Debt Funds - US: Keeping an eye on the prize

Lenders are focusing on short-term transitional business, while keeping an eye on long-dated opportunities once interest rates rise, Christopher O’Dea reports

A few years on from the economic crisis, debt investing is once again becoming all the rage. Leading the resurgence are some key players that weathered the crisis, along with nimble specialised entrants that can move fast to fill the void left by the withdrawal of banks hobbled by new risk regulation.

Today’s most active US debt investors are the repository of credit analysis and other expertise that was lost or dispersed during the crisis. Today that gives them a secure seat at the lending table, and they are making the most of their position – seeing their funds oversubscribed, and capturing a new wave of demand from yield-starved institutional investors.

Macro trends and technology are transforming the real estate industry, while slow growth and low interest rates are providing ample liquidity for investing. In industrial real estate, for example, the ongoing transition to e-commerce distribution is fuelling demand for larger, more networked buildings. 

At the other end of the e-commerce chain, retail real estate owners and investors are adapting their premises to suit the commercial possibilities opened by internet sales and marketing, reconfiguring stores in light of the latest advances in inventory management, design, and production. Most of the work of the networked economy takes place in offices, analysts say, and that is driving plenty of debt capital towards a US office sector where rising demand outstrips supply constrained by a virtual halt to new construction.

Years into the zero-interest rate world, institutions are grappling with the need for long-dated income streams to match against their own long-term liabilities – and that is driving institutions increasingly into the realm of structured real estate debt that provides high single-digit yields with ample cushions against declines in the price of the underlying assets.

The US real estate debt market is seeing significant activity in structured deals to finance transitional or value-added properties and situations. But a new phase is beginning. Structured players that have built franchises on their expertise are expanding their relationships into core transactions, while a major mortgage trust manager is eyeing a bigger push into the US and readying an institutional-only mortgage fund for 2015. Some institutions are demanding segregated accounts aimed at selected sectors, while some established debt players are marketing funds focused on the short-term financing needs of entrepreneurial real estate owners and developers.

But while capital is plentiful, expertise is in short supply. Institutional-quality real estate debt lending “is not one of those things you can create overnight”, says Ryan Krauch, a principal at Mesa West Capital, a privately-held portfolio lender with a capital base of approximately $3.5bn (€2.7bn). Mesa West established a debt platform in 2004 that provides flexibly-structured capital for acquisitions, re-financings and re-capitalisations on office, retail, industrial, multifamily and hospitality property in the US. It was a novel concept at the time, when buyers had two sources of debt: banks or commercial-mortgage backed securities. Pension funds were not yet deeply involved in commercial real estate debt markets, Krauch says, when the firm began to educate institutional investors about the opportunity. He estimates that by 2008 there were 80-90 debt sources jockeying to enter the field, but in 2009 only a handful were able to raise debt capital funds. “In 2009 we were the only commercial real estate loan source,” Krauch says.

Staying the course has paid off. The Mortgage Bankers Association ranks Mesa West as the most active speciality finance lender in the US, along with Meridian Capital Group. Mesa West originated $1.5bn of transactions in 2013, while raising $1.3bn in new capital, and Krauch says the firm is on target to originate the same deal volume in 2014. Originally focused on transitional properties, Mesa West began financing core and core-plus projects after the crisis, filling the gap left by exiting lenders, and today its portfolio is a 50-50 split between transitional and core deals.

Since 2004, Mesa West has originated more than $4bn in non-recourse first-mortgage debt for transitional, institutional-quality commercial real estate assets across the US. Mesa West also provides lower-leverage first-mortgage loans up to $250m on more stabilised core assets through its recently launched Core Lending Fund, a unique open-ended vehicle that allows quarterly redemption and investment in the firms’ first-mortgage lending strategy. Mesa West employs an originate-and-hold strategy that differentiates it from other debt funds, which tend to focus on mezzanine, distressed debt or CMBS trading strategies. “We are hand-picking assets, taking a rifle-shot approach,” says Krauch. The fund currently has $650m under management and seems to have found a following among institutions – another closing of $200m is expected to take place before the end of the year, Krauch says. “We cut our investors’ cheques for 7% to 8% yields,” he adds, “and most of them elect to reinvest in the fund.”

