With traditional lenders chased from the market by the credit crunch, commercial real estate investment companies with cash to spare are delving into the financing business. Shorenstein Properties, JER Partners and Savanna Investment Management are among the firms that have been looking at opportunities to buy or originate debt on high-quality commercial real estate in major markets.
“These properties are generally performing well but were acquired at the peak of the market in 2006 and 2007 with very short-term, highly leveraged debt,” says Sam Davis, a senior managing director for real estate investing at Northbrook, Illinois–based AllState Insurance Co. “This short-term debt is starting to mature, and the borrowers have no ready source for financing.”
The lender pullback prompted San Francisco–based Shorenstein to expand the investment scope of Shorenstein Realty Investors Nine, a $2 billion private equity real estate fund established in 2007, to include the acquisition and origination of junior debt, says Mark McCarthy, managing director and head of debt.
Most of the equity players are active in the mezzanine area, according to Stephen Tomlinson, a New York–based partner of law firm Kirkland & Ellis, which advises real estate equity investors. In a typical commercial real estate acquisition, Tomlinson explains, a property owner will put in anywhere from 10 to 35 percent of equity and obtain a package of debt from banks and other lenders. Interest on mezzanine debt can range from 9 to 15 percent annually, depending on the property, its situation and location, says Kevin DeMeritt, president of Wilshire Finance Partners, a private lender in Los Angeles that is targeting this part of the market.
Most acquisition debt takes the form of a senior mortgage, with the property owner obtaining junior debt for about 10 to 15 percent of the overall cost of the property. The junior debt tends to be substantially more costly than the senior mortgage. Tomlinson says there is significant demand for 50 to 80 percent — the middle portions — of a deal’s equity-and-debt capital structure.
In making its move Shorenstein has returned to a former practice of opportunistically originating and acquiring junior debt. It had discontinued that type of financing several years ago as the collateralized debt obligation market took hold and enabled finance companies to originate and then securitize junior commercial real estate loans at a far lower cost of capital. “It didn’t make sense for us to look at the junior tranches because the yields were too low,” says McCarthy. “But as the credit markets backed up, the CDO market evaporated and we were presented with opportunities to acquire junior debt at attractive yields.”
Shorenstein’s investments have included buying a $50 million mezzanine loan on 660 Madison Avenue in New York from Deutsche Bank as well as a $250 million mezzanine package backed by the Big Apple’s 450 Lexington Avenue.
New York–based Savanna has also broadened its investment mission. “We see opportunities to make great loans on the same types of real estate assets that we typically buy, own and operate for our own account,” says managing partner Nicholas Bienstock. “It is a good market if you have a pool of capital and the ability to underwrite and execute real estate deals.” Savanna recently originated a $45.75 million first mortgage loan on a midtown New York office building, 63 West 38th Street.
AllState’s Davis says that firms that are targeting this market have their work cut out for them. “Even though these properties are generally performing well, the debt packages in place are very complicated,” he notes. “There are multiple layers of debt. The further you go up the risk spectrum, the more difficult it is to refinance the debt. These are the first distressed situations that are coming out of this downturn.”
One downside risk is that some equity investors may find themselves owning the properties if the borrowers are unable to make interest and principal payments. “These funds are prepared to own — that is almost a precondition for underwriting,” says Tomlinson. “In a situation where the equity is wiped out, the lender has to understand what to do with the mezzanine piece and be prepared to own the asset and infuse capital.”
