The Evolution of Commercial Real Estate (Cre) Cdos: Nomura Fixed Income Research

Nomura Fixed Income Research
The Evolution of Commercial Real Estate (CRE) CDOs

I. Introduction January 4, 2006
Recent months have seen a surge in issuance of CDOs backed by commercial real estate assets. A commercial real estate CDO ("CRE CDO") is a type of collateralized debt obligation (CDO) that is backed by commercial real estate assets, such as CMBS, commercial mortgage loans, REIT debt, etc. In our view, CRE CDOs require more expertise in the individual commercial real estate sectors than for regular structured finance (SF) CDOs. Some CRE CDOs use debt instruments that are low down in the capital structure. Moreover, compared to other SF CDOs, CRE CDOs tend to have a relatively small number of underlying assets that makes their portfolio "lumpy." In this paper, we highlight some of the important issues for an investor who may be considering investing in a CDO backed by various CRE assets.
II.
A Brief History
The CRE CDO is not an entirely new product. The first CDO backed by commercial real estate 1 assets appeared in 1999. These earlier deals typically involved a static collateral pool of subordinate CMBS and REIT debt. The CDO structure allowed slightly more flexibility than the traditional repackaging of CMBS securities (i.e., re-REMICs), while providing a long-term, non-mark-to-market financing for CMBS B-piece buyers. The collateral managers of early CRE CDOs were allowed to sell only defaulted or impaired securities. Also, principal repayments were used to sequentially pay down CDO liabilities, rather than to purchase new assets. By the end of 2003, about forty CRE CDO deals amounting to nearly $20 billion were outstanding. CRE CDO entered a new era in 2004, with the emergence of transactions that were backed by 2 actively managed pools of commercial real estate assets. At the same time, new types of unsecuritized collateral assets, such as B-notes and whole loans, began to appear as collateral assets. Many of these new assets are floating-rate instruments and can be prepaid after 12-18 months. In the past, buyers of B-notes and mezzanine loans often used short-term repo to finance these assets. Instead, by putting them into a revolving-pool CRE CDO, these investors are able to obtain matched-term funding at a lower cost.
A total of three CRE CDO deals were issued in 1999. Two of them were: Diversified REIT 1999-1 and Fortress CBO I. Also, so-called "multi-sector" CDOs of structured products often included a small portion of CRE securities. There were a few managed deals as early as 2002. One example is Newcastle CDO I, where the collateral manager, Newcastle Investment, was allowed to trade up to 20% of the underlying portfolio per year during the 5year reinvestment period.
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Issuance of CRE CDOs further accelerated in 2005. The volume approached $14 billion at the end of 3 2005, marking more than 50% growth from $8.4 billion in 2004. Today, about two thirds of new transactions have a revolving structure. At the end of the third quarter of 2005, there were over 50 CRE CDOs and nearly 500 tranches outstanding. From a CDO investor's perspective, this new breed of CRE CDOs provides access to traditionally unrated, unsecuritized commercial real estate assets that do not go into CMBS. On the other hand, with the booming CMBS market and benign credit fundamentals, sourcing cheap, high-quality CMBS collateral has become challenging and deal economics has deteriorated for the traditional, CMBSbacked CRE CDOs. The downside of this evolution, however, is the added complexity in analyzing exposures to the commercial real estate sector that involve multiple layers of pooling and tranching.
III.
CRE CDOs: Old vs. New
The evolution of the CRE CDO market has been gradual. Nevertheless, a comparison between deals from a few years ago with more recent deals reveals stark differences. Graph 1 below compares the average collateral mix of CRE CDOs by issuance year. As we can see, the portion of commercial real estate loans ("CREL") has soared in 2005.
Graph 1: CRE CDO Asset Mix by Vintage

100% 90% 80% Underlying Assets 70% 60% 50% 40% 30% 20% 10% 0% Pre-2002 2002 2003 Vintagel Source: Fitch 2004 2005 CREL Other CMBS REIT debt
It is interesting to compare old vs. new CRE CDOs (see Table 1 in the next page). One example of older CRE CDOs is Anthracite CDO I, issued in May 2002. The deal was backed by CMBS (79%) and REIT debt (21%). The portfolio was completely ramped up at issuance, and reinvestment of principal payments was not allowed. However, the collateral "administrator" was able to sell defaulted or impaired securities and securities with significant credit risk. In contrast, one deal priced in April 2005, Guggenheim Structured Real Estate Funding 2005-1, featured a revolving pool of B-notes (49%), mezzanine loans (22%), and whole loans (11%), in addition to subordinate classes of CMBS (16%). Most of the collateral assets in the Guggenheim
3 According to Moody's. See, Philipp, T., et al., US CMBS 2Q Review: Credit Metrics Slip as Issuance Surges, Moody's special report (28 July 2005).
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deal were first loss pieces. More importantly, unlike CMBS, which are generally longer-term fixedrate bonds with strong call protection, these assets were mostly floating-rate and had relatively short 4 maturities. The deal's collateral portfolio was revolving and actively managed.
