USA: An Introduction to Capital Markets: Securitisation: CRE CLOs

The commercial real estate collateralized loan obligation (“CRE CLO”) is a financing structure used to finance portfolios of bridge loans. Bridge loans enable commercial and multifamily property owners to access capital for significant renovations or lease-up efforts, when properties don’t qualify for long-term, fixed-rate financing. Bridge loans are typically floating-rate, and have short terms with various extension options, providing a cumulative term of five to seven years. Ideally, the borrower will stabilize the property before maturity, enabling the borrower to sell the property or refinance the loan with longer-term financing.

In a CRE CLO, a sponsor sells a pool of bridge loans (or interests therein) to a special-purpose entity that issues tranched securities to investors backed by cash flows on the loans. Many CRE CLOs include a reinvestment period during which principal proceeds can be used to purchase new assets instead of paying down the securities. Unlike repurchase facilities, CRE CLOs provide sponsors with “matched term” financing without imposing “mark-to-market” provisions.

CRE CLO offerings must comply with the restrictions imposed by federal law on the offerings of “asset-backed securities,” including risk retention requirements under Regulation RR. Issuers must also maintain an exemption from registration under the Investment Company Act, which, depending on the exemption, may restrict the types of assets the issuer can hold, or the manner in which the issuer purchases and sells assets. In managed CRE CLOs, the transaction parties must also consider the application of the Investment Advisers Act, which includes restrictions on transactions between the issuer and the manager and its affiliates. As with any securitisation, legal separateness is paramount, requiring careful attention to the organizational documents of the sponsor and various special-purpose entities, and any provisions governing the purchase and sale of underlying loans, to achieve legal isolation. Additionally, the CRE CLO must be structured to provide the secured party with a perfected security interest in the collateral pledged by the issuer under the Uniform Commercial Code to secure the issuer’s obligations under the securities.

The vast majority of CRE CLOs are structured as a “QRS,” whereby the issuer elects to be treated as a “qualified REIT subsidiary” of a REIT, and benefits from the parent’s federal income tax exemption. The success of the CRE CLO is due in large part to the flexibility of the QRS tax structure which, unlike some other tax structures, allows managers to make significant modifications to performing loans. The cost of this flexibility is that the sponsor must retain any securities rated below investment grade, which generally represent the bottom 10-20% of the capital stack. For this reason, the QRS structure represents a significant alignment of interests between the sponsor and investors.

Additionally, CRE CLOs feature “note protection tests” that compare current interest and expected principal payments on the underlying assets with interest and principal due on the securities. If sufficient principal and interest cushions are not maintained, payments on the tax equity retained by the sponsor are diverted to pay down the securities in sequential order until the deficiency is cured. In addition, a typical CRE CLO will provide that if a loan is modified in a material and adverse manner (eg, a spread reduction or term extension), the issuer will not receive full credit for the outstanding principal balance of that loan for purposes of calculating the note protection tests, as the issuer is less likely to make a full recovery of principal. This is accomplished by re-appraising the property and calculating an “appraisal reduction amount,” penalizing the issuer for that modification.

If an asset becomes credit-impaired or defaulted, the manager can generally sell the asset on behalf of the issuer at par to a sponsor-affiliate. This permits the loan to be worked out on the sponsor’s balance sheet, shields investors from losses, and avoids adverse note protection test outcomes. However, an uptick in loan defaults and special servicing transfers could make it more difficult for managers to do this in a liquidity-constrained economic environment. Instead, managers may opt to make use of an “exchange” feature that permits managers to exchange a non-performing asset in the CRE CLO for a performing asset on the sponsor’s balance sheet, with a cash payment for the difference in price. When an exchange is not feasible, managers have performed workouts of loans in the CRE CLO, and even foreclosed on the underlying property.

Bringing new CRE CLOs to market has proven challenging in the recent economic environment. According to Green Street, over USD45.4 billion in CRE CLOs were issued in 2021—the biggest year ever for CRE CLOs. By contrast, less than USD6.7 billion were issued in 2023. The decline in issuance is largely attributable to the significant increase in floating interest rates, which has made it more challenging for lenders to price loans, more expensive for borrowers to hedge their interest rate risk, and more costly for sponsors to obtain financing. In recent years, securitised loans have more frequently been the subject of significant modifications, often to give borrowers additional time to implement their business plan, or to give borrowers limited spread relief, as interest rates and tax, insurance and other operating costs have outpaced rent growth.

The slowdown in new issuance has led some sponsors to innovate, such as by issuing privately placed CRE CLOs or including features that allow the size of the CRE CLO to be increased. Sponsors with attractive, pre-2022 interest rates have generally been utilizing all available capacity in those transactions, which typically represent the lowest-cost financing option compared to repurchase facilities or a new CRE CLO issuance. However, reinvestment periods are rarely longer than two years, so available capacity in legacy CRE CLOs is rapidly dwindling. After the reinvestment period ends, issuers are required to use principal collections to repay principal to investors, rather than to purchase new assets. As a CRE CLO amortizes, sponsors become increasingly incentivized to redeem the securities and issue a new CRE CLO as replacement financing.

CRE CLOs are impacted by many of the legal and regulatory developments affecting broader securitisation markets. For example, after the European Commission’s 2022 report on the EU Securitisation Regulation, sponsors have generally complied with Article 7’s transparency reporting requirements by hiring a third-party administrator to compile the necessary templates, which allows issuers to sell securities to investors in the European Union. The SEC’s recently enacted Rule 192 under the Securities Act will prohibit sponsors, placement agents and others from engaging in certain “conflicted transactions” with respect to CRE CLO securities issued on or after June 9, 2025, subject to certain exceptions. In addition, various CRE CLO special-purpose entities may need to file beneficial ownership reports under FinCEN regulations implementing the Corporate Transparency Act, enforcement of which has been complicated by a recent federal court decision sustaining a challenge to the law’s constitutionality.

Overall, CRE CLOs are flexible financing vehicles that align the incentives of sponsors and investors, and that alignment has contributed to their popularity among both groups. As interest rates settle, we expect to see an increase in loan origination volume, and not long thereafter, a renewed market for CRE CLOs.