In Turbulent Times CMBS and
CDOs Remain Complementary
Darrell Wheeler, Mitch Wasterlain and Jeff Prince
A year ago, Citigroup published an
article entitled “Brothers in Arms:
Comparing the CMBS and CRE
CEO Markets.”1 They concluded
Wheeler
that the two markets are more
complementary than they are
competitive. In light of the continued
growth of both markets, as well as
the recent turmoil related to the
sub-prime residential market,
Citigroup decided to re-examine the
relationship between the CRE CDO
(commercial real estate collateralized
debt obligation) and commercial
mortgage-backed securities (CMBS)
markets. For the most part, we believe
Wasterlain that the conclusions from last year’s
article still hold true. But now we also
address two new questions raised by
the recent meltdown in the residential
sub-prime mortgage market:
• Does the growing importance of ABS and CRE CDOs
as investors in mezzanine CMBS pose a risk to liquidity
in the CMBS market?
• What is the correct pricing relationship between the
two markets?
On the first point, Citigroup concluded that there is
enough liquidity in the CMBS market to absorb supply even
if ABS and CRE CDOs withdraw from the market.
However CDO demand does affect the pricing of CMBS
mezzanine classes because it can be the most aggressive bid
for this paper. On the second point, CRE CDO and CMBS
pricing should continue to converge as the CRE CDO
market grows and develops a broader investor base, but
there will be significant price differences between CRE
CDO bonds depending on the collateral type and the
manager.
MARKET SIZE AND GROWTH COMPARISON
The CMBS market is older and vastly bigger than the
CRE CDO market. The first CMBS transactions were
executed in the mid-1980s as a means for moderately sized
institutional investors to access commercial real estate
investments and as a way for banks to shed their exposure
®
“ Usually the collateral supporting CRE CDOs
is quite different than the collateral
”
backing CMBS transactions...
to large real estate loans. CRE CDOs, on the other hand,
were first issued in 1999 for subordinate real estate
investors to leverage their investments (that is, to
concentrate commercial real estate risk). Therefore, not
surprisingly, the CMBS market is also much larger than the
CRE CDO market. We estimate total U.S. CMBS
outstanding to be nearly $650 billion, while total CRE
CDO debt outstanding is perhaps one-tenth of that
number.
In Chart 1, year-by-year CMBS issuance since 1996 is
compared to total CDO market issuance and, specifically,
CRE CDO issuance. While total CDO issuance and CMBS
issuance is surprisingly similar, the percentage of CDOs
backed predominately by commercial real estate debt is
still quite small (about 9% of 2006 CDO market issuance).
Furthermore, the percentage of CRE CDOs backed by
whole loans is even smaller still (as discussed in the next
section), and it is this small but growing CRE segment of
the CDO market that has some investors wondering
whether CDO and CMBS bankers may at some point
compete for the same clients and the same collateral.
COLLATERAL DIFFERENCES ABOUND
Usually the collateral supporting CRE CDOs is quite
different than the collateral backing CMBS transactions
despite the mutual focus on commercial real estate debt.
CMBS transactions are backed only by secured (first
mortgage) debt, as required by the REMIC guidelines. On
the other hand, CRE CDOs are often backed by second
lien loans, unsecured debt, preferred equity, and even
other ABS (see Chart 2). CRE CDOs can also invest
synthetically, a feature that has been significantly growing
in importance recently. CDOs that reference collateral
synthetically are able to take risk exposure to bonds or
loans that may not be available in the cash markets. In
addition, collateral can be ramped up more quickly in the
synthetic markets, provided there is a willing buyer of
protection. The introduction of the CMBX Index probably
further stimulated the trading in CMBS synthetic
SUMMER 2007 41
 In Turbulent Times CMBS and CDOs Remain Complementary
Chart 1: CMBS and CDO Issuance, 1996–2006 ($ millions)
®
350
300
250
200
150
100
50
0
1996 1997 1998 1999 2000 2001 2002
CDO Volume Less CRE CDOs CRE CDO Volume
Source: Citigroup
“
CRE CDO investors are not as likely to underwrite
individual properties so diversification
in the collateral pool is emphasized.
positions. CMBS transactions are restricted to simple
cash loans, however. Other differences exist as well; for
example, CMBS collateral tends to be 10-year fixed-rate
mortgage while CRE CDO collateral is often floating
rate and shorter in maturity.
Floating rate commercial loans, whether in a CRE
CDO or a CMBS transaction (some large floating rate
loans do get securitized in CMBS) are often considered
“transitional,” which means that the property
collateralizing the loan is underutilized in some way.
Transitional property owners often seek short-term
(prepayable), floating rate loans to make property
improvements, which should attract new tenants or
permit owners to raise rents. Once cashflow from the
property is improved or restored, then the owner often
converts the high-cost, floating rate debt into cheaper
(and longer), fixed-rate debt. The resulting long dated
fixed-rate debt then will likely find its way into a CMBS
conduit transaction, which provides cheap (cheaper than
a CRE CDO) long-term funding. The recycling of the
loan into the CMBS market also goes on to provide B-
pieces and rake bonds for securitization in CRE CDOs.
CRE CDOs backed by whole loans emerged in 2005,
and accounted for 32.4% of the market in 2006. Many
of the loans included in the CRE CDOs are not likely
to find a home in a floating rate CMBS transaction
42 CMBS WORLD®
(cont.)
Chart 2: Comparison of CRE CDO Collateral and
CMBS Collateral, Year-End 2006
REIT 7.5%
Whole Loans
32.4%
CMBS
39.3%
2003 2004 2005 2006 B Notes – Mezz
20.8%
CMBS Issuance
Source: Citigroup
because of their small size. Since in a floating rate