Last November, the firm closed the latest in its flagship series, Mesa West Real Estate Income Fund III, with $752m in equity commitments. Krauch says Fund III is two-thirds invested and, when that reaches 75%, the firm will start marketing Fund IV.

The investor base is primarily public pension plans, along with corporate plans, life insurance companies, funds of funds and ex-US investors. Such investors have increasingly prioritised cash flow and safety, and real estate debt has found a permanent home in the allocations of many institutional investors

The diversity of investors illustrates how institutions have been replacing traditional sources of debt with commercial real estate transactions. In fact, a recent study by Preqin shows institutional interest in real estate debt is growing strongly, with 23% of institutional investors targeting debt strategies in August 2013, up from only 8% in December 2011, and a hefty 62% of those favouring debt investments are below their target allocation. That interest will help fill what Mesa West says is an approximate $2trn funding gap between the amount of commercial real estate debt maturing over the next several years and the capital available to refinance that debt.

Others are moving to fill the gap. Los Angeles-based Thorofare Capital, an alternative investment firm that specialises in commercial real estate bridge loans had, by July, raised more than 80% of its $250m target for Thorofare Asset Based Lending Fund III, the third fund from the firm, which was one of the debt specialists formed in 2009. Fund III, composed of family offices, foundations and investment companies, will be capped at $300m. Miller says the firm’s third fund had a client recommitment rate above 90%. Thorofare finances opportunistic acquisitions, recapitalisations, discounted pay-offs, note acquisitions and other special situations such as open-bid auctions, says CEO Kevin Miller. Fund III, which held its first closing in November 2013, had invested more than $115m in transactions by August, he says.

Timbercreek Asset Management, a Toronto-based specialist in mortgages and public real estate securities, is readying a long-term mortgage fund for institutional investors that will focus on 10 to 20-year loans that match the long-dated liabilities of pension funds. Andrew Jones, managing director of debt investments at Timbercreek, expects the fund will be up and running in early 2015.

“We’ve had very good responses from the investment community,” says Jones. Timbercreek already runs more than $1bn in mortgage strategies through two mortgage investment companies listed on the Toronto Stock Exchange and several smaller vehicles. The current strategies focus on structured loans of 36 months or less, offering premiums of 200-400bps above corresponding government securities, says Jones. The new fund will invest in long-dated first mortgages on property owned by entities that are already investment grade, generating 150-175bps of net yield over relevant benchmark bonds, he says. 

Another trend fuelling demand for debt finance is that property owners are eager to pay off pre-crisis loans early – they have been chipping away at $316bn of debt maturing between now and 2017 that has loomed over the CMBS market since the credit crisis. 

Owners of US properties from skyscrapers to hotels have retired $17bn of debt before it was due during the past 12 months, more than four times the amount retired before maturity in 2011 and 2012 combined, according to Credit Suisse Group. Proprietors of the Mall of America, the largest shopping centre in the US, took advantage of low rates to obtain a $1.4bn loan to repay debt that does not mature until 2016.

Today, pricing and yield conditions vary greatly by market, property, and sector, says Brian Heafey, partner in charge of debt investments for PCCP, a $6bn firm that provides senior debt and bridge debt to transitional opportunities. “We’ve got a very strong pipeline,” says Healy. “It hasn’t let up during the summer.”

The firm recently completed transactions ranging from industrial property in Illinois to distribution facilities in Memphis and a multifamily project with retail outside Boston. While terms vary, LTV ratios for PCCP’s three-to five-year loans are typically between 65% and 75%, Heafey says.

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