Firms battle over realty debt

Private equity, real estate funds are competing for three types of bank obligations

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Liquid Realty's Jeff Giller says investors don't know what's inside CDOs.

Private equity and real estate investment funds, fueled by growing commitments from their investors, are competing to buy the real estate debt now choking banks' books.

But industry insiders warn: Buyers beware.

There are three flavors of bank real estate debt. Two of them — bank loans and commercial mortgage-backed securities — are not all that plentiful or at the bargain-basement prices for which investors long. The third — collateralized debt obligations — are being sold at low prices but have a far greater likelihood of blowing up.

CDOs have become big pools holding every type of real estate security that banks had, explained Jeff Giller, managing principal and chief investment officer of Liquid Realty Partners, San Francisco, a real estate investment firm specializing in the secondary market. They can include everything from whole loans and equity positions to CMBS positions, all leveraged up and sliced into tranches.

It's virtually impossible to know what you hold in a CDO, Mr. Gill-er said. Investors don't know what the underlying properties or structures of the investment vehicles are in a CDO.

Even so, private equity and real estate buyers are gobbling up CDOs.

Just last week, Lone Star Funds, Dallas, bought up a portfolio of CDOs from Merrill Lynch & Co. for 22 cents on the dollar. Industry watchers expected to see a bundle of Citigroup Inc.'s CDOs sell for the same price late last week. Lone Star had no trouble raising a $7.5 billion opportunity fund that closed on July 25.

While they are fewer, other bank debt deals also have closed. In July, real estate investment firm Benson Elliot Capital Management, London, and GEM Realty Capital Inc., a real estate hedge fund in Chicago, bought a portfolio of mezzanine debt for e42.5 million ($66.3 million) at a significant discount to face value, said Denise Olsen, managing director. She declined to give details on the discount.

Investment managers are hoping to make the same big returns they did during the savings-and-loan crisis of the late 1980s. Many of today's largest real estate opportunity and private equity players made their first billion buying up savings-and-loan debt for 20 cents to 50 cents on the dollar and selling when the economy came out of the recession. Included in that list are Apollo Management LP, Colony Capital LLC, The Blackstone Group, Whitehall Funds and JER Partners

“Those who bought that debt for deep deep discounts, like 30 to 50 cents on the dollar back then made an absolute killing,” Mr. Giller said. “Everyone's been waiting for that magnitude of a real estate crisis to return for the last 15 years now.”

Since the current debt crisis began, a number of managers have jumped in to raise funds or use a portion of existing funds to buy debt from banks.

Just last week, Sankaty Advisors LLC, Boston, the credit affiliate of Bain Capital LLC, Boston, closed its fourth fund, the $3.5 billion Sankaty Credit Opportunities IV. Sankaty invests in leveraged loans, high-yield bonds, distressed/stressed debt, mezzanine debt, structured products and equities. Investors in the new fund include the $34 billion Pennsylvania State Employees Retirement System and $63.3 billion Pennsylvania Public School Employees’ Retirement System, both of Harrisburg, and the $16.9 billion San Francisco City and County Employees’ Retirement System.

Other funds aiming to buy debt in distress include Starwood Debt Fund II, Aurora Resurgence Fund, Apollo Investment Management Fund VII, Apollo Credit Opportunities Fund and Siguler Guff's Distressed Opportunities Fund III.

So far, commercial real estate markets are fundamentally strong, and the underlying real estate has not sunk to the depths of the savings-and-loan crisis. With the exception of the CDO grab bags, not much is being sold at the deep discounts investors seek. Yet it is those steep discounts, coupled with high-flying rebounds later, that investors expect will drive high returns.

There is a wide chasm between the banks' and purchasers' ideas of a fair price. Bidders on bank distressed and non-performing development real estate loans are now valuing the debt at 20 cents to 30 cents on the dollar, far below the banks' ranges of 70 cents to 80 cents on the dollar, said Nick Mosich, managing member, ION Capital Partners, Los Angeles.

Also, recent experience shows that investors can be too early. In late spring, sovereign wealth funds and opportunity fund managers bailed out banks and other financial services institutions and bought their debt, investing a total of nearly $285 billion. But second and third write-downs by firms like Citigroup, Lehman Brothers Holdings Inc., UBS AG, Morgan Stanley (MS) and Merrill Lynch have sunk these early investments, said Mr. Mosich.

Whole-loan basis

Even so, this may not be a bad time to commit capital to funds targeting distressed bank debt, so long as its on a whole loan basis rather than a complex CDO pool where you can't evaluate what you are buying, Liquid Realty's Mr. Giller said.

Investors are making big bets that an opportunity will eventually emerge. In July, the Oregon Investment Council, Tigard, which manages the $63.4 billion Oregon Public Employees’ Retirement Fund, Salem, committed $3 billion for credit opportunities to be managed by KKR Financial Advisors in a dedicated separate account, said Ron Schmitz, chief investment officer. (The investment was made before Kohlberg Kravis Roberts & Co. announced that it was going public. Mr. Schmitz said it is too early to tell whether KKR's move will affect the council's investment.)

In February, the $6.2 billion San Bernardino County (Calif.) Employees' Retirement Association doubled its domestic credit strategy allocation to 8% of total assets and added a 5% international credit allocation, said Timothy B. Barrett, executive director and CIO. In July, the association committed $30 million to a fund investing in commercial mortgage-backed securities (AIG Mortgage Opportunity Fund) and a fund investing in asset-backed securities (Halcyon Asset-Backed Value Fund). “We see this as an historic opportunity in the credit markets,” Mr. Barrett said.

It's a challenging investment, said Claudia Faust, co-founder and managing partner at Hawkeye Partners LP a real estate private equity firm in Dallas.

Troubles with commercial real estate are coming, Ms Faust said. “I don't know if it is as big of a value play,” she said. “Our philosophy is that (real estate debt) is a real estate play.”

Buyers have to understand what they are buying and be able to run it, Ms. Faust said. On the commercial real estate side, there has been a bit of mezzanine debt for sale in retail and a little office, she said.

Contact Arleen Jacobius at