The CLO costs more per dollar of loans and still wins, through leverage and the margin call it never makes.
Compare the two on the return to the lender's own equity, not on the spread. On an illustrative $500.0M book of bridge loans at SOFR + 3.25 per cent, a repo line at a 75 per cent advance and SOFR + 2.00 returns 10.60 per cent on equity, and a CRE CLO at an 80 per cent advance and SOFR + 1.65 returns 11.32, although the CLO costs more per dollar of loans. Hold cash against a 10 per cent mark on the repo and the gap widens to 11.32 against 9.08 per cent, 2.24 points in the CLO's favour.
Worked in full in CMBS and CRE CLOs by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A balance-sheet lender that originates transitional bridge loans has two standard ways to lever them: a repurchase facility from a bank, drawn loan by loan, or a CRE CLO, which sells notes against a pool. The tempting comparison is the headline: repo at 2.00 over SOFR, CLO notes at 1.65, so the CLO is 35 basis points cheaper. That ignores three things the equity actually feels: how much each lends, what each costs beyond the coupon, and what happens to the repo when the bank marks the loans down. The figures below are illustrative throughout, chosen to show the mechanism, not quoted from any market.
| Input | Repo | CRE CLO |
|---|---|---|
| Collateral, loans at SOFR + 3.25% | 500.0 | 500.0 |
| SOFR | 4.00% | 4.00% |
| Advance rate | 75% | 80% |
| Spread on the financing | 2.00% | 1.65% |
| Running costs, % of collateral a year | 0.10% | 0.20% |
| Issuance costs, % of notes, over 3.0 years | - | 1.00% |
| Lender's equity | 125.00 | 100.00 |
The repo's running cost stands for upfront and non-use fees spread over the facility; the CLO's covers trustee, administration and collateral management. The CLO note spread is the blended cost of all its classes, weighted by balance, as worked in how to calculate a CRE CLO's weighted average cost of funds.
Financing cost per collateral dollar = advance rate × spread + running costs + advance rate × issuance costs ÷ expected life
Return on equity = SOFR + (loan spread − financing cost per collateral dollar − losses) ÷ (1 − advance rate)
Excel: =SOFR+(LoanSpread-Adv*Spread-Run-Adv*Issue/Life-Loss)/(1-Adv)
Step 1, cost per dollar of loans. Repo: 75% × 2.00% + 0.10% = 1.600 per cent. CLO: 80% × 1.65% + 0.20% + 80% × 1.00% ÷ 3.0 = 1.320 + 0.20 + 0.267 = 1.787 per cent. Per dollar of collateral the CLO is the dearer financing, by 19 basis points.
Step 2, excess spread. Repo leaves 3.25 − 1.600 = 1.650 per cent; the CLO leaves 1.463 per cent.
Step 3, leverage. The repo equity is a quarter of the book, so its excess spread is multiplied by 4.0; the CLO equity is a fifth, multiplied by 5.0. Repo: 4.00 + 1.650 × 4.0 = 10.60 per cent. CLO: 4.00 + 1.463 × 5.0 = 11.32 per cent.
In dollars: the loans pay 36.25 a year. The repo costs 22.50 of interest on 375.00 and 0.50 of fees, leaving 13.25 on 125.00 of equity. The CLO notes cost 22.60 on 400.00, expenses 1.00 and issuance 1.33 a year of the 4.00 paid upfront, leaving 11.32 on 100.00.
Repo is marked to market. If the bank marks a loan down, it can require the advance to be restored against the lower value, in cash. A CLO's notes cannot be called for margin: a weaker loan affects the coverage tests and can divert cash, but nobody asks the sponsor for a cheque. A prudent repo borrower therefore holds liquidity against a plausible mark, and that cash is equity too.
A 10 per cent mark across the book means 75% × 500.0 × 10% = 37.50 of margin, 30.0 per cent of the repo equity. Held in cash at SOFR it earns 1.50. Equity becomes 162.50, income 13.25 + 1.50 = 14.75, and the return falls to 9.08 per cent.
| Mark covered | Buffer held | Repo, no losses | Repo, 0.50% losses | CLO, no losses | CLO, 0.50% losses |
|---|---|---|---|---|---|
| 0% | 0.00 | 10.60% | 8.60% | 11.32% | 8.82% |
| 5% | 18.75 | 9.74% | 8.00% | 11.32% | 8.82% |
| 10% | 37.50 | 9.08% | 7.54% | 11.32% | 8.82% |
| 15% | 56.25 | 8.55% | 7.17% | 11.32% | 8.82% |
| 20% | 75.00 | 8.12% | 6.88% | 11.32% | 8.82% |
Two things stand out. Losses hurt the CLO equity more, five times over against four, so with 0.50 per cent a year of losses and no buffer the CLO's lead shrinks from 0.72 points to 0.22. And the buffer matters more than the losses: covering even a 5 per cent mark puts the repo behind on every line.
The break-even runs the other way too. With no buffer, the CLO stays ahead until its blended note spread reaches 1.83 per cent; against the repo with a 10 per cent buffer, until 2.21 per cent. That is the range in which a sponsor should be willing to pay up for term, non-mark-to-market funding.
Comparing the note spread with the repo spread: "the CLO is 35 basis points cheaper". Per dollar of loans it is 19 basis points dearer once expenses and issuance costs are counted. It wins only through leverage and through the margin call it does not have. The reverse mistake is just as common: a sponsor that sees the higher all-in cost and stays on repo, without pricing the cash it must keep idle to survive a mark. The right comparison is equity return, after the buffer, at the loss rate you actually expect.
Scale is the other condition. Issuance costs are partly fixed, and a CLO needs a pool large enough to be diversified and to absorb them; repo is usually the warehouse that builds the pool before it is securitised. The two are often sequential rather than rival.
The retained-equity return by advance rate, the break-even loss rate and the overcollateralisation test are in the free CRE CLO workbook for this book; the equity arithmetic on its own is in how to calculate the equity return on a CRE CLO.
Per dollar of loans, often not: in the illustration the CLO costs 1.787 per cent of collateral a year against 1.600 for repo, once expenses and issuance costs are counted. It still returns more to the equity, 11.32 against 10.60 per cent, because it lends 80 rather than 75 per cent and cannot make margin calls.
Enough to restore the advance after a plausible mark: advance rate times the book times the mark. On a 500.0M book at 75 per cent, a 10 per cent mark calls 37.50, 30.0 per cent of the 125.00 of equity. Holding that in cash at SOFR cuts the return on equity from 10.60 to 9.08 per cent.
Solve the equity return formula for the CLO spread that equals the repo return. In the illustration the CLO remains ahead of unbuffered repo up to a blended note spread of 1.83 per cent, and ahead of repo with a 10 per cent margin buffer up to 2.21 per cent, against 1.65 assumed.
This article is one calculation from CMBS and CRE CLOs. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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