FEATURE: Teeing up debt

Two days before Christmas in 2007, Ethan Penner joined long-time friend Brett White for a round of golf at the Los Angeles Country Club in California. Penner, then a principal at real estate investment firm Lubert-Adler Partners, had just shared lunch with the chief executive officer of Richard Ellis, during which they discussed the disarray in the financial markets and the opportunities that could arise out of it.

Over the meal, Penner told White: “The single biggest opportunity that will arise from this financial dislocation in 2007 will be that those lenders that have been very active in the commercial real estate arena will suffer massive losses. There will be a natural retrenchment on the part of those lenders, and it is going to create a huge void in the marketplace. New entrants are going to be created to fill that void.”
 
Having met two other friends, the group proceeded around the course, mixing banter with business talk. The 16th hole, however, proved the most important – not to the outcome of the game, but for Penner’s next career move. “By the 16th hole, Brett asked me if I would ever consider joining the firm to build and run that business,” he says.
 
Three months later, Penner came on board to launch CBRE Capital Partners with chief operating officer Frank Scavone. That real estate debt investment business, run from Penner’s offices at 200 Park Avenue in New York, is part of CBRE Investors, the investment management platform with $37.9 billion in assets under management.
 
Wide open fairway
Almost four years on and with the credit markets still on shaky ground, debt funds, particularly those focused on providing mezzanine debt, are ramping up activity as the supply of real estate capital remains constrained. You could say the fairway has been left clear for such firms.

“The world financial system is still on very shaky ground, arguably shakier or certainly not much less shakier than it was in 2008,” says Penner, who anticipates “a big gap between the level of capital required by the real estate industry and the level of capital that traditional first mortgage providers could provide.”

Nearly $2.8 trillion in commercial real estate mortgages will be maturing between 2011 and 2020, with almost $1.8 trillion in debt maturing between now and 2015, according to Trepp, a New York-based provider of commercial mortgage and mortgage-backed securities information. Of the commercial loans that are due to mature in that five-year period, 60 percent, or about $1 trillion, currently are underwater, meaning that the properties backing the debt are valued at less than the outstanding loan amount, the firm says.

For three- to five-year loans that were originated between 2005 and 2008 – the years when property values were peaking and lending was at its most aggressive – loan-to-value (LTV) ratios on commercial mortgages ranged from 80 percent to 100 percent, whereas today’s senior loans are being underwritten at 55 percent to 60 percent LTV on property values that have fallen 30 percent to 40 percent, says Jerome Gates, managing director at Hamilton Lane, a Pennsylvania-based private equity investment management firm.
 
Even if a portion of the funding gap – the difference between the size of the existing and new commercial mortgages – is reconciled through loan losses and construction and land loans are excluded, about $300 billion to $320 billion of new subordinate debt and equity will be needed to recapitalize the debt originated during that four-year period, according to a report from Prudential Real Estate Investors, the Parsippany, New Jersey-based real estate investment and advisory business of Prudential Financial.

Meanwhile, the CMBS market, which was a significant provider of real estate capital prior to the financial crisis, made a brief comeback last fall and this spring, but it has pulled back again in recent weeks as a result of uncertainty over pricing that occurred during the summer, according to John Cahill, a partner in the real estate practice at law firm Paul Hastings. “Until we see far more stability in spreads in the US, it’s going to be very hard for the traditional CMBS players that put out a lot of product because they don’t know how to price it and therefore they don’t know how to then sell it,” he adds.

Bright outlook
In light of these factors, “the outlook is extremely bright” for debt funds, especially those that provide subordinate, bridge or flexible financing, according to Bruce Batkin, founder and chief executive officer at Terra Capital Partners, a New York-based commercial real estate finance and investment firm. “We’re going through a great recapitalisation period for a lot of over-financed, overleveraged property,” he says, noting that a large volume of the debt set to mature will require some form of restructuring or gap financing.

In addition, “at this point in the market, we see much better risk-adjusted returns in the debt portion of the capital stack than in the equity,” says Batkin. The reason is “we don’t see a lot of growth in cash flow in commercial property over the next several years” because of what is expected to be tepid employment growth, he explains.

After selling 100 percent of its portfolio interests in June 2007, amid concerns over excessive credit and escalating property values, Terra began fundraising again in 2009 for its Terra Secured Income Fund series, on behalf of which the company provides financing primarily for office and multifamily properties nationwide. The firm has completed 10 deals on behalf of the first Terra Secure Income Fund and currently is considering other transactions, including a bridge loan for an industrial property that ultimately will be redeveloped into a multifamily asset in a major East Coast market.

Terra is expected to close on Terra Secured Income Fund 2 by the end of the year and will likely be launching a new $500 million closed-end debt fund next year, says Batkin. For both funds, the firm is seeking a current annual yield of 9 percent, distributed monthly, and an IRR after management fees of 10 percent to 12 percent.

Filling the void
Historically, there haven’t been many funds that have specialised in lending because “there were many providers of loans filling that space,” including commercial banks, insurance companies and the CMBS market, says Gates. “So there was no need to go the fund route to provide that capital to real estate owners,” he adds.

Debt funds can generate yields in a couple of different ways, according to Gates. With a distressed debt fund, managers employ an opportunistic ‘loan-to-own’ strategy, whereby they potentially can make money by foreclosing on the real estate and eventually selling the property at a profit, getting a discounted payoff from the borrower or buying the loan at a deep enough discount and holding it to maturity for its yield.

