ABS & CDO - The Alphabet of Real Estate Investing

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If you're considering getting into the world of real estate investing, there are some basic terms that are important to understand. Buying and selling property is, of course, one way to invest, but there are other investments that offer favorable returns. However, it can sometimes be difficult to master the confusing alphabet soup of investment opportunity.

Packaged investment products include the Asset-Backed Security (ABS) and a Collateral Debt Obligation (CDO). In some ways, they are similar; each is typically bundled as a group investment for marketing purposes. Financial return is realized as payments are made by the pool of consumers included in the group. 

The ABS evolved historically, beginning in the 1980s, with the lender practice of bundling mortgage-backed securities for resale, primarily to other institutions. Today the practice continues, but mortgage debt is classified as a CDO, with specific real estate as the collateral. It is a specialty designation under the umbrella of asset-backed securities. The breakdown can be complex, and terms are sometimes confusing.

Financing that comprises CDO debt includes all the underlying characteristics of the ABS, in addition to the specialized assets of both commercial and residential Mortgage-Backed Security (MBS) or REIT (Real Estate Investment Trust) debt. A unique type of CDO that only includes mortgages is known as a CMO, referring to Collateralized Mortgage Obligation. 

Most investors really don't need to know more, but there are other designations that are commonly used:

• A CLO is the term for Collateralized (Bank) Loan Obligation;
• A CBO designates a Bond Obligation;
• Credit-backed debt is sometimes referred to as synthetic CDO to distinguish it from cash-backed debt.

Various types of CDO debt are batched into three (or more) classes, known as tranches, with varying degrees of risk and return. Although the maturity level may be the same, an Equity Tranch investment offers the highest potential return but bears the lowest credit rating. A less-risky Senior Tranch boasts a higher credit rating, and the Mezzanine Tranch is in the middle.

Typically, an ABS investment package comprises credit card debt, student loan debt, home equity loans, auto loans, and large sum debt-repayment contracts for other goods, with no mortgages in the package. 

An investor in either an ABS or CDO earns a return, in part or in full, as the pool of debt is repaid by the individuals whose loans have been pooled. The risk of default is spread over the spectrum of loans, and investor risk is assessed, largely in proportion to the number and type of loans included in the package. 

These various types of investment packages are usually marketed only to institutions, rather than to individual investors, however there are ways for individual investors to purchase shares through the investment firm.