Comment – Mezzanine

The origination, structuring, and management of real estate debt investments have been a cornerstone of Heitman’s business since its inception in 1966. In 2007, the global real estate investment management firm hired Greg Leadholm and Steve Bailey as the two senior managing directors to lead its real estate debt business. Since then, Heitman has been investing on behalf of prominent institutional investors, creating innovative debt financing structures and implementing a variety of strategies to seize attractive risk-adjusted returns during a highly volatile but favorable investment period.

Under Bailey and Leadholm’s leadership, Heitman has originated structured debt transactions totaling about $1 billion on behalf of its separate account clients.

Recognizing the changing dynamics in the real estate debt capital markets landscape and the growing importance of structured finance as a tool for capitalizing real estate investments, the firm is now forming a commingled fund, Heitman Real Estate Debt Partners, which has a targeted fund size of $350 million to take advantage of these conditions and construct an attractive portfolio for investors. The fund will have its first close in October 2014 and will focus on executing mezzanine debt strategies, leveraging the firm’s market position, extensive relationships, and expertise to pursue these opportunities.

As of June 30, 2014, Heitman manages $30.7 billion in assets across its three business units: real estate debt, public real estate securities, and private real estate equity; these investments span the gamut of property types and geographies globally. The firm’s scope and market position help foster a creative, collaborative atmosphere that leads to exchanging information amongst the various business units, helping Heitman’s various investment teams stay abreast of changing global market conditions across all areas of real estate. In addition to its Chicago headquarters, where Bailey and Leadholm are located, the firm has 10 offices throughout North America, Europe, and Asia-Pacific.

Bailey and Leadholm recently shared their thoughts on market opportunities and how they are positioning their team to take advantage of them.

Q. What are the latest developments in the market? What do you believe are the current interesting opportunities?
Leadholm: We continue to see a wide variety of investment opportunities for mezzanine debt strategies. At Heitman, our preferred method of sourcing investment opportunities is with companies or sponsors where the firm or either of us has an established relationship. As long time participants in and operators of real estate, our value proposition to owners of real estate includes a strong understanding of the capital market environment which allows us to offer competitive, cost effective solutions to our sponsors seeking to capitalize their real estate investment strategy. Because we also have an appreciation for many of the elements of risk in opportunities associated with the various real estate value creation strategies executed by our sponsors, we are able to be more creative and flexible in terms of structure, offering sponsors multiple ways to solve their financing needs. Investment strategies that we like to pursue involve existing assets vis-a-vis acquisitions, as maturing debt is coming due, as well as situations that require a re-calibration or recapitalization of the capital stack and ground-up construction. All of those scenarios are suitable for mezzanine debt financing.

Q. Why do you believe this is a good time to invest in mezzanine debt?
Bailey: The current level of real estate investment activity strongly supports continued need and demand for mezzanine debt investment capital. Some of the relevant factors include continuing economic growth, strong real estate market fundamentals, minimal new development over the past six years excluding the multifamily sector, and broad access to low cost senior debt from lenders who are generally remaining very disciplined relative to advance rates and loan structure. Many of our sponsors are executing development and other value-added strategies that respond to the robust demand for space in their locations and sectors.

At the same time, many investors view mezzanine debt investment strategies as a complement to their real estate private equity strategies. Though the supply of capital is growing for this type of investment strategy, the relationship between investment opportunities and competitive capital is more favorable in mezzanine debt than in the real estate private equity market. In addition, in the event interest rates rise over the short-term and trigger a change in capital market conditions, investors also appreciate there is a portfolio benefit from the shorter duration holding period typically found in ezzanine debt investments.

Q. What kinds of returns are you targeting with mezzanine debt?
Leadholm: We believe current market conditions offer mezzanine debt investment opportunities with risk profiles that would result in net returns to capital in a range of low to mid-teens.

Q. What kinds of sectors/geographies are you targeting in mezzanine?
Bailey: In terms of geographies, we primarily focus on the top 30 metropolitan areas that have better risk-adjusted return potential. We are spending relatively less time on the most competitive markets, like New York or San Francisco. Examples of markets where we focus would be Chicago, Atlanta, Dallas, Houston, Austin, Denver, Minneapolis, and Seattle, among others.

In terms of sectors, we’re active in all four traditional property types: multi-family residential properties, office, retail, and industrial sectors. We also include specialty assets like self-storage, student housing, and medical office properties in constructing our investment portfolios.

Q. What strategies are you currently pursuing at Heitman?
Bailey: Heitman believes there are ample opportunities for strong risk-adjusted returns from debt investment strategies that target multiple points in the capital stack, including mezzanine (generally 66-85% of the capital stack on a value basis) and structured senior debt generally 0-85% of the capital stack on a value basis). In addition to direct investments in real estate debt, we also are executing a global CMBS investment strategy through a joint venture with a related fixed income investment firm. The strategy invests in high-quality CMBS debt securities that have been issued and are secured by real estate situated in Europe and the US. We have observed that certain securities are mispriced by broader fixed income market participants. Given our insight into the real estate market in both regions, we believe we have an ability to identify where those mispricings can be converted into better than market returns for our clients.

We are constantly assessing the market conditions and relating them to our conversations with clients to develop new solutions-oriented strategies that allow us to showcase our debt investment capabilities, expand our business, and most importantly, maximize risk-adjusted returns for our clients.

Q. How do you plan to differentiate yourself from other large, well-established players in the space?
Leadholm: Heitman is an active real estate investor, owner, and operator. This insight sets us apart from many of the one-dimensional firms we compete with in the industry. We’re not just a mezzanine fund or just a senior debt investor. Our goal is to be viewed by our clients and sponsors as a diversified, sophisticated source of real estate financing that is always active in the market and able to properly assess risk and reward, and position our capital accordingly. We are tactical and careful, as we’re not looking to complete the biggest deal out there. We have a real estate centric approach and are a mid-market lender in the space. This keeps us out of the commoditized end of the business.

Our investment process also differentiates us from other firms in the industry. Our process is weighted evenly between a fundamentals driven bottom-up evaluation of the merits of the real estate, its sponsor, the market in which it is situated, and the nature of the risk of execution of the real estate value creation strategy, as well as a top-down, macro-economic and capital markets overlay that helps us determine what return is appropriate to pursue a debt investment. Our investment team members, including property market research specialists, are aware and focused on producing opportunities that we favor both because of that process and our expectations for that sector over the holding period.