals with slight complications--deals they used to shy away from.

For instance, a property with 30% vacancy can be mitigated with a master lease signed by the borrower or seller that burns off once the space is leased up. Similarly, for a property that does not meet the 1.2 Debt Service Coverage Ratio, reserves for tenant improvements and leasing commissions can be withheld at funding rather than deducted from underwritten cash flow.

However, any value-added play that involves transitional properties, such as extraordinary vacancy levels, rehab, repositioning, or re-tenanting, has no place within the CMBS structure. As any real estate professional knows though, adding value is key to realizing superior returns on investment capital.

In order to fill the void left by CMBS, and by extension, to acquire more deal flow, capital markets have expanded financing options for commercial real estate transactions with the CDO--the collateralized debt obligation.

Fundamentally similar to CMBS, the CDO is a special purpose vehicle established by a sponsoring organization (i.e. a life insurance company, a bank, or a credit company) to hold collateral and issue securities. The main difference between CDO and CMBS comes down to flexibility.

When a loan is closed and pooled in a CMBS issuance, the legal structure of the Real Estate Mortgage Investment Conduit, (or the REMIC), fixes the securities and restricts the collateral within the bond from being altered. The CDO, on the other hand, is structured with a co-issuer system that contains both an offshore limited partnership and a Delaware corporation which permits the portfolio manager to actively reinvest cash flows by buying and selling assets.

When structuring a CDO, the underwriters split the security into rated and unrated tranches of bonds and equity, where each bond's rating is determined by its credit risk. The payments of interest and principal to the various bond tranches are first made to the senior tranches and then to the subordinate tranches. The senior bonds are usually rated AAA to A and have the first claim on cash flows. Since the payment on higher rated senior bonds is more certain, the return is lower.

Further down the ladder, mezzanine and subordinated bonds (rated BBB to B) provide credit enhancement for senior investors and thus have a subordinate claim on cash flows. However, since repayment is less certain because of their position, they enjoy a higher return than the senior tranches.

The equity tranche, which is the first-loss position, is generally unrated and receives all or most of the residual interest proceeds of the collateral.

However, if there are defaults or the collateral underperforms, the CDO collateral manager can buy a bad loan out of a collateralized pool for resolution to protect the equity position. It is this flexibility that allows CDO lenders to take on the additional risk incapable of CMBS lenders.

Prior to the CDO, loans for unstabilized, speculative properties were only funded by commercial banks or high-yield real estate funds. However, with the advent of the CDO structure, CDO lenders can offer bridge financing for non-stabilized, non-traditional property types such as vacant buildings, condo conversions, new construction projects, rehab projects, and more.

Even though CDO lenders can take on more risk than CMBS lenders, they still expect the borrower to have a successful track record and a well thought out business plan. In addition, the borrowers risk substantial loss since the collateral manager can take over the sponsoring entity if the borrower defaults.

The flexibility of the CDO coupled with the collateral manager's workout experience makes CDO lenders feel comfortable making bets on these risky, yet high yielding transactions.

In addition to bridge financing, CDO lenders also offer highly leveraged, 10-year fixed-rate permanent debt with five year I/Os. As an added bonus, borrowers that require both a first mortgage and a mezzanine piece can obtain both from a single CDO lender as opposed to CMBS which requires two separate sources of capital.

Loans can also be structured with greater pre-payment flexibility unlike CMBS where the borrower is locked in with expensive options such as defeasance or yield maintenance as the prepayment penalty.

In addition to all the above-mentioned benefits, the CDO collateral manager is uniquely positioned to solve any unforeseen difficulties by structuring any necessary bells and whistles, such as earn outs, to get the deal closed.

The additional flexibility offered by the CDO structure has created a much broader playing field when it comes to financing deals.

There is now a non-recourse, competitively priced source for speculative deals and unconventional property types.

Even more striking though, the CDO represents the evolution of securitization thereby positioning itself as the dominant capital source for commercial real estate financing in the future.

By Ronen Abergel

Prodigious Capital Funding, LLC