issuance CMBS investors generally prefer to re-
underwrite each loan in a CMBS pool, a highly diverse
pool based on small loans becomes a challenge due to
” the sheer number of properties to inspect. Thus, for
floating rate issuance, CMBS execution lends itself to
static, chunky, collateral pools that are well studied prior
to investment. As a result, it is not uncommon for the
largest loan in a floating rate CMBS transaction to be
$500 million or represent 15%-30% of the entire
collateral pool.
CRE CDO investors are not as likely to underwrite
individual properties so diversification in the collateral
pool is emphasized. Thus, relatively small loans are
preferable in CDOs, so that the risk profile of the pool
does not change dramatically if a loan defaults or
prepays, or if a manager substitutes one loan for another.
While small loans still constitute the bulk of the CRE
CDO portfolios, loans of $50 million or more have
become more prevalent in 2006 and 2007. These loans
are facilitated by the growing size of CRE CDOs. In
2006, the average CRE CDO deal size was $780 million
compared to $537 million in 2005. If this trend
continues, we may see more overlap between CMBS
originators and CRE CDO originators.
On a positive note, the collateral segmentation and
the liquidity created by an active CRE CDO market can
lead to more CMBS collateral, and vice versa. CRE
CDOs have increased liquidity for subordinate debt,
which has enabled CMBS lenders to win more first
mortgages in their competition with traditional portfolio
lenders, which, of course, has created collateral for
CRE CDOs.
In Turbulent Times CMBS and CDOs Remain Complementary
Chart 3: Structural Comparison of CRE CDOs and CMBS Transactions
Feature
Domicile
Collateral
(as discussed in the previous section)
Collateral ramp up period
Collateral Quality
Collateral Quality Tests
Portfolio Profile Tests
Collateral Management
Management Fees
Issuance Costs
(Banker fees)
Hedging inside of transaction
Structural Support for Debt
Writedown upon loss?
Interest only tranche
Callable?
Source: Citigroup
COLLATERAL MANAGEMENT DRIVES STRUCTURAL
DIFFERENCES
The ability to actively manage a portfolio is important
when collateral is expected to prepay or mature quickly
(for example, within two to three years). Investment
flexibility allows a manager to reinvest principal
proceeds into new collateral, and thus, mitigate the need
for frequent and expensive securitization, and avoid the
degradation of the transaction economics for the
subordinate investors. The cost of this flexibility (from
an investor’s point of view) is the imposition of many
collateral eligibility guidelines, management fees, cash
trapping mechanisms, and relocation of the trust to an
offshore tax haven (see Chart 3).2 Thus, most structural
differences flow from the need for collateral and
management flexibility in handling these smaller asset
positions.
CDO technology is designed to give a collateral
manager freedom to: (1) seek relative value in a variety
of collateral types, (2) minimize collateral pool losses, (3)
realize gains as opportunities present themselves, and
(4) utilize the efficient funding provided by
securitization for an extended period of time.
One difference between CRE CDOs and CMBS that
deserves further explanation is the cash trapping
mechanisms contained in CDO “waterfalls,” which
allow a CDO to divert excess interest proceeds to senior
(cont.)
®
CRE CDO CMBS
u Offshore (e.g., Cayman Islands) u Domestic (e.g., Delaware)
u Secured and unsecured debt u Mortgage debt only
u Short or long dated u Short or Long dated
u Derivatives (synthetic collateral) are OK u No derivatives (except interest rate swaps)
u Yes (e.g., six months) u No, collateral defined entirely at close
u Usually below investment-grade u Investment-grade or lower leverage mortgages
u Yes u Set Day One
u Yes u Set Day One
u Reinvestment of principal for a period (e.g., five years)
u Discretionary trading (e.g., 10% per year) u None
u Senior (e.g., 10 bp) u Master servicer fees (2 bp-4 bp)
u Junior (e.g., 15 bp) u Special servicer fee as needed
u Incentive fees
u High u Low
u Interest rate hedges are common u Restricted to interest rate management
u Conceivable to have short buckets
u Subordination u Subordination
u Cash diversion mechanisms
u No, cash diversion mechanisms permit the transaction u Yes
to repair itself
u Rarely u Common
u Yes, transaction may be called by equity holders after u Maturity dependent on the expiry of the mortgages
a period of time (e.g., five years)
debt when significant collateral losses occur (see Chart
4). CDO transactions often have the opportunity to
repair themselves by paying off senior debt principal
with interest dollars to bring overall CDO debt levels
back into equilibrium with collateral levels (and thus
avoid the need to write-down junior debt). For CRE
CDO debt investors, this constitutes another source of
subordination (protection) that is not present in a CMBS
transaction. Consequently, CDOs generally do not have
an interest only (IO) tranche to absorb excess interest.
Instead, excess interest can be diverted by the cash-
trapping mechanisms to enhance credit protection when
an over-collateralization (OC) test is triggered.
Otherwise, when the transaction is performing, this
excess interest is paid to the most subordinate tranche
(the “equity” tranche).
Interestingly, for static CMBS pools, early
liquidations or prepayments also have the potential to
improve the pool’s credit enhancement. As a result of
these paydowns, many CMBS pools have experienced
collateral upgrades as the collateral has benefited from
the real estate cycle and pools have paid down.
ISSUER RATIONALE: RISK DIVERSIFICATION VERSUS
RISK CONCENTRATION
The general mechanics for issuing a CRE CDO may
be similar to the mechanics for issuing a CMBS
transaction, but the rationale is often quite different.
SUMMER 2007 43
 In Turbulent Times CMBS and CDOs Remain Complementary (cont.)