Table1 : Old vs. New CRE CDOs at a Glance

Deal Issue date Portfolio Anthracite CDO I May 2002 Static CMBS (79%) REIT debt (21%) Guggenheim Structured Real Estate Funding I April 2005 Revolving B-Notes (49%) Mezzanine loans (22%) CMBS (16%) Whole loans (11%) Baa3 to NR (below Caa3) B3 (3464) 8.0% (whole loan) 5 years 1.8 years Floating-rate only Floating-rate Reinvested Herfindahl score = 20 64% 28 bps 18% 180 bps 32% of collateral pool Caa1 or lower
Underlying asset
Collateral rating A3 to Caa1 Average rating (Moody's WARF) Ba3/B1 (1831) Max single exposure 12.6% (CMBS) Reinvestment period None Weighted average maturity 7.0 years Collateral Fixed-rate only Liabilities Floating-rate Handling of prepayment Sequentially pay off the liabilities. Diversity / lumpiness Moody's D-score = 5 Triple-A subordination 59% Triple-A spread 45 bps Triple-B-minus subordination 28% Triple-B spread 350 bps Comment High servicer concentration Source: Moody's and S&P
IV.
Motivation for Creating a CDO
Since the early days, the primary motivation of CRE CDOs has been the financing needs of B-piece buyers and special servicers, who have extensive experience in the commercial real estate market. 5 CRE CDOs allow them to achieve higher leverage and greater diversity in their investments. In other words, B-piece buyers can "condense" risk and reward of lowly quality CRE assets by putting them into a CDO portfolio, where they typically retain the below-investment-grade portion of a CRE CDO. Subordinate lenders often exercise great influence on the fortune of troubled CRE loans, and the involvement of commercial real estate experts also benefits other CDO investors. Newer CRE CDOs that include unrated, first-loss portions of CRE loans have expanded the benefits of CDOs for both B-piece buyers and other CDO investors. These deals open the door for investors who otherwise could not invest in these types of assets. Given the low collateral quality and the revolving structure, the manager's ability and expertise have become ever more important. Also, some asset managers seek to increase their assets under management via CRE CDOs. CRE CDOs of this type tend to have higher collateral quality than the first type, as underlying portfolios consist primarily of investment grade collateral. For this type of CRE CDOs, therefore, the existence of "arbitrage" between collateral spreads and liability spreads is essential. Not surprisingly, the recent tight spread environment in the CMBS market has caused a decline in issuance of these asset
4 However, in some of the recent CRE CDOs, many collateral managers are first timers with no previous experience in managing a CDO.
For B-piece buyers, the fact that a cash CDO does not require mark-to-market also makes it an attractive alternative to other means of financing. Furthermore, a CDO allows the term of financing match that of underlying assets.
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management CRE CDOs. Furthermore, even non-CMBS collateral can be difficult to source in the current environment, giving CMBS originators some advantage.
Table 2: Deal Economics of a Sample CRE CDO

Assets Liabilities Type Portion Spread* Tranche Size Spread B-Notes 50% 275 AAA 35% 35 Mezz. debt 20% 475 AA 15% 55 Whole loans 10% 130 A 20% 100 CMBS 18% 250 BBB 12% 225 REIT debt 2% 113 NR 18% Average spread 293 bps to Treasury 68 bps (excluding NR) to 1mL Average rating B2/B3 WARF 3500 * All spreads are indicative levels as of January 2006. Source: Nomura Securities International, Bloomberg
Table 2 above shows the economics of a sample CRE CDO, which is backed by B-Notes, Mezzanine debt, whole loans, CMBS, and REIT debt. The average spread of the underlying assets is about 300 bps, while the average spread on the liability side is only about 70 bps, excluding the non-rated, firstloss tranche. The available return on the equity portion, which the deal's manager often retains, is the important driver of a transaction.
V.
CRE CDO Ingredients What They Are
As mentioned above, the older CRE CDOs were predominantly comprised of CMBS bonds and REIT debt, although some deals included small amounts of whole loans. However, the portion of CMBS and REIT in a CRE CDO has declined significantly over the past year or so. Table 3 below shows the average deal composition for the first half of 2005, reported by Moody's. As we can see, the average portion of B-notes in CRE CDOs issued during the first half of 2005 was greater than that of 6 CMBS. In the second half of 2005, we began to see many deals solely consisting of non-CMBS 7 assets. The Data Appendix at the end of this report lists CRE CDO deals since 2001.
Table 3: Collateral Composition of Recent CRE CDOs (H1 2005)

Collateral type B-Notes CMBS Mezzanine loans Whole loans Credit tenant leases Preferred equity REIT debt Other (corporate mezzanine loans, synthetics, CRE CDOs, etc.) Total Source: Moodys Share 28% 25% 20% 14% 6% 4% 2% 2% 100%
6 7
US CMBS 2Q 2005 Review: Credit Metrics Slip As Issuance Surges, Moody's special report (28 July 2005).
One example is a deal called Carbon Capital II, priced in August 2005. The deal's underlying portfolio was comprised of mezzanine loans (60%), B-notes (27%), and whole loans (13%). The triple-A tranche and the tripleB tranche priced at 31 bps and 165 bps, respectively, to Libor.
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While all these assets represent risk exposures to the commercial real estate sector, their risk profiles vary significantly. The following are brief descriptions of various commercial real estate assets included in many of the recent CRE CDOs.
A.
Whole Loans
A whole loan is a un-tranched loan secured by a commercial mortgage. In the sample structure on the following page, this would represent the entire $100 million. Whole loans are more commonly included in REMIC deals, as they offer better execution to the issuer, and thus, better pricing to the 8 property owner. However, borrowers are looking to CDO structures more and more because of the greater flexibility. Within a REMIC trust, it is very difficult for a borrower to take equity out of a property, because prepayment options, like defeasance, can be very costly. However, CDO structures, which may offer substitution of collateral, may not involve such prohibitive prepayment constraints.
