What's the difference between Reits and CDOs? Not forgetting for many years CDOs are AAA rated and were deemed to be "risk-free"?

Hi anon, this is an interesting question and when I first went to find out more about it, I was quite confused about it too! Let me to try and answer it to the best of my understanding.

TL:DR

1. REITs - advantages and disadvantages
2. CDOs - advantages and disavantages
3. Why were CDOs AAA and risk free, why isn’t it now?
4. Observed differences between REITs and CDOs

REIT which stands for Real Estate Investment Trust is an investment instrument which allows investors to purchase shares in commercial real estate portfolios that receive income from a variety of properties. These properties are grouped under 5 categories which include

1. Healthcare e.g Parkway Life, First REIT
2. Retail e.g CapitaLand Mall Trust, Frasers Centrepoint Trust, Sasseur REIT
3. Office e.g Capitaland Commercial Trust
4. Industrial e.g Ascendas REIT, Mapletree Industrial Trust
5. Hospitality e.g Ascendas Hospitality Trust, Far East Hospitality Trust

Below are some advantages and disadvantages of REITs

What is a Collateralized Debt Obligation (CDO)?

From my understanding, CDO which stands for Collateralized Debt obligation structured financial product that pools together cash flow-generating assets and repackages this asset pool into discrete tranches that can be sold to investors. The CDO is then sliced into what are called tranches. Each tranche carries a different combination of risk and reward. For example, the selection of tranches might include:The tranches in a CDO vary substantially in their risk profiles. The senior tranches are generally safer because they have first priority on payback from the collateral in the event of default. As a result, the senior tranches of a CDO generally have a higher credit rating and offer lower coupon rates than the junior tranches, which offer higher coupon rates to compensate for their higher default risk.

How do CDOs work?

When a bank approves loans for either mortgages, automobils or credit cards, these loans are then sold to an investment bank. This is then repackaged to form an investment instrument called as the CDO which is then sold to investors. The principles and interest payments made on the loan are redirected to investors in the pool. The promised repayment of the loans are the collateral that gives the CDO value. Here are some of the advantages and disadvantages of CDOs.

Since CDOs are broken into different tranches and based on your risk appetite, different investors choose to go for different tranches, CDO cannot be generalised as a AAA credit rated investment instrument. Like all investment instruments, there will be certain risks that comes along with it, and the CDO is like no other.

It is not wrong to say that CDOs had a higher credit rating than in the past. I believe this is so as CDOs were backed by a diverse group of loans which limited the risk of default and it was thus well-known for being a stable instrument in the past. Due to the housing boom, the banks started to use alot of sub-prime mortgages (a type of loan granted to individuals with poor credit scores, who, as a result of their poor track record, does not qualify for conventional mortgages). as their main source of collateral. With the increase in popularity of CDOs, homelenders continued to lend money to high risk borrowers. When mortgage default started to rise, these sub-prime borrowers could no longer afford their monthly mortgage payments. CDO issuers and the investors suffered mega losses which subjected CDOs to increase in risk.

What’s the difference between REITs and CDOs

I’m assuming when you are comparing REITs to CDOs, you are talking about Mortgage REITs vs CDOs and I can see why they seem similar. A mortgage REIT acts like a CDO. Although they are similar, here are a few differences which I have observed.

I'm not an expert at this, haven't even been into uni yet but I'll try my best to answer this after watching 'The Big Short' and reading other materials.

I think your question highlights the doubt that CDOs aren't actually that safe as their rating grades them to be, as can be seen during the 07-08 recession.

The biggest difference between REITs and CDOs would be the underlying assets tied to the product. SOME triple A CDOs were rated after mixing badly rated CDOs and junk bonds and repackaged by institutions into the triple A rated ones that, out of greed, became very popular between institutional investors. Credible credit rating agencies are few and didn't mind rating them highly for the sake of customer loyalty. Besides, not everyone is so keen to look through the tonnes of paperwork to find out what the underlying loans that these CDOs were invested in. Having a big-name-sponsor associated to the product made it even more attractive.

Now, back to the present. The same credit agencies are still here and people behind the junk CDOs are still working at high positions. Poor, unethical management culture still (allegedly) exists in big banks like HSBC, Citi and Deutsche. I won't be too surprised if any deceptive financial products from pre-2007 still exists.

Whereas to judge the underlying assets of REITs is much less academically taxing. Visit the physical property and take a look at the financial reports and judge then yourself.

Of course, there still remains the risk of mismanagement of the REITs and perhaps the occasional false reporting of numbers, but that's much easier to fish out than something as complex as a CDO