Chart 4: Stylized Comparison of CRE CDO and CMBS Waterfalls

®

CRE CDO Waterfall CMBS Waterfall

Interest Principal Interest Principal

Proceeds Proceeds Proceeds Proceeds

Senior Tranche Senior Tranche

Fail

Interest Only Tranche (IO)

Test

Mezzanine Tranche Mezzanine Tranche

Fail
Test

Equity Tranche Equity Tranche

Source: Citigroup

Chart 5: List of CRE CDO Issuers

Asset Managers Mortgage REITs Real Estate Loan or Opportunity Investors

Mass Mutual (Babson Capital Management, LLC)* Anthracite Capital, Inc. (BlackRock) Brascan Real Estate Financial Partners
Ellington Management Group, LLC ARCap REIT, Inc. Five Mile Capital Partners
ING Baring (US) Capital Corporation Newcastle Investment Corp. (Fortress) Guggenheim Structured Real Estate Advisors
MFS Investment Management Capital Lease Funding, Inc. CW Capital LLC (Allied)
Putnam Investments CT Investment Management Co., LLC Sorin Capital Management, LLC
Wells Fargo Arbor Commercial Mortgage, LLC Arbor Commercial Mortgage, LLC HSH Nordbank AG
Alliance Capital Management L.P. LNR Property Corp. J.E. Robert Companies
Prima Capital Advisors Gramercy Capital Corp. Taberna Capital Management
TIAA Advisory Services NorthStar Realty Finance Corp. GMAC Institutional Advisors, LLC*
G Funds Asset Management (GMAC)
Structured Credit Partners
Legg Mason Real Estate Investors
*Contributed to CMBS transactions.
Source: Citigroup