Sample Capital Structure

AAA AA $55 mm $70 mm Loan (A-Note) CMBS Transaction BBBUnrated Class
$100 mm Property
$10 mm B-Note $5 mm C-Note CRE CDO
$15 mm Mezzanine Loan $30 mm Equity $5 mm Pref. Equity $10 mm Common Equity
Source: Nomura
B.
B-Notes and Mezzanine Debt
B-notes represent a subordinate portion of a commercial mortgage in the so-called A/B structure. A mezzanine loan is not secured by a lien on the property in question; it is a pledge of equity interest of the first-mortgage borrowing entity that is subordinate to the first-mortgage, but above the hard equity holder, on the capital structure. Investors who choose to purchase B-notes and/or Mezzanine debt expose themselves to greater risk than those buying investment grade bonds, and as such, are typically compensated with higher yields (see Table 4 in the next page).
8 With conduit/fusion deals increasing in size, issuers were able to include the entire loan without hurting the diversity of the deal.
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Table 4: Risk and Return Characteristics of Selected Commercial Real Estate Assets
Position on Capital Structure A-Note (senior) B-Note (junior) Mezzanine Equity Perceived Relative Risk Low Moderate Moderate-High High Likely Range of Spreads/ Expected Returns Treasury + 75-150 Treasury + 200-350 Treasury + 400-550 Mid Single Digits 15% + Swaps + 60 Swaps + 125 Swaps + 185 Swaps + 240 area Swaps + 650 area LTV 0 55% 55 65% 65 90%
A CMBS Low BBB CMBS Low-Moderate BBB- CMBS Moderate BB CMBS Moderate-High B CMBS High Source: Nomura Securities International
The fundamental concerns facing these investors (and thus, the potential CDO investors) deal with the underwriting and structural features of the loans. More specifically, on the underwriting side: How much equity does the borrower have at risk in the property? It is important to assess the borrowers capacity to back a project should it get into trouble. Along the same lines, what kind of leverage is associated with the loan? (Note that floating rate B-Notes tend to be more leveraged because the asset is typically more transitional in nature) What is the reputation of the sponsor of the project, and how much real estate experience does he/she/they have? What amount of assets, especially liquid assets, do they own or manage? If a sponsor has a reputation of bailing out when its projects experience problems, this will deter future investors. Is there any amortization in the capital stack through the life of the loan? What is the exit strategy? Due to the higher leverage involved in B-notes, investors prefer amortizing loans to IO loans. All parties involved are concerned about an exit strategy in order to protect their principal investment.
Investors also analyze the health/value of the property, paying close attention to: Historical operating performance Competing properties in the area Typical incomes of people living near the property (demographics). How the local economy is forecasted to perform going forward. Is the property located in a primary, secondary, or tertiary market?
More specifically, for specific property types, For an office, what do your rent rolls look like? Are there any above market rent-payers coming to the end of their lease? Below market-payers? What is the financial health / ratings of your tenants? Are you heavily dependent on any one tenant/industry? For hotel properties: How is the tourism industry performing, overall and in your market? Is your hotel easily accessible? How far is the nearest airport from your property? Is it located on or near a main thoroughfare?
As for structural matters, B-note /Mezzanine debt investors look at whether the borrower may incur additional debt, types of financial covenants involved with the property, if the loan contains any lockbox provisions, and if so, what the triggers are, etc. In the event of default, the B-Note holders right to principal and interest payments will be subordinate to the holder of the A-Note. Also, the A-note holder will generally have greater, if not exclusive, control over any bankruptcy proceedings dealing with the workout of a troubled loan. Typically, for the B-note holder to obtain greater control over the workout of a troubled loan, he will have to exercise the option usually granted the B-Note holder of buying out the A-Note holders participation
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in the loan, at par plus accrued interest. Other important rights that the B-note holder may have include, but are not limited to: The right to hire and fire the special servicer The right to cure defaults in order to keep the senior lender from foreclosing (usually, there is a limit to the number of times this right can be exercised)
Approval rights associated with the property budgets, leases, and property managers The mezzanine lender is generally afforded certain rights as well, including, but not limited to: The right to cure defaults in the first mortgage loan or loans The ability to foreclose on the borrowers ownership interest and take control of the underlying property (subject to the lien of the first-mortgage, which the mezzanine lender 9 normally has the right, but not the obligation, to purchase in the event of default) .
C.
Rake bonds
Rake bonds were common on older floating rate deals, but have become less popular in recent days. These bonds are typically subordinate on the capital structure, and are tied to the performance of a specific loan. As might be expected, the lack of diversity inherent in this type of bond leaves it more open to downgrade and default risk relative to a bond backed by a pool of mortgages. CDO investors should be aware of exactly which property in a deal their rake bond is exposed to, and make sure they are comfortable with the loan/asset.
D.
REIT Debt
Real Estate Investment Trusts, or REITs, by definition, are companies that purchase and manage real estate or real estate loans using capital invested by shareholders. As of October 2005, according to NAREIT, total unsecured REIT debt outstanding was about $98 billion. In order to qualify for REIT status, the company must:
1. Distribute at least 90% of its annual taxable income, excluding capital gains, as dividends to its shareholders.
2.
