Institutional investors have been piling into CRE CDOs, relatively new high-yield debt vehicles, like clowns into a circus car. First issued in 1999, CRE CDOs are commercial real estate collateralized debt obligations, a new twist on mortgage securitizations that provide higher yield than conventional commercial-loan packages by adding in more highly-leveraged, short-term components.

From just $6 billion in 2004, CRE CDO issuance skyrocketed to $40 billion in 2006, and it's expected to hit $70 billion this year, according to Wachovia Securities estimates. It's easy to see why: CRE CDO yields range from 5 percent for the highest-rated bonds — conventional CMBS (commercial mortgage-backed securities) issues, such as mortgages on fully-leased buildings with stable cash flow — to as much as 25 percent on the riskiest so-called “equity” pieces, which consist of unrated debt from a number of sources.

The CRE CDO game is just beginning to open up to individual investors, too. At first, the only way for an individual investor to get into CRE CDOs was to invest in private equity or hedge funds that bought the instruments. But in the past three years, certain mortgage REITs have begun to buy CRE CDOs (and issue them), as well. (Mortgage REITs don't actually own properties, they own mortgages and make money when interest rates move on those mortgages.) Mortgage REITs still only hold around 4 percent of all issuance, but there is a growing number of such REIT offerings for investors to choose from. More recently, a handful of companies has begun working behind the scenes to create master limited partnerships (MLPs) that will invest in the equity portions of multiple CRE CDO deals and trade publicly.

But beware. CRE CDOs are only for the truly adventurous. Even for those with high risk tolerance, says Joseph Chinnici III, managing director of KeyBank's Debt Capital Markets Group and Structured Products Group. “You would only put a small percentage of your portfolio in CRE CDOs — less than 5 percent.”

Why are they so risky? Unlike CMBS, in which only fixed-rate and long-term mortgages are included, in a CRE CDO, underwriters add floating-rate debt, short-term mezzanine loans (short-term third-party loans with a floating rate and leveraged asset backing), bridge loans and construction loans. And because of these short-term pieces, some of the actual underlying collateral changes over the length of the investment, as managers replace expiring loans with similar obligations. What's more, measuring the risk associated with the instruments is difficult: though rating agencies have developed complex models for evaluating CMBS issues, the art of CRE CDO rating remains in its infancy.

In addition, mortgage REITs that hold CRE CDOs tend to sell the highest-quality pieces directly to institutional investors, because demand from institutions is so great. CDOs are bundled pools of debt that are then divided up and packaged into what are called “tranches” of debt — ranging from highest to lowest quality. These are then sold separately and priced according to risk. After they sell to institutions, the public REITs that invest in CRE CDOs tend to keep the riskiest, highest-yielding pieces for themselves, which are called preferred and common equity. That means that retail investors in the publicly traded REITs get exposure primarily to these riskiest bits. (REITs are just now beginning to sell portions of their equity shares to companies like MLPs.)

Indeed, New York City-based Anthracite Capital, a mortgage REIT that is active in the CDO arena, says that its exposure to CDOs is not a good reason for retail investors to buy its shares. “We haven't marketed our CRE CDOs to retail investors,” says Anthracite President and COO Richard Shea. “CRE CDOs have been an institutional market because institutions generally have the resources to keep track of the risk.” Anthracite provides debt financing for real estate owners — mortgages that the REIT then slices and dices into different financial structures including CRE CDOs. It then issues CDOs that are created with its own loans and sells off pieces of the CDOs.

Following is an example of a deal in which Anthracite keeps a large equity portion. The company recently closed the Anthracite Euro CRE CDO 2006-1 P.L.C. — the mortgage REIT's first euro-denominated secured debt offering and the global markets' first-ever European CRE CDO transaction. It retained 12.5 million euro of below investment-grade debt and all of the CDO's preferred shares and sold 263.5 million euro of nonrecourse debt to several European and U.S. institutions. It could make Anthracite an interesting diversification play for some retail investors: The European real estate markets are far more fragmented and diversified than the U.S. real estate markets.

Similarly, Gramercy Capital recently closed a $1 billion CRE CDO offering, Gramercy Real Estate CDO 2006-1. The New York-based mortgage REIT retained $57.5 million worth of preferred equity and common equity, in addition to $38.75 million of non-investment grade bonds. The remaining securities consisted of $903.75 million of bonds rated AAA through BBB- that were purchased by institutional investors.

The MLPs

And then there are the master limited partnerships. These structures have been around for a long time and are common in the energy industry, but they are new to the CDO business. Dallas-based Highland Capital Management, which has more than $33 billion under management, is the first to try this MLP strategy, and the first non-REIT to make CRE CDOs open to retail investors. The company manages Highland Financial Trust, which filed an initial public offering in late 2006. The trust plans to invest in the preferred equity pieces of CDOs and will be traded on the New York Stock Exchange, according to the S-1 documents filed with the Securities & Exchange Commission. The company is in its quiet period and declined an interview.

Another eight to 12 firms are rumored to be raising money for their own MLPs, says KeyBank's Chinnici, though he couldn't name names. Investment vehicles like Highland Financial Trust are so new that most industry players haven't even heard of them, he says. To qualify as an MLP, the entity must receive at least 90 percent of its income from natural resource activities, interest, dividends, real estate rents, income from sale of real property, gain on sale of assets and income and gain from commodities or commodity futures. Like stocks, MLPs are traded publicly — usually on the New York Stock Exchange — and they generally do not pay income taxes.

In February 2006, Highland Financial Trust completed an initial private offering of common shares and raised roughly $241 million. And, in October 2006, the trust completed an additional private placement and generated about $162.5 million. According to the S-1 filing, the company plans to use the proceeds to purchase equity in several CDOs that Highland Capital has structured. Since 2005, the equity tranches of the 12 Highland Capital CDOs have provided an average annualized dividend yield of 19.4 percent and an average internal rate of return based on the net asset value of the CDOs of 16.4 percent.

It is unknown when Highland Financial Trust will complete its IPO. And, Chinnici isn't sure when other MLPs will file, but he feels confident that the CRE CDO market is opening to retail investors.

“If you draw a parallel to other markets, generally institutional investors have access first and then the investments become available to retail investors,” he explains. “In the future, it will be much easier to invest in CRE CDOs.”