CMBS transactions are executed to enlarge the effective
lender base for large commercial real estate and to
permit banks to manage the risk of their commercial real
estate loan books. However, risk transference is often a
secondary concern for many CRE CDO issuers
(generally junior lenders such as mortgage REITs), who
want to keep the real estate risk but need better sources
of financing. Thus, the sponsors of CMBS (investment
banks and large commercial banks) tend to be different
from the sponsors/managers of CRE CDOs.
Occasionally, an asset manager may also issue a CRE
CDO to grow assets under management. In Chart 5, we
identify most of the CRE CDO managers that have
issued to date. With a few exceptions (Mass
Mutual/Babson and GMAC), none of these CRE CDO
issuers have issued or contributed to a CMBS
transaction. The list does include every first loss buyer
for CMBS issuance, demonstrating how CRE CDOs are
helping distribute subordinate CMBS risk. In addition,
a number of the mortgage REITs (real estate investment
trusts) have issued re-REMICs (real estate mortgage
investment conduits) which, with recent market
turbulence, may be the easiest market execution due to
the long-term static characteristics of a re-REMIC.
PARTIALLY OVERLAPPING INVESTOR BASE
Structural and collateral differences notwithstanding,
the investor bases for CRE CDOs and CMBS do
overlap; both markets regularly sell to asset managers,
banks and insurance companies. Historically, insurance
companies dominated the CMBS investor base, but
others – including money managers, pension funds and
hedge funds – have become increasingly active.3 In part,
the broadening appeal of CMBS is due to its inclusion

