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REAL ESTATE - Heading Back into the Water

Some investors in commercial real estate debt, sensing the biggest buying opportunity in a decade, are raising billions to plunge into the depressed sector.

THE WIDESPREAD TROUBLES in credit markets have been creating plenty of pain for investors and financial services firms, but they’re also presenting buying opportunities. Over the past few months, savvy money managers like Highland Capital Management and investment banks including Goldman, Sachs & Co. and Lehman Brothers have raised so-called opportunity funds to buy beaten-down corporate and residential mortgage-backed debt that investment banks and other lending institutions need to sell at hefty discounts to clean up their balance sheets. Now interest is shifting to the market for commercial real estate debt, which also has been buffeted by the wider credit market concerns.

Participants in the commercial real estate markets estimate that some 20 to 25 funds, worth as much as $15 billion, are being raised to target undervalued commercial-mortgage-backed securities and collateralized debt obligations containing CMBS. The firms forming these vehicles — including Centerline Capital Group, Dune Capital Management, Guggenheim Structured Real Estate Advisors, Lone Star Funds and Lubert-Adler Partners — hope to exploit what many in the industry say is the best buying opportunity in nearly a decade. Spreads on high-grade CMBS have widened by about 50 basis points in the past three months, reaching levels that these investors believe are out of proportion with the underlying fundamentals. In some cases, holders of this debt also owned residential mortgage bonds and CDO tranches that have been plummeting and have had to sell assets to raise cash.

“The historically wide spreads for CMBS and CDOs represent illiquidity in the wider fixed-income market, as opposed to prices that relate to the underlying fundamentals of the securities,” says James (Larry) Duggins, head of the commercial real estate group at New York–based Centerline, which is raising a roughly $1 billion fund to acquire mispriced securities. “We have a platform designed to understand the underlying real estate fundamentals, and we can identify investments where there is a disconnect.”

Market participants also expect commercial mortgage defaults to rise slightly in coming months and that a number of borrowers will have trouble refinancing debt in the current liquidity crunch, creating additional sources of potential profits for these new vehicles. Opportunity funds can step into both situations by providing a market for distressed sellers and by funding new loans for troubled borrowers.

The move into beaten-down commercial real estate debt is being led by such experienced hands as Centerline, which, Duggins says, is raising the bulk of the capital for its fund from its longtime clients. But other types of investors also are flocking to the sector, smelling easy money. That, of course, creates the possibility that some players who lack extensive knowledge of the complex CMBS and CDO markets may see losses.

“Some of the managers raising capital are those who have been long active in executing debt-related strategies. Others are equity specialists who believe returns in debt are more attractive than returns in equity,” says Bruce Cohen, CEO of Chicago commercial real estate finance company Wrightwood Capital. “So there is a massive migration on the part of fund managers to raise capital to execute debt strategies.”

Wrightwood is keen to lend in this environment, particularly because borrowers are willing to put up with much less friendly terms than were the norm before markets headed south over the summer. The firm is devoting as much as $1 billion to making new investments in commercial real estate debt, according to Cohen.

“You can make a mezzanine loan today and take far less risk while getting equitylike returns,” he says. “There is more demand for structured capital. There are also more structural mitigants to compensate for the risk.”

The search for depressed assets also extends to partnership interests in existing real estate funds. Business is picking up, for instance, at San Francisco–based Liquid Realty Partners, which provides liquidity for institutional investors seeking to sell their interests in private real estate funds. Institutions have been especially interested in off-loading their stakes in debt-focused funds, says Scott Landress, Liquid Realty’s CEO. Opportunistic investors also are looking to acquire these stakes on the cheap. “We are seeing limited partners who are worried about a market topping out or about allocation issues,” he says. “The limited partner has some degree of stress, or a desire to sell.”