Over the past few years, the story with allocators investing in private equity had a rich-man, poor-man quality. A spate of big distributions left cash on hand but nowhere comparable to invest it. Real estate emerged as a go-to asset class, driving up valuations alongside a growing public demand for properties, which only added to an already frothy market. Now, as interest rates are beginning to rise, investors are wary of a correction and turning to parts of the real estate debt market as a hedge.
Commercial real estate bridge loans are one such hedge. Bridge lending is a type of temporary financing that fills in gaps while developers make changes to a property, like renovations or repurposing. Historically, bridge loans have been done one deal at a time, with developers seeking financing based on a business plan and a 12- to 18-month timeline for repayment. Traditional bank lenders have been in and out of this market, since underwriting can be tricky: Buildings in transition often have negative cash flow when they apply for financing, which is a hard sell to banks. As a result, nonbank lenders have stepped in to meet the demand at interest rates slightly above the banks. Those nonbank lenders are beginning to approach bridge lending more systematically by raising short-term debt funds.
On January 4 Los Angelesbased Mesa West Capital closed its fourth and largest fund to date, at $900 million. The vehicle will originate short-term loans ranging from $20 million to $300 million. Mesa West was one of the first managers to focus exclusively on commercial real estate debt and has since deployed more than $11 billion of loans. When we launched our first fund in 2005, there werent that many institutions, beyond insurance companies, in this space. But weve seen more institutions, and pensions specifically, come around to the asset class, says Mesa West co-CEO Jeff Friedman. Both the San Joaquin County Employees Retirement Association and the Indiana Public Retirement System disclosed commitments to Mesa West Real Estate Income Fund IV as part of their real estate allocation. Other investors include corporate pensions, endowments, foundations, and sovereigns.
Friedman says the current fundraising environment is strong for firms that have an existing track record, and he expects that 2017 will be a solid year in terms of lending volume. This is a demand that always exists, he contends.
Christopher Acito, founder, CEO, and CIO of New Yorkbased limited partner Gapstow Capital Partners, agrees, arguing that 2017 looks like a particularly interesting year for bridge financing. This is an industry that is now turning to institutional investor capital as its primary source of financing, he says. Gapstow invests in both credit managers and assets and has committed approximately $100 million to bridge lending and other small-market commercial real estate debt strategies.
According to Acito, in addition to the consistent demand for new bridge loans from developers, 2017 will also see a wave of ten-year commercial-mortgage-backed securities (CMBS) vehicles, which were put together just before the financial crisis, hit maturity. Many of those vehicles will need refinancing, and traditional banks will have to contend with newly implemented risk-retention rules, which could limit new CMBS issuance, creating an opportunity for nonbank lenders to step in.
At the upper end of the market, leverage limits on banks are also likely to keep the advantage with nonbank lenders. There is a real void when it comes to moderate-leverage large bridge loans, and weve been able to step in and do those deals, says Boyd Fellows, managing partner at San Franciscobased Acore Capital. Fellows adds that demand is spread consistently across major cities and large metropolitan areas. We are confident that this will continue over the next one to two years, he says.
Despite this rosy picture, some managers remain philosophical about how broad-based institutional investments will be in the near term. David Loo and Richard Ortiz, comanaging partners at New Yorkbased Hudson Realty Capital, have had Gapstow as an LP since 2011. The relationship grew from what was basically a separately managed account, a setup that the team at Hudson has since used with other interested LPs. According to Loo, even though investors are coming around, theres still a lot for them to get comfortable with. I dont think traditional core class-A investors are all of a sudden going to start getting into subordinated debt across the spectrum, he says. But there is more interest in the space than there has been previously.
There are advantages for both developers and investors that opt to go the private lending route: Borrowers are assured that the transaction will close, and debt investors have the security of a path to recovery even if a deal goes sideways. The transactions are also somewhat difficult to source, creating natural barriers to entry. There are shoe leather costs with this type of lending, Gapstows Acito says. You have to be local; it requires loan origination and networking. You cant look up these deals on a Bloomberg. But we think its worth it.