Last week, Harrison Street Real Estate Capital LLC, Chicago, closed a $595 million real estate fund, $95 million above its fundraising target. The fund was set up to explore both debt and equity investments, said Christopher Merrill, Harrison Street co-founder, president and CEO.
In May, Prudential Real Estate Investors closed the largest-ever real estate mezzanine debt fund, the closed-end Pramerica Real Estate Capital 1 Fund — at $800 million. (Mezzanine debt is a loan that gets paid after all of the other loans on a property are paid).
“Many are new players in the (real estate debt) space. They may have been equity providers in times past, but they saw the need for debt and so raised a debt fund,” said Randy Bramel, the founding principal of real estate investment banking firm Bridgeport Investments, Tustin, Calif.
Other equity real estate investors that are turning to debt include Starwood Capital Group LLC, Colony Capital LLC, Square Mile Capital Management LLC, AREA Property Partners, Brookfield Properties LLC and Shorenstein Properties LLC.
Some are strictly mezzanine investors, such as AREA Property. Others, including Starwood and Apollo Global Management LLC, are focusing on first-mortgage debt.
So far this year, eight real estate debt funds received a total of $8.3 billion in capital commitments, according to Preqin, a London-based alternative investment research firm.
Harrison Street, which specializes in education and health-care real estate, already has invested 25% of the capital of the new fund on properties and loans from banks at deep discounts, allowing the firm to make money if the loan is paid off or if it ends up owning the property, Mr. Merrill said.
Prudential began developing a new strategy at the height of the financial crisis in anticipation of the need for debt. It hired a team of veteran real estate debt investment executives, said Jack Taylor, managing director and head of the global debt team. He had been a partner at real estate investment firm Five Mile Capital Partners LLC.
“We were ahead of the ball,” Mr. Taylor said.
Other equity real estate investment managers are flirting with the idea.
“While the debt market has rebounded significantly, it is still way off its historical peak and given the volume of debt that is coming due, we see a real need for mezzanine financing,” said Mike Kelly, managing director and head of debt capital markets for J.P. Morgan Asset Management, New York. “We think ... now is a good time to be providing that type of capital.”
And with mortgage REIT returns rising, some REIT managers are taking a hard look at them. Commercial mortgage REITs earned 41.99% in 2010, according to the National Association of Real Estate Investment Trusts, a Washington-based trade group.
“We do believe that there is potential for commercial mortgage REITs to play a role as a source of capital in the wake of the looming unwind of legacy CMBS and the traditional balance sheet lenders (such as banks and insurance companies) from the last cycle,” said Al Otero, managing director, portfolio manager U.S. REITs and global real estate securities for New York-based real estate manager European Investors Inc.
While European Investors does not now invest in mortgage REITs, executives are ”going through an internal process to better assess the potential opportunity” he said.
Other managers that are in the market to raise debt funds include AXA Real Estate Ltd. and Henderson Global Investors Ltd. Private equity firms Kohlberg Kravis & Roberts & Co., Apollo, Lone Star Funds and Blackstone Group LP are ramping up or acquiring real estate debt businesses.
In all, there were 122 funds in the market targeting $49 billion for real estate debt as of May 31, according to Preqin.
Hedge funds, including Och Ziff Capital Management Group LLC, also have been getting into real estate debt.
Veteran debt managers are getting together to form new firms to take advantage of the investment opportunity, including NXT Capital LLC, formed by former founders and executives of Merrill Lynch Capital Inc. and Heller Financial Inc.
“One needs to think of mezzanine in two contexts. In the overheated market coming into the financial crash, mezzanine was treated, wrongly, like a liquid instrument. Post-financial crash mezzanine, (if it is) done right and earlier before excess liquidity (develops), is a very different animal,” Prudential's Mr. Taylor said.
A number of managers lost their shirts on mezzanine investments made in 2004 and 2005, Mr. Taylor said. Investors that made mezzanine loans or bought them from Wall Street at the time treated them like securities, not real estate, he said.
“They did not see the need to do the same level of analysis and underwriting. I call it the momentum-trading period. They were taking positions they felt they could get out of by resecuritizing them or selling them off,” he said. “They were liquid until they weren't.”
Mr. Taylor declined to name names. Sources said that some of the real estate managers active in real estate debt that failed include Lehman Brothers, Guggenheim Partners, Capmark Financial Group and Transwestern Investment Co. Some mortgage REITs also blew up during the crisis including Istar Financial and Grammercy Capital Corp.
Prudential executives say banks will start to sell or foreclose on more loans because their improved financial positions allow them to take some losses.