Invest at least 75% of its assets in real estate, mortgage loans, shares in other REITs, cash, or government securities. Derive at least 75% of its gross income from rents, mortgage interest, or gains from the sale of property. At least 95% of gross income must come from the aforementioned sources, together with dividends, interest, and gains from securities sales. The REIT must have at least 100 shareholders and must have less than 50% of the outstanding shares concentrated in the hands of five (5) or fewer shareholders.
3.
4.
REIT unsecured debt ratings are typically clustered around the BBB range, and yield spreads have historically been very similar to that of BBB rated conduit/fusion CMBS classes. Thus, portfolio managers often view the investments as alternatives for one another, with the investment decision 10 generally based on the relative spreads, at a certain point in time, between the two.
9 This means that the mezzanine lender would have to buy out both the A-note and B-note holder, since both positions are above him on the capital structure.
According to Moody's, REIT upgrades outpaced downgrades during 2005, at 2:25:1 ratio (9 upgrades, 4 downgrades). This reversed the trend from 2004, when there were 9 downgrades and only 6 upgrades. See; Moody's Credit Opinions (November 2005).
10
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Certain REITs are specialized, that is, only invest in a particular property type, usually diversifying by geography (e.g. Equity Office Properties Trust). The most common are Office, Retail, and Apartment REITs, though there are also a substantial number of Industrial and Lodging REITs. Others, such as Vornado Realty Trust, are more general and diversify across property type and location. The types of REITs that are often involved in the CDO market are classified as commercial financing REITs and include names such as Gramercy, Anthracite Capital, Arbor Realty Trust, Inc., and CRIIMI MAE, Inc.
VI.
Spreads and Credit Performance of CRE CDOs vs. CMBS
U.S. CDO spreads have tightened significantly over the past couple of years. In general, CRE CDO spreads have moved in line with structured finance (SF) CDO spreads. Graph 2 below shows the triple-A spreads for both SF CDOs and CRE CDOs, which have generally been moving in sync.
Graph 2: Spreads of Triple-A CRE CDOs vs. Triple-A SF CDOs

80 70 60 Basis Points 50 40 30 20 2Q01 3Q01 4Q01 1Q02 2Q02 3Q02 4Q02 1Q03 2Q03 3Q03 4Q03 1Q04 2Q04 3Q04 4Q04 1Q05 2Q05 3Q05 4Q05
AAA CRE CDO Sources: Nomura Securities International
AAA SF CDO
Credit performance has been extremely positive for the U.S. commercial real estate sector over the last few years. CMBS has been one of the best performing sectors within the structured finance market. Graph 3 shows the numbers of upgrades and downgrades of North American CMBS over the past quarters.
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Graph 3: CMBS Quarterly Rating Changes

400
Number of ratings changed
300
200
100
0 1Q03 2Q03 3Q03 4Q03 1Q04 2Q04 3Q04 4Q04 1Q05 2Q05 3Q05
11
Upgrades Sources: S&P
Downgrades
In 2005 (through the third quarter), S&P upgraded 600 CMBS tranches while downgrading just 80. Investment-grade tranches dominated upgrades, and more than 190 tranches were upgraded to triple-A. On the other hand, below-investment-grade tranches dominated downgrades, representing more than 70% of all downgrades over the same period. Not surprisingly, CRE CDOs have exhibited particularly good performance as well. Of the CRE CDOs issued to date, only a handful of the deals experienced negative rating migrations. According to Fitch, of the 52 CRE CDO deals it rated, just five tranches from two deals have been downgraded 12 to date. Both of the two deals were issued prior to 2002. In these deals, non-CRE factors, such as exposures to the manufacturing housing (MH) ABS sector, contributed to the downgrades (see Table 5 below). However, Fitch predicts that rating performance is likely to be different for newer deals that have a revolving structure and different underlying assets.
Table 5: Credit Performance of CRE CDOs

Issued Deals Tranche Prior to 2002 11 62 2002 12 83 2003 9 76 2004 9 93 2005 YTD 11 84 Total 52 398 Source: Fitch Vintage Downgraded (Tranche) 5 Upgraded (Tranche) 19 29 16 5 69
11 12
CMBS Quarterly Insights, Third-Quarter 2005, S&P research (27 October 2005).
Rezak, J., and K. Kendra, U.S. Commercial Real Estate CDO 2005 Performance Review, Fitch special report (6 October 2005).
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VII.
