Institutional Investors have typically steered clear of private mortgage funds, which earn a return by making high-yielding, short-term bridge loans to commercial property developers who need money more quickly than traditional financing permits. But a few intrepid institutions have begun to allocate money to this niche, attracted by low volatility or steady returns not correlated to stock and bond markets.
Real estate investors and property developers turn to providers of bridge financing when, for example, a traditional lender pulls out of a deal or an investment opportunity materializes within only days or weeks of a transaction’s closing date. A decade ago, when interest rates and risk premiums were considerably higher, investors in private mortgage funds could count on annual returns of as much as 20 percent. Today returns are in the 9 percent to 10 percent range.
Even so, “bridge loans can be a very profitable and satisfactory investment,” says Michael Sonnenfeldt, chairman of MUUS & Co., a private investment firm in Westport, Connecticut. Sonnenfeldt, who developed Jersey City’s Harborside Financial Center -- one of New Jersey’s largest private developments -- is a bridge loan investor and former sponsor of a private mortgage fund.
One beneficiary of the heightened institutional interest in these investments is San Franciscobased California Mortgage and Realty, a specialty lender with $400 million in assets whose loans are paid off, on average, in 20 months. The firm has traditionally attracted wealthy individuals as investors, but in February it announced that an unnamed pension fund and insurance company had committed more than $100 million to a new offering for institutional investors called CMR Mortgage Fund. The firm expects to more than double its asset base by 2008 by raising $600 million in the latest fund.
California Mortgage and Realty is targeting returns of as much as 15 percent by using leverage. “Institutional investors are willing to live with the perceived risk,” says James Gala, the lender’s CEO.
New Yorkbased W Financial Mortgage Fund I, a bridge loan and mezzanine lender with $32 million in assets, plans to launch a fund for institutional investors in August. The firm is looking to raise $250 million and will likely require a minimum investment of $1 million. It plans to charge a 2 percent management fee -- and will likely structure the fund to pay out an 8 percent preferred return before taking an incentive fee equal to 20 percent of the profits.
W Financial provides mortgages and mezzanine loans and focuses mostly on the New York metropolitan area. Its new institutional fund will invest alongside the firm’s original offering for wealthy individual investors, which requires a two-year lockup. From July 1, 2003, to May 31, 2007, that fund delivered a compound annual return of 10.91 percent, about 36 basis points above the Standard & Poor’s 500 index.
“We are launching the second fund because of requests we’ve received from institutional investors that said, ‘We like what you are doing, we like your track record, and we like the fact that you have no defaults or foreclosures, but we cannot live with a two-year lockup,’” says Gregg Winter, manager of W Financial and president of Winter & Company, a New Yorkbased commercial mortgage brokerage firm that helps source the fund’s loan opportunities. He expects the new institutional fund to have a one-year lockup and require a six-month notice for redemptions.
Default risk -- which can be high -- means that writing bridge loans is not for the faint of heart. “I never made a loan where I wasn’t willing to own the property for the value of the loan,” says Sonnenfeldt.
As an investor in private mortgage funds, Sonnenfeldt says he sticks with managers who have “skin in the game” and aren’t in a position to earn a profit before investors do. Since bridge loans are priced according to the value of the underlying property, not the cash flow it produces, Sonnenfeldt invests with lenders that, he believes, thoroughly understand equity valuations. That expertise is crucial because the best deals often arise when bridge lenders uncover hidden value and write loans at higher rates on properties that are shut out of conventional financing. Workout experience in the real estate industry is also crucial, he adds.
Bridge loans may be risky, but investors are increasingly likely to take the leap. As Sonnenfeldt puts it, “Sometimes greed gets the better of fear in the search for yield.”
