A new phrase has come into common parlance in US real estate circles: “loan to own”. It sums up the ambition of some of the dozens of vulture funds that have been springing up on the back of the credit squeeze, economic downturn and tumbling US property values.
As the turmoil on Wall Street continues in the wake of the Lehman Brothers collapse, these funds are circling loans facing default or foreclosure, looking for debt they can buy on the cheap.
Douglas Wisner, a partner in the New York office of law firm Mayer Brown, says: “I’ve been involved in several situations where banks have been selling their pieces of the debt to opportunity funds. The funds wish to buy specifically because they want to make a play for owning the property.”
He adds: “You used to have a group of lending institutions all trying to maximise the return. Now it’s different. Now your bank group is a mix of banks that may want to keep the debt going, and of opportunity investors who don’t want to keep it going. But who owns what percentage of the debt? And who will call the shots in a default situation? It’s a bad situation for borrowers. In the past they could sit down with the bank and get a waiver, or pay a fee. Now they have to pay out dearly.”
According to Private Equity Intelligence, which tracks real estate private equity funds, 144 US-based opportunity and value-added funds are looking for a total of $93bn. Of those funds, 35 had raised $33.4bn by mid-July. Last year, 85 such funds raised nearly $50bn. Those with funds ready to pounce on properties and mortgages include Blackstone, Westbrook, Apollo, Goldman Sachs, CB Richard Ellis Investors, Morgan Stanley Real Estate, Philadelphia-based Lubert-Adler Partners, and San Francisco-based Shorenstein Properties. There are many more.
Of course, after the recent tumultuous events on Wall Street, there is no guarantee that these funds will still be so bullish. Some will hold off while they take stock of the situation others are linked to institutions that have their own financial problems. Indeed, Lehman Brothers set up an opportunity fund before its own collapse, which was triggered by losses of almost $14bn on subprime property loans.
Some deals involving distressed assets have already taken place, however, and the pace is expected to pick up as more borrowers default on their loans and regulators crack down on banks, pushing more properties onto the market.
So far, many of the defaults and foreclosures have been related to the collapse of the residential market. But there is a growing expectation that loans on commercial buildings, particularly shopping centres, will start experiencing difficulties as borrowers find that they cannot refinance, forcing them to sell or default.
Many problem loans were issued, pooled and securitised in 2006 and early 2007, based on the assumption that rents and commercial property values would continue to rise (see CMBS panel). Some required only the interest payment for the first three to five years, and have balloon payments due in 2009 or 2010.
The collapse of Lehman Brothers could be the trigger for banks to “accelerate the write-offs”, say Eric Anton and Ronald Solarz, both principals at New York-based real estate services firm Eastern Consolidated.
Like all agents, they have witnessed a fall in conventional investment activity, caused by the illiquid credit markets and exacerbated by uncertainty over values.
“A lot of trades have been medium-sized – around $50m – because buyers in that segment are less sensitive to the ability to finance,” says Solarz. “There aren’t many guys with $100m of cash in their pocket.”
The volume of sales stood at just under $63bn by the end of the first half of this year, according to Cushman & Wakefield (see graph). That’s about a sixth of last year’s record total of $406bn of deals, which was driven by REIT privatisations and subsequent property flipping in the first half – before the credit squeeze.
Gone are the heady days of 90% loan-to-value deals. “There is debt out there if you have a relationship with a portfolio lender, but now there are no 75% loan-to-value ratios – it’s 50%,” says Ray Torto, global chief economist with CB Richard Ellis. “You can get a hedge fund to step in, but it has to be a rich deal to make that work.”
Yields (or capitalisation rates) are moving out, almost reaching 2006 levels, according to Cushman’s H1 figures: for offices they reached an average of 5.6% in the first half of this year retail hit 6.6% industrial 7.1% and hotels 7%. Investors expect further movement. “There are real estate funds, both domestic and from outside the US, that are interested in opportunities here,” says Mayer Brown’s Wisner. “But what are the current valuations? They don’t want to come to find out three months from now that they overpaid.”
Keith Willner, a fellow partner at Mayer Brown, based in Washington, says: “At the start of the year, there were those who thought the slowdown would end in the fourth quarter of 2008, and there were those who thought it would last at least until the third or fourth quarter of 2009. The big change I’ve seen is that the more optimistic people have taken cover. No one thinks that anymore.”
However, there is still optimism that the touted billions of equity sitting on the sidelines will eventually come in to US real estate. “The pension funds, investment managers and sovereign wealth funds have the capital, and they don’t need that much debt,” says CBRE’s Torto.
He is researching how much money the sovereign wealth funds might put into real estate if they mimic the capital allocations of pension funds, which typically put 8% of their capital into property. He believes that, on this basis, sovereign wealth funds could pump around $300bn into real estate around the world.
“There’s a lot of money and potential money – but pricing is still a problem,” Torto says. “They’re just not going to buy until they know where prices are. The chaos lies in the uncertainty.”
Willner agrees: “I don’t think anyone knows when the market is going to bottom out,” he says. “Things are never so bad that they can’t get worse.”
