If all indicator lights hold true, then the European CRE CLO market is primed and ready for take-off, explains Iain Balkwill, partner at Reed Smith.

Indeed, if this market manages to follow the same eye-watering trajectory of growth experienced in the United States, then not only are we in for a majestic ride but this could be truly transformational for the European commercial real estate (CRE) finance market.

Just like CMBS, at its core a CRE CLO features the securitisation of a pool of loans secured by CRE. However, unlike CMBS, it is not designed to exploit an arbitrage between capital markets and loan interest rates, but instead it is a balance sheet financing tool which is ideally suited for those debt funds that have stepped into the lending void created by the retraction of the banks from the lending space. To date, such funds have largely financed their loans using either pure equity, loan-on-loan facilities or repo lines, but with the arrival of the CRE CLO they now have another string to their bow.  

For the debt funds, on an economic level a CRE CLO makes a lot of sense given the high level of leverage it enables them to obtain, the compelling weighted average interest rate, as well as the ability to match fund their underlying loans. From a business perspective, these structures are appealing as they allow the sponsor to retain an ongoing relationship with the underlying borrowers. In addition, the funding product has the capacity to cater for a change of the composition of the securitisation pool with loans being replenished as well as actively traded. Comparing these attributes against the other financing options certainly makes embracing this technology a truly exciting funding alternative for the erstwhile debt fund.

From an investor’s perspective, the CRE CLO offers a mouth-watering proposition. The attractiveness of the product stems from the fact that the CRE CLO notes demand a premium compared to CMBS, as well as a number of structural benefits. Chief among these is the fact that the sponsor retains a significant amount of equity in the structure and there is the presence of note protections tests which cut off payments to the equity at times of distress. Further assurance is also derived from the sponsor continuing to have an active role in managing the underlying collateral.

On a macro-economic perspective, the arrival of the CRE CLO can be considered a hugely positive development given that this technology is a neat way of distilling CRE finance risk from the banking sector and transmitting this risk across a wide and diverse investor base. Securitisation also by its very nature shines a light on a traditionally opaque financing market. From a CRE perspective, the tantalising prospect about the product is that it has proven to be ideal at providing back-to-back financing for funding transitional assets. Moreover, it has the capacity to play a key role in enabling property owners to embrace ESG principles, as well as financing the repositioning of properties so that they are better tailored to the practical realities of a post-pandemic world.

Although the benefits of a CRE CLO are great, it also comes with its drawbacks. For example, putting in place a securitisation is more challenging than other forms of finance especially if notes are to be rated, listed and sold to both European and US investors. These structures also come with a high upfront price tag when you factor in all the relevant fees in setting up the structure and preparing the relevant disclosure. Sponsors – and to a certain extent their underlying borrower will also find themselves – under the permanent gaze of the capital markets. However unappealing these stark truths are, when you factor in the overall positive economics and associated benefits, then these drawbacks are put into perspective.

At this point in time, the European CRE CLO product can definitely be considered to be a true game-changer when it comes to financing European CRE. In a world of rising interest rates, coupled with once-in-a-generation demand to adapt and repurpose properties, the arrival of this technology will be hugely welcome. So, when it comes to the European CRE CLO, now is the time to fasten seat belts and prepare for take-off. Whether this will be a plane flight or a rocket ride, time will tell, but if all the indicators prove true then the infamous countdown has already begun.