44 CMBS WORLD®
In Turbulent Times CMBS and CDOs Remain Complementary
Chart 6: Nearly 50% of CRE CDO Paper is Sold Overseas –
Geographic Distribution
Non-U.S.
46.0%
54.0%
Source: Citigroup
“ Probably the most striking difference between
CRE CDO investors and CMBS investors
is the participation of foreign investors.
in various fixed income indices, but solid historical
performance and investors’ need to diversify also
contribute to its growing popularity.
Early CRE CDOs, which were often backed by a
static pool of CMBS and REIT debt, also appealed to
traditional CMBS investors who could reunderwrite the
entire portfolio. Thus, many CRE CDO investors also
were regular CMBS investors. However, the reverse was
not always true. Probably the most striking difference
between CRE CDO investors and CMBS investors is
the participation of foreign investors. As much as 46% of
CRE CDO paper is sold overseas (see Chart 6), while
fixed-rate CMBS paper is almost exclusively sold
stateside, with only floating rate CMBS having a major
overseas investor base.
CRE CDO debt investors include European and
Asian banks (senior paper), insurance companies
(mezzanine and senior paper), and CDO managers 4
(mezzanine paper). CRE CDO equity is often held by
the CDO manager. If not, it is then sold to a smattering
of asset managers, banks, insurance companies (often in
combo form), pensions, and private individuals. A
relatively high rating-adjusted spread and the ability to
diversify explain the broad appeal of CRE CDO paper
for most investors.
(cont.)
Chart 7: CMBS Spreads to Swap
®
BBB+ BBB BBB-
1/5/2007 60 75 90
2/2/2007 60 75 90
3/2/2007 80 90 110
3/30/2007 110 120 155
Source: Citigroup
U.S.
HOW IMPORTANT IS THE CDO BID TO THE CMBS
MARKET?
Market sources estimate that ABS, CRE CDOs and
re-REMICs accounted for a substantial percentage of
the demand for newly issued triple-B-rated CMBS paper
in 2006 (at a minimum, 20% of the total demand, and
potentially as high as 80% if we include re-REMIC
actives). A significant portion of this demand evaporated
in March 2007 due to the reduced presence of ABS and
CRE CDOs following the turmoil in the sub-prime
market. CDOs became less active due to uncertainty
over the pricing spreads at which the CDO liabilities
would eventually get sold. Furthermore, warehouse
lenders have become more restrictive, and in some cases
have closed warehouses for CDOs where the manager
”
was not putting up a significant amount of equity. This
contributed to the fact that triple-B CMBS spreads have
widened substantially between late February 2007,
when they were at swaps plus 75 basis points (bp), and
late March 2007, when they were at swaps plus 125 bp.
Other market factors such as greater volatility and a
reduced investor appetite for risk were clearly
responsible for much of the curve steepening that
occurred during this period.
In fact, triple-B CMBS have rapidly gone from being
almost 15 bp rich to being 25 bp cheap, and this has
brought portfolio investors back into the market. It
remains to be seen when demand from CDOs will
rebound, and at what spreads. At current spread levels,
the equity returns to a CDO are considerably higher
then they were, even when taking into account wider
CDO liabilities. This occurs because approximately 85%
of the liabilities of an investment-grade CRE CDO are
rated triple-A, and triple-A spreads have only widened
by a few basis points. Even if triple-B CDO spreads
widen by 100 bp, the weighted average cost of liabilities
for the CDO is only 3-6 bp wider, whereas some asset
spreads are now 100 bp wider. Because of this we expect
over time that new CDOs and re-REMICs will boost
demand for triple-B CMBS and bring the spreads back
down. What constrains this in the short run is availability
of warehouse funding and uncertainty over the CDO’s
ability to clear the market. But even then Citigroup did
a recent survey of insurance companies and found a large
proportion would buy a re-REMIC of triple-B CMBS at
SUMMER 2007 45
 In Turbulent Times CMBS and CDOs Remain Complementary
Chart 8: Spread to Swaps of CMBS and CRE CDOs
®
250
200
150
100
50
0
2/11/05 6/11/05 10/11/05 2/11/06 6/11/06
CMBS AAA (Sr) CMBS AA
CRE CDO AAA (Sr) CRE CDO AA
Source: Citigroup
reasonable spreads even given recent market turbulence.
Basically we feel the CMBS market has the investor
foundation to stage a recovery of both CMBS and eventually
CRE CDO spreads.
This brings us to the question of relative pricing between
CMBS and CRE CDOs. The spread between those two
sectors has steadily converged, as shown in Chart 8.
Will the relationship ever be inverted? We think not, at
least in the near term. CDOs present greater uncertainly
than CMBS, and are more difficult to analyze, due to the
manager’s ability to reinvest and substitute collateral. This
flexibility, along with the manager’s ability to call the CDO
after three to five years, means that there is little potential
for upgrades in a managed CDO. On the other hand, many
seasoned CMBS bonds have been upgraded due to rising
real estate values. Thus, CDO investors demand a premium
for giving up this upside.
There is also a technical relationship between CMBS and
CDOs that should keep CDO spreads wider. Basically
anytime CDO spreads tighten to levels that are at or near
CMBS spread levels, an attractive arbitrage is created
whereby CDOs can buy CMBS bonds and repackage them.
This, of course, will cause CDO buyers to bid up CMBS
bonds and drive CMBS spreads lower.
We should also note that there will continue to be
significant, and perhaps growing spread differences between
different CRE CDOs based on collateral type, structure, and
manager reputation. Currently, whole loan CDOs price at
the tightest levels, followed by investment-grade CRE
securities CDOs, B-Note and Mezz CDOs, and CMBS B-
piece CDOs.
46 CMBS WORLD®
(cont.)
This relationship seems logical, as investors demand
greater spreads for portfolios that are more highly
levered. Over time, we also expect to see greater price
differences within each of these categories as managers
become differentiated based on their track records.
OUTLOOK FOR CMBS AND CRE CDO MARKET
INTERACTION
It is true that CDO technology, due to its flexibility,
continues to be applied to a growing number of asset
classes, including real estate loans that traditionally are
securitized in other markets, such as the CMBS market.
However, due to the reasons provided in this article, we
believe that the CRE CDO market and the CMBS
market will continue to complement each other and
10/11/06 2/11/07 drive issuance of the other product for quite some time.
CMBS BBB
Large floating rate loans will likely be securitized in
CRE CDO BBB CMBS, but small loans most likely will be picked up by
CRE CDOs. Meanwhile, fixed-rate commercial
mortgage loans will remain the domain of CMBS, but
provide subordinate assets for CRE CDOs and re-
REMICS.
So, instead of competing with one another, a growing
CMBS market should provide additional collateral (both
directly and indirectly) for securitization in the CRE
CDO market, while a recovering CDO market could
support CMBS spreads. Basically, a healthy CRE CDO
market will likely ensure a ready market for subordinate
commercial real estate loans, which should permit
CMBS lenders to increase their issuance. While current
turmoil in the CDO market will only marginally increase
commercial mortgage spreads, it will provide a
foundation for the eventual recovery in both markets. ❑
Darrell Wheeler is Managing Director at Citigroup Global
Markets. Jean-Michel (Mitch) Wasterlain is Executive Vice
President and Chief Investment Officer at NorthStar Realty
Finance Corp. Jeff Prince is Vice President at Citigroup
Global Markets.
1
Brothers in ARMs: Comparing the CMBS and CRE CDO
Markets, Jeffrey Prince and Darrell Wheeler, Citigroup, April 6,
2006.
2
Some CDOs, including CRE CDOs, are structured as static
portfolio transactions, and, in these cases, many of the “costs”
are not present (such as a collateral management fee).
3
Insurance companies consider CMBS a low risk extension of
their commercial mortgage lending portfolios and like the
certainty that accompanies their ability to reunderwrite a static
pool of collateral. Because of this cautious investor base, spreads
on CMBS debt can be significantly less than for CDOs.
4
CDO managers are often hedge funds managers or asset
managers.