How CRE CDOs Are Analyzed
Since the early days of CRE CDOs, the rating agencies have been applying similar rating methodologies for CMBS and CRE CDOs. The approach is reasonable, because the source of risk is the same: underlying commercial real estate loans. Naturally, the rating agencies assign their CMBS groups to rate CDOs that are backed predominantly by commercial real estate assets. At Moody's, 13 for instance, its CMBS group rates a CDO if the transaction contains 75% or more CRE assets. If a CDO includes unrated assets, such as B-notes and mezzanine loans, the first step is to "shadow rate" them using a similar approach used in rating CMBS. At the loan level, the rating agencies examine the loan-to-value ratio (LTV) and debt service coverage ratio (DSCR) to assess the credit risk of each loan. The risk profile of an asset could vary significantly, depending on its position in the capital structure and other structural features. After the loan-level analysis, information is aggregated to assess losses at the CDO level. At the portfolio level, they would focus on the concentrations (i.e., "chunkiness") of individual deals or loans, property type, vintage, servicer, and geographic location, in order to assess the portfolio's diversity. 14 The rating agencies now use a simulation-based approach in analyzing CRE CDOs. Simulation allows incorporating correlation of underlying assets more easily. Also, simulation can show the implications of having a "lumpy" portfolio more precisely than arithmetically derived measures, such 15 as diversity scores or the Herfindahl score. Some market participants believe that CRE CDOs are punished for their lower diversity than other types of CDOs, because CMBS and REIT debt are treated as more highly correlated with each other than other assets, such as corporate credits. However, others think that there is little room for additional benefit from pooling CMBS and REIT debt that are already diversified. In general, a senior CRE CDO tranche tends to require larger subordination than a similarly rated tranche of a high-yield corporate CBO. However, subordination levels can significantly vary depending on the underlying portfolio's characteristics.
VIII.
Synthetic CRE CDO
Over the second half of 2005, issuance of synthetic CDOs referencing CMBS picked up. Some cash CRE CDOs, such as CW Capital Cobalt I, began to include a small portion (about 6%) of synthetic CMBS along with cash CRE assets. Also, there have been several 100% synthetic CMBS CDOs in 2005, where the CDO's reference pool consists of triple-A CMBS securities. For the time being, these synthetic CRE CDOs involve a static portfolio of highly rated CMBS, rather than subordinate 16 pieces. Halcyon 1 and Abacus 2005-4, issued in July 2005, were such deals, both referencing 30 17 triple-A rated CMBS.
13 According to the presentation given at Moody's 5th Annual U.S. CDO Investor Briefing, New York (7 September 2005). 14 Moody's admits it now "relies exclusively" on the newer simulation-based model, rather than on its binomial expansion model, when analyzing a CRE CDO. See, Levidy, N. et al., CMBS: Moody's Approach to Rating Static CDOs Backed by Commercial Real Estate Securities, Moody's rating methodology (17 June 2005). 15
Moody's Herfindarl score measures a pool's lumpiness and is calculated as
Herfindahl _ score =
(p
i =1
/ P )2
where n is the number of assets, pi is the principal balance of each asset, and P is the aggregate principal balance.
16 17
See, Bailey, B., et al., Synthetic Overview for CMBS Investors, Fitch special report (26 September 2005). The junior triple-A tranches of the two deals priced at 1mL+55 and 1mL+60, respectively.
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Issuance of synthetic CMBS is also gaining some traction. Synthetic CMBS is a credit default swap (CDS) referencing a CMBS tranche, rather than a pool of CMBS. As of the third quarter of 2005, trading of CMBS CDS represented as much as 30% of all structured finance (SF) CDS volume. The rapid expansion owes largely to the introduction of the standardized documentation for SF CDS in June 2005. In addition, a consortium of dealers is working on creating synthetic CMBS index, along SM the lines of the publicly traded, synthetic corporate indices, such as the Dow Jones CDX. In late 2005, we started to see the application of leveraged super senior (LSS) technology to CRE 18 CDOs. Leveraged super-senior became a popular structure in corporate-backed synthetic CDOs in 2005, where investors can take on a leveraged exposure to the super senior portion of the capital structure. As in the corporate version of LSS, these structures tend to come with additional triggers, 19 such as loss triggers or spread triggers. Given the relatively short history of structured finance products, however, assessing the likelihood of spread triggers can be challenging.
IX. One Final Thought: a CRE CDO has Some Characteristics of a CDO-Squared!
Between 2004 and 2005, the "resecuritization" of existing CDOs, or CDO-squared (CDO^2), has attracted much attention for its complexity and high leverage. Like CDOs of structured finance products (i.e., ABS CDOs), a CRE CDO that includes tranches of existing securitizations involves two layers of tranching; one at the asset (loans or CMBS) level and the other at the CDO level. In our view, such a structure is subject to similar sensitivity and volatility to CDOs-squared. For example, a CRE CDO comprised of 30 CMBS tranches can be viewed as a CDO-squared comprised of 30 "inner" CDO tranches. Like inner CDOs of a CDO-squared, each of the underlying CMBS tranches represents a portion of a diversified portfolio. The risk profile of the CDO-squared tranche is greatly affected by characteristics of the inner CDOs such as portfolio quality, tranche size and subordination. Moreover, CDOs-squared are known to be very sensitive to the level of 20 correlation and "overlaps" among underlying assets. If we look at a CRE CDO as a CDO-squared consisting of many inner CDOs (CMBS), there are several important factors to consider. First, some CMBS have overlapping exposures to the same mortgage loans in the form of "pari passu" bonds. Second, CMBS portfolio tends to be "chunky" with several large loans making up a large portion of the portfolio. Third, CMBS tranches tend to be relatively thin, resulting in a high probability of tranche wipeout and thus a higher severity rate. On the other hand, CRE loans that are increasingly included in CRE CDOs are likely to have significantly different risk characteristics from CMBS. These assets generally represent lower portions of the capital structure and hence are by themselves more risky than CMBS. However, one can benefit from pooling a large number of these assets, while the benefit of diversification is likely to be much smaller for CMBS that are already diversified. In our view, investors should distinguish between the underlying CRE risk (at the loan level) and the structural implications when analyzing a CRE CDO. Unfortunately, it is not clear at present if the rating agencies and market participants fully appreciate the implications of structural characteristics in different CRE assets.
