IBD | Private Equity Jumps into Lending Via Real Estate Debt Funds

Private Equity Jumps Into Lending Via Real Estate Debt Funds - Investors.com

11/30/12 9:56 AM

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Private Equity Jumps Big Into Real Estate Lending

By JOE GOSE, FOR INVESTOR'S BUSINESS DAILY Posted 11/29/2012 06:16 PM ET

Private equity firms are grabbing a greater stake in commercial real estate lending, filling a void left by banks stuck with distressed property and still hesitant to shell out credit to the recovering sector.

The money in closed-end private real estate funds pursuing debt strategies is surging. And with $2 trillion in commercial property loans maturing over the next five years, the funds have plenty of takers in the property world.

"We're seeing a lot of interest from new participants in the market," said Ryan Krauch, a principal of Los Angeles-based Mesa West Capital, a private lender that does acquisitions, refinancings and recapitalizations of office, retail, industrial, apartment and hotel properties.

Over the first three quarters of this year, global fund managers launched 14 real estate debt funds seeking $11.4 billion, according to a recent report by alternative asset researcher Preqin — and much of that was in recent months. In all of 2011, money managers launched 17 such debt funds seeking $4.1 billion.

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For the first time in their history, many pension funds, endowments, foundations and other institutional investors are adding debt strategies to their real estate investment options in an effort to find decent returns in a low-yield environment. Historically, funds have allocated 5% to 10% of their cash to real estate equity — but not debt.

Strategies Shift In October, independent investment consultant NEPC in Cambridge, Mass., recommended that the City of San Jose Police and Fire Department Retirement Plan apportion 5% of its real estate allocation toward debt over the next three years, according to an updated strategic plan. Prior to the recommendation, there was no allocation toward real estate debt in that California plan.

Meanwhile, the $23.4 billion Iowa Public Employees' Retirement System, IPERS, could soon select one or more funds to implement a real estate debt strategy seeded with $200 million, according to a request for proposal issued in August.

Mesa West is in the market seeking $650 million for its third commercial real estate debt fund since 2004. To date about half of the subscribers are new to the strategy, Krauch says. Among other investors, the $25 billion Texas Permanent School Fund committed $75 million to the fund in July.

"It takes the institutional investor world a while to adjust to a relatively new asset class," he said. "Real estate debt historically just hasn't been a large part anyone's portfolio."

Accelerating Trend Institutional investors have plenty of opportunity to try it now. In the third quarter alone, six debt funds aiming to raise $7.6 billion launched, http://news.investors.com/print/business-inside-real-estate/112912-635147-private-equity-replacing-banks-as-real-estate-lenders.aspx

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Private Equity Jumps Into Lending Via Real Estate Debt Funds - Investors.com

11/30/12 9:56 AM

including a Blackstone Group (BX) high-yield debt vehicle hunting for $4 billion, Preqin says.

The activity rise is an acceleration of a trend that began after the 2008 financial crisis as real estate private equity managers started to pursue resulting credit play opportunities.

In 2006, for example, funds that focused solely on equity took in 93% of all capital raised by closed-end real estate funds, according to Preqin. In the first ten months of 2012, funds combining debt and equity strategies raised 51% of all capital.

Bank wariness is driving fund launches, too. In many cases banks shouldered a lot of commercial real estate loan distress during the recent downturn and still have properties on their balance sheets, says Michael Schlachter, a managing director at investment consulting firm Wilshire Associates, in L.A. "Banks are no longer as willing to provide the debt that they have in the past, so funds are stepping up and doing it," Schlachter said.

"Whether it's a long-term trend, I'm not entirely positive."

It nevertheless represents an opportunity for a few years — at least until a revived economy and a broad-based rise in property values fuel more lending by banks, he says.

Debt strategies vary from originating loans for acquisitions to buying distressed debt at a discount. For institutional investors, some of the most appealing will center on originating loans at higher interest rates than conservative senior mortgages secured by trophy properties in big markets, according to Schlachter.

Higher-interest plays include loans to borrowers who want to improve a property as well as providing mezzanine loans, debt that is subordinated to senior mortgages.

"Investors are looking at Treasury bonds or investment grade corporate bonds and thinking, 'Maybe I can get 4%,'" Schlachter said. "Or I can invest in real estate and get 8% or 9% if it's properly structured."

Among other drawbacks, investors unfamiliar with pure debt strategies need to realize that they won't benefit from a property's appreciation, Schlachter says, so there's less potential upside than with an opportunistic equity investment.

Opportunities Ahead?

In October, a partnership by asset manager and capital provider USAA Real Estate Co. and Square Mile Capital Management originated its first mezzanine loan — a $68 million note for a 4.5-million-square-foot Southern California office portfolio — after pairing up earlier in the year to pursue the strategy.

New York-based Square Mile, a real estate investment firm focused on debt and equity strategies, has some $1.7 billion in assets under management and expects to originate $150 million in mezzanine loans by year-end, says Craig Solomon, a co-founder of the firm.

While it concentrates more on other strategies, such as buying distressed debt and seeking resolutions with borrowers, Square Mile should see plenty of opportunities for mezzanine transactions, he says.

"Given how low interest rates are, you can write a subordinate loan and get a very substantial premium over cost of funds," Solomon said.

"That's why you see people pouring into the marketplace." © 2012 Investor's Business Daily, Inc. All rights reserved. Investor's Business Daily, IBD and CAN SLIM and their corresponding logos are registered trademarks of Investor's Business Daily, Inc. Copyright and Trademark Notice | Privacy Statement | Terms and Conditions of Use

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