Increasing Defaults on Apartment-Backed Bonds as Housing Market Cools

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As the housing market cools and interest rates continue to rise, defaults on a niche mortgage bond primarily used to fund apartment building purchases are increasing. This bond, known as collateralized loan obligations (CLOs), are mortgages packaged into bonds that are then sold to investors. CLOs played a significant role in driving housing costs in Sunbelt states like Arizona, Texas, and Nevada by facilitating the purchase of buildings with potential for increased rent.

In recent years, rental apartments accounted for a large percentage of the CLOs issued. These mortgages were appealing to property owners because they required less equity and allowed for more debt compared to traditional bank mortgages. Additionally, CLOs typically have shorter terms and floating interest rates, making it easier for owners to sell or refinance their buildings after a few years.

However, the same characteristics that made these loans attractive also made them riskier and more susceptible to sudden changes in borrowing rates. The surge in interest rates, coupled with a softening rental market and increasing expenses, has led to many landlords no longer generating enough income to pay back their loans.

One notable example of the impact of CLOs can be seen in the case of a Los Angeles landlord who missed payments on a loan packaged into a CLO. Their plan to increase rents by $700 per month per unit was partially hindered by low rent collections, resulting in the sale of the properties to a Miami-based group.

According to estimates by real estate data firm Trepp, nearly $88 billion in securitized mortgages are at risk of default, with 42% of them backed by apartment buildings. Most of these at-risk apartment loans are CLOs. The loans face default because the buildings they back do not generate enough income to cover debt payments.

Although defaults remain rare, their occurrence has been on the rise since last year. As interest rates surged and hedges protecting against even higher rates began to expire, borrowers faced increasing financial pressure. Construction and insurance costs have also risen, causing many renovation projects to run out of funds. Additionally, expiring loans have become harder to refinance as lenders become more hesitant to issue new mortgages.

In the case of rising defaults, CLO lenders are more likely to face losses than bondholders. These lenders typically retain the most junior 15% to 20% of bonds they create, meaning they are the last in line to receive payment. The list of the ten largest issuers includes affiliates of well-known companies.

One of the most prominent apartment buyers to utilize CLOs was a Los Angeles-based firm, which purchased $1.7 billion of apartment properties in 2021 alone. These properties were primarily located in Southwest markets, such as Phoenix and Las Vegas, where rents were booming until recently. However, for some investments, higher interest rates and falling rents have led to reduced profits, according to loan records.

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