Prior to the onset of the COVID-19 pandemic, debt funds had carved out a solid niche for themselves in the commercial real estate lending space. But as has been the case with other lenders, many loan funds have been shelved or started taking care of distressed loans after the economic lockdown put a halt to commercial property sales. and created distress overnight. Some, however, remain on the market. What is the difference between both ? Leverage.
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In particular, debt funds that relied on warehouse lines faced debilitating margin calls as the crisis unfolded. Meanwhile, those who have rebuilt their capital by selling some of their loans to banks or in the secured lending market have also seen those sources dry up. Some of the biggest debt funds, including TPG Real Estate Finance Trust, Colony Credit Real Estate and Granite Point Mortgage Trust, had to sell assets to improve their liquidity positions.
“A lot of leveraged players have seen their lending explode and have had to give up a lot of equity,” said Gary Bechtel, CEO of Red Oak Capital Group, a Grand Rapids, Michigan-based debt fund. “But funds that don’t use leverage, stay in the market and continue to raise and deploy capital.
Flexible but expensive
Loan funds are private, unregulated pools of capital that typically provide borrowers with short-term loans for construction, value-added projects, or other situations requiring bridge or bridge financing. Debt funds generally offer higher loan-to-value ratios, faster execution, and more flexible terms than banks. But borrowers pay up to 250 basis points more for loan fund capital. Leveraged funds can generate annual returns of 12% to 15%, while balance sheet debt funds provide 9% to 11%.
Although debt funds only represent a small percentage of the overall commercial real estate lending market, the space has attracted many players in recent years, including separate accounts held by life insurance companies and banks. By using bridge lenders as loan fund proxies, Bechtel has tracked the growth of these alternative lenders. In 2019, the number peaked at more than 360, up from 150 in 2015, he said. Today, that number is likely down to less than 200, he estimated.
Additionally, 91 real estate funds raised more than $39 billion in 2017, the highest dollar volume in the past five years, compared to 60 funds that raised nearly $16 billion in 2015, according to Preqin. . Only 20 funds raised around $7 billion in the first two quarters of this year.
Douglas Weill, managing partner of Hodes Weill & Associates, a New York-based real estate capital advisory firm, suggested that debt fundraising could remain muted for the next few quarters. The institutional investors his firm works with who regularly invest in the funds are looking to be more aggressive in this environment, he said.
“In our view, institutions have increased their return and risk profile – they are a little less interested in a strategy that is yielding 8-10% today,” he said. “They think they should play more attacking and focus on fairness and distress.”
Debt funds that finance transactions from their balance sheets remain active, although they have become more selective and conservative. Before the pandemic, borrowers of debt funds could obtain financing with an interest rate of 5% to 6% based on the 30-day London interbank offered rate of around 1.7%, said Joseph Iacono , CEO and Managing Partner of Crescit Capital Strategies, a New York-based alternative commercial real estate lender. Today, that interest rate is 8% or more, even though LIBOR is around 150 basis points lower.
“The risk premium has gone up,” he explained. “Loan funds aren’t spending as much money, and they’re charging more for the money they’re spending, and they’re going to be very picky about where they put that money.”
While debt funds have long favored a value-added strategy that takes advantage of significant increases in rental rates or property values, continuing these deals today makes less sense given the uncertainty over the future. ‘coming. Instead, the funds finance projects that need light improvements or rentals.
Loan funds are also seeing more opportunities to provide construction loans as banks have pulled back, said Toby Cobb, co-founder and managing partner of 3650 REIT, a commercial real estate lending services company. and investment management. Yet even though lenders may demand better terms for loans to mitigate risk, they are more difficult to provide than loans on transitional assets, he added.
“Cost overruns and mishaps are a real part of being a construction lender,” Cobb said. “And, right now, construction loans are more complicated – it’s not easy to issue capital because of questions about how long the pandemic will last and whether we should build anything.”
To the rescue
To take advantage of more opportunistic situations, some funds provide “white knight” capital to stressed hotel and retail owners, who buy back existing debt at a 20% to 40% discount from their lenders.
In Colorado Springs, for example, Dallas-based Revere Capital provided the owner of a 360,000-square-foot mall with $19.6 million this spring, which funded a $22 million refund. on the $34 million loan held by a mortgage REIT as well as a rental expense reserve account. The REIT had seen its share price drop about 70% since the lockdown and needed to improve its liquidity position to meet a margin call from its repo lenders, said Clark Briner, founder and director of Revere Capital.
“Discount discounts were great business between 2009 and 2012, and we’re seeing them return,” Briner said. “Banks and other lenders are trying to monetize their allocations in the retail and hospitality space, if they can, because they don’t know how the coronavirus is going to affect those assets.”
Acres Capital, based in Westbury, NY, is considering similar deals in the hospitality industry. An owner of 55 hotels has the opportunity to buy back loans at a discount but can’t find conventional financing, said Mark Fogel, CEO of Acres. That kind of momentum should pave the way for one or two well-located hotels with high-quality flags, he added.
“Lenders just don’t want to dig a deeper hole by spending more money and not getting their debt service paid,” Fogel said. “They think they can get their best price now, before a flood of troubled tickets start hitting the market.”
Loan funds clearly recognize these potential opportunities in such an environment, and with the end of forbearance periods, they are likely to become even more abundant. The ability of funds to profit from this, however, depends on their ability to look forward rather than backward.
“The very idea of playing offense today depends on how well a fund is raised and the status of your loans,” said Jack Gay, global head of commercial real estate debt for Nuveen Real Estate. . “If you have a lot of leverage and more difficult asset classes like hotels and retail, then you definitely focus on liquidity and play defense rather than attack.”
Read the October 2020 issue of CPE.