Retained CRE CLO equity is five times the excess spread against five times the losses, and the best advance rate depends on which of the two you expect.
The annual return on CRE CLO equity is SOFR plus the excess spread, divided by the equity share: SOFR + (collateral spread − advance rate × note spread − expenses − amortised issuance costs − losses) ÷ (1 − advance rate). On an illustrative $1,000M pool at SOFR + 3.25 per cent, financed 80 per cent with notes at SOFR + 1.90 per cent, the retained equity earns 10.32 per cent before losses and 7.82 per cent after a 0.50 per cent annual loss. Every 0.10 per cent of annual loss costs the equity 0.50 per cent, five times over.
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 sponsor that securitises its own bridge loans through a CRE CLO usually keeps the bottom of the structure. That position is a leveraged bet on the gap between what the loans pay and what the notes cost, and the arithmetic fits on one line once the costs are in the right units.
| Input | Value |
|---|---|
| Collateral, floating-rate bridge loans | $1,000.00M |
| SOFR | 4.00% |
| Weighted collateral spread | 3.25% |
| Advance rate (notes sold / collateral) | 80.00% |
| Weighted note spread at that advance rate | 1.90% |
| Servicing, trustee and administration, per year | 0.20% of collateral |
| Issuance costs, amortised over a 3.0-year expected life | 1.00% of notes |
| Annual loss rate | 0.50% of collateral |
Equity return = SOFR + (sc − a × sn − e − a × k ÷ WAL − loss) ÷ (1 − a)
sc is the collateral spread, a the advance rate, sn the note spread, e expenses, k issuance costs as a share of the notes. SOFR appears once on its own because the equity's share of the collateral earns the full floating coupon with no floating cost against it. In Excel: =SOFR+(Sc-a*Sn-e-a*k/WAL-Loss)/(1-a).
| Line | Amount |
|---|---|
| Collateral interest: 1,000.00 × 7.25% | 72.50 |
| Note interest: 800.00 × 5.90% | −47.20 |
| Expenses | −2.00 |
| Issuance costs, 8.00 over 3.0 years | −2.67 |
| Losses | −5.00 |
| To the equity of 200.00 | 15.63 |
15.63 ÷ 200.00 = 7.82 per cent. Check with the formula: the excess spread after costs and losses is 0.76 per cent of the collateral, the leverage multiplier is 1 ÷ 0.20 = 5.0, so 4.00% + 0.76% × 5.0 = 7.82%. Before losses the equity takes 20.63, a 10.32 per cent return.
The unlevered pool yields 7.25 per cent, or 6.55 per cent after expenses and losses. Securitisation turns that into 7.82 per cent on the equity, because the notes cost less than the loans pay. The cushion is the break-even loss rate: the equity returns zero at an annual loss of 2.06 per cent, and it earns no more than SOFR, the return on cash, once losses reach 1.26 per cent a year.
Losses are multiplied by the same leverage as the spread. At an 80 per cent advance rate a loss of 1 per cent of the pool is a loss of 5 per cent of the equity. That is the whole trade: five times the excess spread, against five times the losses.
More leverage is not free. The deeper the structure, the more of the notes sit in lower-rated classes, so the weighted note spread rises with the advance rate.
| Advance rate | Note spread | 0.00% loss | 0.50% | 1.00% | 1.50% | Break-even loss |
|---|---|---|---|---|---|---|
| 70.00% | 1.60% | 9.66% | 7.99% | 6.32% | 4.66% | 2.90% |
| 75.00% | 1.75% | 9.95% | 7.95% | 5.95% | 3.95% | 2.49% |
| 80.00% | 1.90% | 10.32% | 7.82% | 5.32% | 2.82% | 2.06% |
| 85.00% | 2.15% | 10.26% | 6.93% | 3.59% | 0.26% | 1.54% |
With no losses, the return peaks at 80 per cent and falls at 85, because the last five points of notes are expensive enough to cost more than they earn. From an annual loss of 0.50 per cent upwards, the lowest advance rate wins: there the 70 per cent structure returns the most, 7.99 per cent, and at 1.50 per cent it returns 4.66 against 0.26 per cent at 85. The optimal advance rate is a loss view, not a financing preference. SOFR moves the result one for one: 6.82 per cent at a 3.00 per cent SOFR, 8.82 per cent at 5.00.
The common mistake is to quote the equity return before losses and before issuance costs, and to describe it as the "arbitrage". Here that headline would be 11.65 per cent, against 7.82 per cent after a modest loss rate. The second mistake is to forget that losses do not only cost interest. In a structure with an overcollateralisation test, defaults carried at a haircut can trip the test and divert all of the equity's cash to pay down the senior notes until it is cured, so the equity can earn nothing for several quarters well before the annual loss rate reaches 2.06 per cent. This one-line model gives the running return in a stable pool; it is not an IRR.
CRE CLO equity earns SOFR plus five times the excess spread at an 80 per cent advance rate, and loses five times the losses. Here that is 10.32 per cent before losses and 7.82 per cent after 0.50 per cent a year, with a break-even at 2.06. Choose the advance rate on the loss view, not on the headline. The free workbook for this case gives the retained-equity return by advance rate, the break-even annual loss rate and the overcollateralisation test with the haircut as an input.
It is the annual loss rate at which the equity's cash return falls to zero: SOFR times the equity share, plus the collateral spread, less the notes' spread cost, expenses and amortised issuance costs, all as a share of collateral. In the illustrative deal at an 80.00 per cent advance rate it is 2.06 per cent a year; the equity earns less than SOFR above 1.26 per cent.
No. Deeper structures sell more lower-rated notes at wider spreads, and the leverage multiplies losses too. In the example the return before losses is 10.32 per cent at 80.00 per cent and 10.26 per cent at 85.00, and with 1.50 per cent annual losses the 70.00 per cent structure returns 4.66 per cent against 0.26 per cent at 85.00.
Because the equity's share of the floating-rate collateral earns SOFR with no floating-rate cost against it. The notes' SOFR cost is offset by the SOFR earned on the same amount of collateral. In the illustrative deal a one point change in SOFR moves the equity return by one point, from 6.82 per cent at 3.00 per cent SOFR to 8.82 per cent at 5.00 per cent.
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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