18 See; Hypo Leverages Super Senior CMBS Tranche, Securitization News (26 December 2005). According to the report, this particular transaction is built on a synthetic CRE CDO deal called Halcyon 2, which priced in October 2005. .
Breaching of a trigger forces the investor to reduce leverage or take mark-to-market loss, and this feature drives a large portion of risk in LSS. These triggers are included to compensate a sponsoring dealer for the so-called gap risk, or the risk that the reference portfolio suffers a large amount of loss and the amount invested is not adequate to cover the loss.
20
19
For detailed discussion of CDOs-squared, see; CDOs-Squared Demystified, Nomura Fixed Income Research (4 February 2005).
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X.
Conclusion
In this paper, we discussed the evolution of commercial real estate (CRE) CDOs. One aspect of the evolution is that CRE CDOs now include unrated, non-securitized CRE assets that were previously held only by a handful of commercial real estate players. The newer, more flexible structure of CRE CDOs allows more efficient risk transfer by expanding the investor base beyond the traditional CRE players. However, some market participants have expressed concerns about the rapid expansion of 21 the CRE CDO sector. While there would be additional risk associated with including assets from the lower part of the capital structure and in allowing reinvestment in the collateral portfolio, we think that significant risk lies in their structures. In our view, the analysis of a CRE CDO should involve a similar approach to the drill down process used for a CDO-squared. Such an approach is likely to be able to grasp how the risk of the underlying commercial real estate filters through complex structures of each loan or CMBS deal.
21
For example, see: Who Let the CRE CDO Issuers Out?, Asset Securitization Report (7 November 2005).
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XI.
Appendix: CRE CDO Analytical Approach by Rating Agency

A. Moody's
At Moody's, the CMBS group rates CDOs when more than 75% of the collateral pool consist of CRE assets. Moody's assigns "shadow ratings" to unrated CRE assets using a CMBS-like loan analysis. For B-notes and mezzanine debt that are behind securitized A-notes, the analysis conducted for the A-note is used to assess the risk of the subordinate assets. On the other hand, whole loans are analyzed much in the same way as loans included in a CMBS deal. Moody's shadow rating of an unrated asset is based on the so-called "bottom-dollar" default probability, which is unadjusted for loss severity. To determine it, Moody's calculate a "bottom-dollar" LTV, as a LTV of the last dollar of debt on the property. On the other hand, loss severity rate depends on property type and thickness of an asset in the loan's capital structure. Loss severity for a CRE loan is generally lower than that for a thinly tranched CMBS. Moody's also reports a Herfindahl score, which is a measure of diversity of a CDO portfolio. Correlation between non-CMBS CRE assets is assessed based on the pool's diversity. Correlation for a CRE loan is generally assumed to be lower than CMBS, which are viewed as already diversified. Naturally, correlation is adjusted depending on characteristics such as property type, location, vintage and issuer. The table below summarizes the general assumptions Moody's currently uses.
Moody's CRE Analysis

Asset Default probability B-notes Mezzanine debt Based on bottom-dollar LTV Whole loan Source: Moody's Loss severity rate Lower than CMBS Lower than CMBS but higher than B-notes About 40% (much lower than CMBS) Correlation Lower than CMBS
Moody's employs two types of Monte Carlo simulations, one for loan pool losses and the other for 22 bond-level losses. Simulating pool losses for each underlying CMBS deal is advantageous when multiple tranches of the same CMBS deal are included in a CRE CDO. It would arguably yield better results than treating these CMBS tranches as separate assets in the same industry. On the other hand, a bond loss simulation generates correlated defaults for each CMBS security based on its credit rating. This approach is similar to the simulation commonly used in synthetic CDOs of corporate credits. Correlation is determined based on sectors, issuers, and vintages, as well as bonds' ratings. In a more general CDO context, Moody's has recently revised its assumptions for correlation among TM 23 structured finance products used in its CDOROM model. Under the new approach, Moody's assigns pair-wise correlations between asset classes, derived from the historical ratings transitions over the past 20 years. The table below shows Moody's correlation assumptions for CMBS, REIT, and RE CDO sectors.
In the loan pool loss simulation, the loss curve of an individual CMBS deal is derived from the initial subordination levels of the deal. Correlation depends on the deal type, with stress added for issuers and vintages. Once the loss amount for the deal is simulated, the corresponding tranche loss can be determined and aggregated for the CDO portfolio losses.
23 Toutain, O., et al., Moody's Revisits Its Assumptions Regarding Structured Finance Default (and Asset) Correlations for CDOs, Moody's special report (27 June 2005).