Los Angeles-based real estate investment firm Colony Capital, for example, raised $885 million for its Distressed Credit Fund in 2008 in anticipation of opportunities arising from the credit market dislocation and has invested approximately $2 billion in distressed debt deals during the past two years. The firm is said to be targeting up to $1 billion in commitments for its Distressed Credit Fund II, according to sources.
 
While distressed debt funds generally buy existing debt, mezzanine debt funds typically are focused on providing new financing via a mezzanine loan that is subordinate to the senior debt or by providing the entire loan and then splitting up the debt into a lower-risk, lower-yield senior piece and a higher-risk, higher-yield junior piece. Under this strategy, the manager keeps the junior piece and sells the senior piece to an insurance company or bank that is looking for lower-risk debt.

The single best spot
With traditional lenders now less active, more mezzanine debt funds are starting to come to the market, as investors have shown increasing interest in the space, particularly over the last 12 to 18 months. “Now is one of those few times when there will be fund investment opportunities that institutional investors will be interested in because of the void that exists, which also creates wider spreads,” says Gates. Indeed, managers of some of these funds have worked at traditional financial institutions and have spun out to create their own first-time funds, he notes.

“The opportunity for the mezzanine portion of the debt structure in commercial real estate is the single best spot to be in as an investor in commercial real estate in the US, and it will be for the foreseeable future,” says Penner. “The needs of the industry, by virtue of having been desperately overleveraged in the last cycle, are for higher and higher leverage, so the combination of the supply of capital being tight and the demand for capital being high means that the demand for mezzanine money is very high and will continue to be high for a long time.”

Given Penner’s view, perhaps it isn’t surprising then that CBRE Capital Partners launched two separate open-ended mezzanine debt funds in 2009. According to documents filed with the US Securities and Exchange Commission in May, CBRE Capital Partners US I, which focuses on low-risk investment, has raised $147 million in capital commitments, while CBRE Capital Partners US Special Situations I, which offers high-risk returns, has closed on $111 million in commitments. Although Penner declined to comment, one source says the capital raised for both of those funds now is approximately double of what it was at the time of the SEC filings.

On behalf of those funds, CBRE has committed to about 30 transactions totaling just north of $600 million since making its first investment in late 2009. Recent deals include financing the opportunistic acquisition of a foreclosed office building on the West Coast and the purchase of a pool of loans backed by multifamily properties in the San Francisco Bay area from Tamalpais Bank. In the latter case, the bank was facing a cease-and-desist order from the Federal Deposit Insurance Corporation for having too many nonperforming loans and was under pressure to sell as many of its commercial real estate loans as it could.

Shot selection
“We think the best opportunity for income in today’s market is in the mezzanine space,” Batkin agrees. The returns offered on mezzanine, he says, are in many cases more than double the return on both the equity and the senior debt on a current basis. At the same time, it requires less risk than the equity, he adds.

“There’s a dearth of capital available in the mezzanine space,” says Gates. As a result, “it’s possible as an investor to earn high single-digit current returns and low teen IRRs if you’re investing in a fund in this space.”

According to Gates, Hamilton Lane expects to be allocating capital to the mezzanine debt space on behalf of clients by the end of the year.  “Investors are concerned today about the uncertain economic environment and the possibility that this uncertainty could last for some time,” he says. For some clients, “we’re looking for more conservative investment strategies, where a preponderance of the return is generated as current income, as opposed to waiting until the end of an investment for a big capital event to occur.”

Given the current economic uncertainty, an investment strategy that offers some principal protection may be preferred by some clients, adds Gates. Mezzanine debt offers that protection via the equity that the borrower must put into the recapitalisation of a property, he explains.

Mezzanine debt, however, can add a layer of complexity to a deal, says Cahill of Paul Hastings, which saw twice as many commitment letters on deals involving mezzanine debt in August than any month since the start of the financial crisis. Insurance companies providing the senior loan are often less accepting of mezzanine debt than an investment bank that intends to exit with commercial mortgage-backed securities, which use a standard form that is widely accepted in the market, he notes.

Hitting the sweet spot
Of course, the size and scope of a mezzanine debt fund is key. “A lot of funds, especially the largest funds, have a bit of a challenge because you can’t focus on deals that are smaller than a certain size when you raise too much capital,” Penner says. Funds that are managing billions of dollars aren’t going to look at a deal that’s not $100 million or larger, he notes. The problem, however, is that the majority of the commercial real estate deals in the US are under $50 million, according to Penner, whose firm generally provides mezzanine financing in the range of $15 million to $60 million.

As an example, Penner points to the recent auction of the $9.65 billion Anglo Irish Bank loan portfolio, whose bidders included consortiums led by The Blackstone Group and Cerberus Capital Management. The portfolio eventually was sold to the team of Dallas-based private equity firm Lone Star Funds, Wells Fargo and JP Morgan Chase in August.

“It becomes a frenzy for them,” Penner says.  “When the rare mega-deal comes along, you have to do it because they don’t come along that often. So the pressure to actually win those deals causes those few funds to compete so heavily that they’re forced to overpay, and then they’re in a very compromised spot.”

Hence, the importance of having a “right-sized” fund, where managers have just enough capital to address most of the opportunities in the commercial real estate market. “Sitting with too much capital causes managers to make investment decisions that don’t necessarily lead to optimal investment outcomes,” Penner says, noting that the mezzanine debt market currently is flush with deals in the $10 million to $50 million range. “I think having capital that can address those kinds of opportunities is wise because it’s where most of the opportunities are.”