Bonds Backed by Apartments Are Under Stress as Housing Market Cools
Defaults are rising for a niche mortgage bond used primarily to fund apartment-building purchases, another sign that rising interest rates are upending the property sector.
This product, known as collateralized loan obligations, or CLOs, are mortgages packaged into bonds that are sold to investors. These mortgages helped fuel the rise in housing costs across Sunbelt states such as Arizona, Texas and Nevada, facilitating the purchase of buildings where property owners saw opportunities to raise rents.
Rental apartments accounted for two-thirds of the CLOs issued in 2021 and 81% of those issued in 2022, according to real-estate data firm Trepp.
The mortgages associated with CLOs appeal to property owners because they can put down less equity and take on more debt than with bank mortgages. They also have shorter terms and floating interest rates that make it easier for owners to sell or refinance their buildings after a few years.
But some of the same characteristics that made these loans attractive to property owners also made them riskier and more vulnerable to sudden changes in borrowing rates. Last year’s surge in interest rates, a softening rental market and rising expenses mean many landlords no longer earn enough money to pay back their loans.
“The market has really changed for these people,” said
chief executive of Beacon Default Management, a company that helps lenders foreclose.
Applesway Investment Group lost two properties tied to CLOs last month after defaulting on floating-rate loans. Downtown Los Angeles landlord Laguna Point missed payments on a loan packaged into a CLO, after a plan to increase rents by $700 a month per unit was stifled in part by low rent collections, according to loan documents. Laguna later sold the properties to Miami-based Fifteen Group in March, according to data provider MSCI Real Assets.
Nearly $88 billion in securitized mortgages are at risk of default, and 42% of them are backed by apartment buildings, Trepp estimates. CLOs make up the majority of these at-risk apartment loans.
The loans are in danger of default because the buildings they back earn insufficient or barely enough money to cover debt payments, Trepp said.
Defaults remain rare but have become more common since last year. About 1.4% of commercial real estate CLOs were delinquent as of April 30, according to data company CRED iQ, up from 0.4% last July. Ms. Parelskin said she expects a lot more defaults in the months to come because property CLOs are “more volatile” than other types of mortgages.
Property CLOs trace their roots to the aftermath of the global financial crisis. Following the crash, banks became more conservative, eschewing risky property deals and lending less money as a share of a building’s value, brokers say. That meant investors looking to buy buildings that were vacant or in need of extensive repairs needed an alternative source of money. CLOs popped up to help fill that void. These securities were popular with bond investors because they offered higher yields at the same time interest rates were low, analysts said.
Surging apartment rents kicked off a buying frenzy in 2021 as investors bought more multifamily properties than in any year in history. Many took out securitized loans. Commercial real estate CLO issuance rose to a record $45.4 billion in 2021, up from just $8.7 billion in 2020, according to CRED iQ.
Now, borrowers are getting squeezed from multiple sides, said
At the same time, construction and insurance costs have risen, meaning many renovation projects are running out of money. Expiring loans are harder to refinance because many lenders are reluctant to dole out new mortgages.
CLO lenders, rather than bondholders, are most in danger of losses if defaults rise, said
a senior director at Fitch Ratings. That is because these companies typically keep the most junior 15% to 20% of bonds they create, meaning they are last in line to get paid. The list of the 10 biggest issuers includes affiliates of Arbor Realty Trust,
Berkshire Residential Investments, LoanCore Capital and Blackstone, according to CRED iQ.
One of the biggest apartment buyers to use CLOs was Los Angeles-based Tides Equities. The company snapped up $1.7 billion of apartment properties in 2021 alone. The buildings are mostly located in Southwest markets such as Phoenix and Las Vegas where rents were booming until recently.
But for at least a handful of Tides’s investments, higher interest rates and falling rents are combining to push down profit, according to loan records.
One of the properties is Tides on Gilbert West, a 113-unit low-rise complex in the Phoenix suburb of Mesa, Ariz. Interior renovations were running behind schedule last year, according to a note from CBRE Loan Services, and asking rents at the property are down about 20% from early 2022, data from CoStar
Last year the building didn’t earn enough money to cover debt payments, according to Trepp. The company overseeing the property’s mortgage placed it on a watch list for potentially troubled loans. Tides has so far stayed current on payments, however.
a Tides executive, said a temporary fall in profit at some properties is an expected part of a business plan that depends on renovating empty units, then leasing them back out at an initially discounted rate.