22
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Pair-wise Correlation for CRE Sectors

(Assuming North American assets with full vintage effect but no key agent stress) CMBSCMBS-Conduit CMBS-CTL REIT-Hotel REIT-Office Large loans CMBS-Conduit 35% 7% 7% 6% 6% CMBS-CTL 35% 7% 6% 6% CMBS-Large loans 35% 6% 6% REIT-Hotel 45% 15% REIT-Office 45% RE CDO Source: Moody's RE CDO 6% 6% 6% 6% 6% 34%
As mentioned above, the most significant change in the CRE CDO market is the shift from static pools to revolving (i.e., managed) pools. In order to control the uncertainty of changing portfolio composition, Moody's has published detailed criteria for revolving pools both at the pool level as well as the asset level. A compliance mechanism may be installed where the revolver is shut down or suspended (i.e., the portfolio switches to static) once credit quality of the pool deteriorates and certain triggers are breached. Recently, Moody's expressed its concern about reinvestment flexibility in CRE CDOs. Apparently, some issuers started to demand a mechanism where new collateral assets can be purchased without a detailed review by the rating agency, in order to take advantage of changing market conditions. Moody's stresses the important role played by subjective judgments in assessing credit quality of certain unrated CRE assets. An "out-of-the box" analysis can be particularly important for management/capital intensive properties, such as hotels and healthcare facilities, compared to multifamily, office and retail properties. Also, risk tends to be much greater for a low-diversity pool with "chunky" assets.
24
B.
S&P
25
S&P applies its CDO simulation model, CDO Evaluator, to analyzing CRE CDOs. For unrated, unsecuritized assets, S&P also assigns "shadow ratings" before putting them into the model. For CMBS and REIT debt, S&P uses three sector categories for rated CRE assets; diversified CMBS (conduit) and CTLs, other CMBS (large loan, single borrower, and single property), and REITs (and REOCs). Correlation is assumed to be 30% within the same sector and 10% across different sectors. For B-notes, mezzanine loans and whole loans, S&P treat them as one sector and assigns a single correlation number of 15%. Recovery rate is assumed to vary based on the type of CRE loans, as 26 listed below. S&P Recovery Rate Assumptions
Senior B notes First-loss B notes Whole loans Mezzanine loans / preferred equity Source: S&P 35% 30% 50% 25%
C.
Fitch
For analyzing CRE CDOs backed by CRE loans, Fitch conducts a loan-level review that is similar to the one used for analyzing conduit CMBS deals. Default probability and loss severity are assessed for individual loans and then aggregated to arrive at expected losses for the entire portfolio. For each loan, default probability is determined from a debt service coverage ratio (DSCR), while loss severity
24
Philipp, T., et al., US CMBS 3Q 2005 Review: Conduit Leverage Levels Off in Moody's Rated Deals, Moody's special report (31 October 2005). S&P released the latest version of its model, CDO Evaluator 3.0, on December 19, 2005. According to the presentation at the S&P
25 26
Annual Global CDO Conference, New York (19 September 2005).
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is assessed from a loan-to-value (LTV) ratio. Both numbers are adjusted to take into account characteristics of the underlying property, such as property type, cash flow volatility, position in the capital structure, etc. At the portfolio level, Fitch reviews originators and servicers of the underlying loans. For a revolving deal, the deal's reinvestment criteria would be evaluated. Interestingly, Fitch does NOT use its Vector simulation model for a CDO that includes only unrated CRE assets. To the extent that the deal includes rated securities, the rating agency combines simulation outputs and the results from the 27 loan-level analysis.
27 For Fitch's approach to CRE CDOs, see, Lee, J., et al., Rating Methodology for U.S. Revolving Commercial Real Estate Loan CDOs, Fitch criteria report (28 September 2005).
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XII.
Data Appendix: CRE CDO Deal List

Deal Issue Date Amount Sr. triple-A spread (bps) 37 50 28 37 33 32 32 45 32 26.5 Jr. triple-A subordination 57.5% 27.18% 31.85% 74.14% 65.65% 39.26% 80.31% 3.30% 26.65% 22.65% % of CMBS 0% 100% 67.1% 92.5% 0% 16.3% (sub-prime RMBS) 16.2% REIT 7.5% (REIT debt) 59.8% (B notes) 31.7% (mezz loans) 8.5% (whole loans) % Other RE 36.3% (mezz loans) 34.2% (whole loans) 26.9% (B notes) 2.6% (preferred equity)
