Securitization has long been a powerful tool for financing asset pools by converting them into interest-bearing instruments. This process involves backing these securities with assets such as mortgage, auto or credit card loans.
Issuers then create securities for investors to purchase, allowing them to finance these assets. Investors receive monthly cash flows from the interest and principal payments on the underlying loans, without directly investing in the loans themselves. The securities are divided into tranches, which enable investors to choose to take more risk and earn higher returns or less risk with lower returns.
Commercial mortgage originators and brokers should understand the securitization process and how its use has greatly expanded within the commercial real estate sector as a way to finance projects and gain investors. And a new way of securitizing a type of bridge loan could be a game changer for commercial real estate.
Growing transition
Residential transition loans, which are a form of bridge loans (with a duration of usually between 12 and 36 months) are used by real estate investors to buy, renovate, resell and reposition housing properties. These types of unrated loans have been around informally for years. As the market has developed, mortgage originators have increasingly turned to the financial markets to seek capital investments.
One of the first widely syndicated unrated transition loan securitizations was launched in 2018. Since then, the asset class has expanded significantly, with the annual gross supply of residential transition loan deals rising from less than $1 billion in 2018 to $4.5 billion through just the first seven months of 2024, according to Morgan Stanley Research.
Earlier this year, there was a successful closing of the first-ever rated transition loan securitization. The $240 million deal was rated by Morningstar DBRS, the first nationally recognized statistical rating organization to finalize a methodology for rating residential transition loan securitizations. Due to the limited historical data available for this new asset class, the deal was rated with a cap of “A,” which is typical for asset classes that do not yet have the track record needed for higher ratings such as “AAA.”
This deal marked a crucial turning point for the industry, representing a significant step toward the broader institutionalization of the residential transition loan market. Since then, other companies have completed similar rated deals, with more on the way. Other prominent rating agencies are now developing their own frameworks for assessing this asset class.
Funding funnel
While the initial unrated loan deal expanded the investor pool, the introduction of rated residential transition loan securitizations has set the stage for further growth. What, then, are the potential short- and long-term impacts of this development?
There are at least three ways these rated loan securitizations will continue to transform the industry. Previously, only a limited number of investors could engage with unrated securities. Rated residential transition loan securitizations now allow a broader range of fixed-income investors, such as insurance companies and certain money managers, to participate.
Many of these investors are required by their charters to invest only in rated securities. Even when capital is available for unrated securities, it usually represents only a small fraction of what can be invested in rated transactions. As the market for these types of loans has grown, large financial institutions that previously couldn’t participate due to rating requirements are now able to invest. The introduction of rated bonds following years of investor education has created substantial investor demand, and as more rated offerings become available, they will attract even more capital, driving further issuance.
Risk versus reward
As the number of rated residential transition loan deals increase, a clearer distinction in the rates offered will be seen for different types of loans, such as those that do not meet the criteria for rated bonds. Such loans will still be funded but will likely have higher interest rates compared to those that qualify for rated securitizations.
Such non-qualifying loans may end up in the hands of private investors which have higher return requirements. Conversely, loans that meet the criteria for rated deals will benefit from lower costs of capital for originators, leading to lower interest rates for borrowers.
Morningstar DBRS is expected to reassess the current “A” rating ceiling as it gains more confidence in the asset class’s performance. This could eventually lead to higher ratings, such as AA or AAA, resulting in further improved bond pricing and more availability of capital.
Other rating agencies are also working on their frameworks for residential transition loan assets, though this process is time-consuming. Companies have spent six years educating Morningstar DBRS about this loan asset class, providing historical performance data, and sharing their credit philosophy. As more deals gain traction and other agencies develop their rating systems, the number of options for issuers will increase as will the number of fixed-income investors interested in this loan market.
Housing impact
Banks have traditionally been reluctant to finance single-family and smaller multifamily construction projects, due to adverse regulatory treatment of this category of loans. The demand for capital in this sector has driven the growth and institutionalization of the private lending industry. Rated residential transition loan securitizations are expected to increase both the availability and affordability of capital, accelerating the ongoing shift from legacy hard money lenders to institutional funding sources.
This increased funding will support more construction projects, including new builds, renovations and conversions, all at more efficient pricing. This could play a role in addressing the U.S. housing crisis. As rated securitizations become more common, brokers, originators and funders will focus more on high credit underwriting to qualify for these deals. This will result in greater issuance volume and liquidity in the market for rated loan offerings, resulting in further improved terms and differentiation compared to unrated deals. The first rated residential transition loan securitization was a significant milestone that has set the stage for continued industry transformation. Subsequent deals have validated this approach, bringing new institutional investors and capital to the sector, and providing essential support for the development of needed housing stock.
