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Distressed real estate fundraising could break new record

by Taina Rosa  |  Published February 10, 2012 at 2:04 PM ET
Related's latest fund drew a slew of institutions, including University of Michigan Board of Regents, which committed $35 million, the Texas County & District Retirement System, with $30 million of commitments, and Siguler Guff & Co. LP's Distressed Real Estate Opportunity Fund, with a $100 million-plus outlay, a source confirmed.

Some of the country's largest PE investors in real estate are in the market. Greenwich, Conn.-based Starwood Capital Group plans to raise $3 billion for its Starwood Distressed Opportunity Fund IX Global LP, according to a Dec. 18 regulatory filing. Colony Capital LLC of Santa Monica, Calif., has raised $350 million of a targeted $990 million for its Colony Distressed Credit Fund II LP, according to a regulatory filing dated Dec. 19. Washington's Carlyle Group has raised $2.25 billion for its Carlyle Realty Partners VI LP opportunistic fund, exceeding a $2 billion hard-cap on the vehicle, filings indicate.

The largest player, New York buyout giant Blackstone Group LP, with about nearly $21 billion of real estate assets, is now raising its seventh dedicated pool, with a reported $10 billion target. It closed its sixth in 2008 with about $11 billion. That fund is showing a net internal rate of return of 8% as of Sept. 30, filings show.

Representatives from firms that are fundraising did not return calls or declined to comment about new funds, citing regulatory restrictions.

Private equity funds are not the only game in town. They compete with real estate investment trusts, which last year raised $51.3 billion in public equity and debt. That's more than the $49 billion record set in 2006.

Even so, investors believe they can still get assets at attractive discounts. Related Cos. managing principal Justin Metz said his firm has seen discounts of between 30% and 75% of replacement cost, including any additional completion or improvement costs.

Opportunity funds either acquire portfolios of debt or the assets themselves, or a combination, providing liquidity where liquidity in credit markets is constrained. Opportunity fund managers point to greater availability of target assets as debt maturities approach.

With maturities coming due, "borrowers have no way of refinancing the debt secured by the asset," said Paul Fuhrman, a principal at Colony Capital.

In 2009 to 2010, after cash-strapped regional banks received money from the government's Troubled Asset Relief Program, many institutions could not afford to sell loans at discounts, explained Christopher Graham, managing director of Starwood Capital, which has been investing in distressed commercial real estate loans.

As banks gradually cleaned up their balance sheets, they began to shed unwanted portfolios, a trend that accelerated in mid-2011. "Now I would say the regional banks are in the third or fourth inning out of nine in getting rid of nonperforming loans," Graham added.

Buying the debt gives the owner greater flexibility, which makes it more interesting, as compared to investing in lender-owned real estate assets or real estate-owned property.

"Loans are often preferable because you have more options," Graham said. "You can negotiate a discounted payoff with the borrower. Often these loans come with guarantees and the borrower does not want the lender to go after their personal assets."

The investor can also modify and extend the loan if the borrower is doing a good job and is the most qualified person to run the asset. "In this case we often get a higher interest payment and/or a significant pay-down in exchange for extending the loan for a few years," he said.

Another option is to convert the borrower's loan into equity and take ownership of the asset along with the borrower and work together to maximize the upside. If nothing else works, the firm can foreclose on the loan and manage the assets itself, Graham said.

Between 2009 and 2011, Starwood scooped up loans with about $6.5 billion worth of unpaid balances from 18 different banks and the Federal Deposit Insurance Corp. Graham said these included about $5.5 billion worth of loan portfolios and about $1 billion "in various one-off deals."

More recently, Starwood took on a commercial loan portfolio with an outstanding principal balance of about $312 million from an unnamed southwestern regional bank. The portfolio consists of 106 first mortgage loans and real estate-owned assets.

Colony employs similar strategies, preferring to take on loan portfolios from banks rather than purchase tranches of commercial mortgage-backed securities, or pieces of commercial real estate loans bundled together.

"If you buy a CMBS tranche you do not have the same control as if you bought the whole loan from a bank," Fuhrman said. "By buying the whole loan we become the lender and are able to have a direct dialogue and a relationship with the borrower to work out a solution."

Fuhrman believes CMBS may be more attractive to debt traders than to real estate-focused investors, although the firm has made CMBS bets successfully in recent years.

Maturities are also approaching for CMBS assets issued prior to the financial meltdown of 2008. This year alone, some 5,900 loans worth $91.6 billion will be coming due, according to Trepp. Levels will peak in 2016 when 10,119 loans worth $135.1 billion will mature. In January, the delinquency rate for U.S. commercial real estate loans in CMBS was 9.52%, compared with 9.20% a year ago.

Private equity could play a role in easing the pain in the commercial real estate sector, said industry practitioners.

"In a sense, private equity investing in distressed real estate loans is a good thing because it may clean out the system," said Masood Sohaili, a partner at Manatt, Phelps & Phillips LLP's Los Angeles office.

"Hopefully, real estate prices will strengthen over time as a result of the improving economy and the availability of capital," Sohaili said. "If this happens, the dislocation in the market by the anticipated loan defaults may not be as bad as some people think."