Arbor Realty Mortgage Securities 2005-1 ARCap 2005-1 Newcastle VII Sorin RE CDO II* Brascan RE CDO 2 Acacia CRE CDO I JER CRE CDO 2005-1 Halcyon 2* Wrightwood CDO 2005-1 N-Star CDO V
12/20/2005 12/19/2005 12/8/2005 12/8/2005 11/23/05 11/23/2005 10/25/2005 10/5/2005 10/19/2005 9/13/2005
$475.00 $568.40 $525.00 $400.00 $300.00 $261.75 $415.00 $92.00 $650.00 $500.00
100% 100% 0% 75.9%
Carbon Capital II LNR CDO III Guggenheim Structured RE 2005-2 Abacus 2005-4* Halcyon 2005-1* FMC Real Estate CDO 2005-1
8/18/2005 8/8/2005 8/4/2005 7/21/2005 7/20/2005 7/1/2005
$455.00 $1,100.00 $350.00 $6,000.00 $82.63 ($/) $439.40
31 28 32 60 55 33
73.80% 61.75% 40.56% 2.13% 2.35% 60.00%
0% 82% 17.7% 100% 100% 0%
30 AAA CMBS 30 First mortgage loans 19.8% (REIT) 5% (CRE CDO) 2.4% (STL) 1.2% (B notes) 60.2% (mezz loans) 27.1% (B notes) 12.7% (whole loans) 16 (B notes) 2 (mezzanine loans) 42.4% (B notes) 21.6%(whole loans) 15.0% (mezz loans) 30 AAA-rated CMBS 30 AAA-rated CMBS 59.2% (B notes) 37.7% (mezz loans) 3% (whole loans) 24% (B notes and rake bonds) 5.4% (mezz notes) 2.5% (REIT bank facility) 42% (whole loans) 41% (B notes) 12% (mezzanine loans) 57.1% (B notes) 23.1% (Mezzanine loans) 4.8% (CRE CDO) B notes mezz loans whole loans 49% (B notes) 22% (mezz loans) 11% (whole loans) 21% (B notes) 23% (whole loans) 6% (synthetic CMBS) 2% (CRE CDOs) 8.4% (REIT) 14% (REIT) 6 (RE CDO) 64.5% (B notes) 19.2% (mezz loans)
Sorin Real Estate CDO I
6/24/2005
$403.00
30
18.21%
33%
Gramercy Real Estate CDO 2005-1 N-Star REL CDO IV
6/21/2005
$1,000.00
32
43.00%
0%
5/27/2005
$400.00
35
53.75%
15.0%
Prima Capital 2005-1
5/10/2005
$376.00
26
25.00%
Guggenheim RE CDO
4/29/2005
$500.00
28
63.86%
16%
CW Capital Cobalt I Newcastle CDO VI N-Star REL CDO III Capital Trust RE CDO 2005-1 CapLease CDO 2005-1
4/18/2005 4/19/2005 3/10/2005 3/2/2005 2/3/2005
$450.00 $468.00 $377.00 $337.80 $300.00
28 30/40 28 29 42
42.84% 35.4%/23.6% 26.5% 37.26% 16.00%
49% 66% 73% 16.3%
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Sr. triple-A spread (bps) 45 33 34 33 35 36 40 50 48 45 25 (MM) 42 70 53 55 58 57/90 57 65 47 48 45 45 47 55 55 49 50 47 50 Jr. triple-A subordination 61.00% 56% 22.40% 44.49% 26.75% 51.18% 21.50% 69.1% 55.00% 26.0% 21.0% 22.89% 26.9% 87.63% 20.00% 63.00% 22.67%/13.9 48.28% 18.99% 76.47% 40.55% 58.49% 24.60% 22.12% 27.49% 25.60% 24.00% 18.00% 28.00% 24.00% 41.9% 33.7% 52.1% (REIT) 6.0% whole loans 66.3% (REIT) % of CMBS 0% 80.0% 54.3% 0% 72.0% 83.5% 65.4% 85.4% 88.0% 52% 70.7% 63.4% 63.3% 100% 37.9% 71.2% 42.3% 81% 55.5% 100% 83% 79% 65.1% 39.3% 50.9% 66.1% 35.4%
Deal Arbor Realty Mortgage Crest 2004-1 Newcastle CDO V Capital Trust RE CDO 2004-1 N-Star REL CDO II Anthracite CDO III Newcastle CDO IV G-Force 2003-1 Crest 2003-2 TIAA Real Estate CDO 2003-1 Newcastle CDO III N-Star Real Estate CDO I Newcastle CDO II LNR 2003-1 Crest Dartmouth Street 2003-1 Crest 2003-I G-STAR 2003-3 Anthracite CDO II G-STAR 2002-2 LNR 2002-1 G-Force 2002-1 Anthracite CDO I TIAA Real Estate CDO 2002-1 Crest 2002-I G-STAR 2002-1 Newcastle CDO I Crest G-Star 2001-2 Putnam Structured Product CDO 2001-1 Crest G-Star 2001-1
Issue Date 12/16/2004 10/11/2004 9/22/2004 6/30/2004 6/29/2004 3/16/2004 3/11/2004 12/5/2003 11/26/2003 10/20/2003 9/8/2003 8/8/2003 8/5/2003 6/25/2003 3/20/2003 3/5/2003 2/27/2003 11/26/2002 11/5/2002 6/28/2002 5/31/2002 5/14/2002 5/6/2002 4/24/2002 4/10/2002 3/28/2002 11/16/2001 11/13/2001 8/7/2001
Amount $305.00 $351.00 $500.00 $324.00 $400.00 $435.00 $450.00 $540.10 $325.00 $300.00 $480.00 $402.00 $472.00 $801.70 $350.00 $600.00 $450.00 $307.13 $397.50 $416.50 $1,097.18 $515.81 $500.00 $660.00 $323.95 $500.00 $350.00 $300.00 $500.00
% Other RE 56.7% (mezz loans) 35.5% (whole loans) 2.2% (B notes) 20% (REIT, whole loan, Junior A note, RE CDOs) 20.5% (REIT) 92.1% (B notes) 7.9% (mezz loans) 23% (REIT) 5 % (RECDO) 11.9% (REIT) 16.8% (REIT) 10.8% (B note) 2.4% (RE CDO) 1.3% (whole loan) 12% (REIT/CTL loan) 47% (REIT) 19.9% (REIT) 32.2% (REIT) 4.4% (RE CDO) 25.9% (REIT) 56.7% (REIT) 5.4% (whole loans) 28.8% (REIT) 15.0% (REIT) 16% (REIT) 3% (whole loans) 29.2% (REIT) 17% (whole loans) 21 (REIT) 33.7% (REIT) 60.7% (REIT) 49.1% (REIT) 26.0% (REIT) 58.3% (REIT) 2.0% CMBS CDO
Crest 2001-1 2/1/2001 $500.00 Source: S&P, Moody's, Fitch, Bloomberg, IFR * denotes synthetic
END
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