For some private equity real estate groups, ‘real estate finance’ doesn’t just mean financing fresh acquisitions. It also can mean an exciting avenue for growth.
The most recent example of a private equity real estate firm buying a real estate finance businesses is Starwood Capital Group, which announced its plans to acquire LNR Property, a Miami-based distressed debt manager, in January. Starwood, along with its commercial mortgage real estate investment trust affiliate Starwood Property Trust, is working to finalize a deal to buy the real estate finance business for $1 billion, having beaten out such bidders as Rialto Capital for ownership of the platform.
The deal is a monumental one for Starwood Property Trust and by extension Starwood Capital, which will own a minority stake in LNR through its latest real estate fund, Starwood Distressed Opportunity Fund IX. “The acquisition makes Starwood, which – in our opinion – already was a very significant player across the commercial real estate lending landscape, an absolute behemoth in commercial real estate,” wrote Gabe Poggi, an analyst for FBR Capital Markets, in a recent research note. “This transaction, in our opinion, makes Starwood the most comprehensive full-service commercial real estate finance company in the publicly traded markets.”
Another private equity real estate behemoth, meanwhile, has decided to go down a similar route to achieve growth. In September, The Blackstone Group acquired the investment management business of Capital Trust, the New York-based real estate finance REIT. The transaction added $2.4 billion of assets under management (AUM) to the firm’s growing Blackstone Real Estate Debt Strategies (BREDS) business, which it launched in 2008 and currently has more than $6.4 billion of AUM.
“We’re trying to be the best debt player out there,” says Michael Nash, senior managing director and chief investment officer of BREDS. The Capital Trust acquisition “will help us get there.”
The historical perspective
Capital Trust and LNR are just two of the latest examples of private equity real estate firms acquiring specialty finance platforms, following similar deals – including Fortress Investment Group’s purchase of CW Capital in 2010 – that have occurred over the past couple of years.
The capital needs of many specialty finance platforms have led the private equity real estate industry to view such businesses as attractive investment opportunities. Capital Trust, LNR and others suffered major losses from bad assets on their balance sheets in the wake of the global financial crisis. While some businesses went under, others managed to resolve liabilities with creditors and have been stabilized. Many, however, still require new sponsorship in order to continue or expand their operations.
“There’s more liquidity and more transparency as to the value of these platforms, where the capital markets are, what sort of value you should place against them and how you can reignite them,” says Nash. “That’s why you’ve seen companies like ours taking a fresh look.”
At the same time, there continues to be a need for financing alternatives in the industry. While banks made commercial real estate loans readily available prior to the crisis, fewer institutions remain now, and surviving banks have reduced their risk exposure to commercial real estate.
“We just lost a lot of banking power through the crisis,” says Nash. “So the crisis has created a higher role – a more interesting role – for nonbank lenders.” Indeed, the global debt funding gap is expected to reach $226 billion over the next two years, according to a November report by property services firm DTZ, up from $216 billion last May.
Strategic importance
Specialty finance businesses have both financial and strategic importance for their private equity buyers. For example, LNR, which is the largest US servicer in the country, will be a source of valuable information for Starwood Property Trust.
“As a servicer, Starwood will now have the opportunity to view thousands of loans for potential refinancing, A-note/B-note split, etcetera,” wrote Poggi in his report. “This ‘flow,’ and the extended business lines that LNR brings to the table, will be a constant fuel to Starwood’s ‘core’ origination business.”
Prior to the acquisition, the lowest loan balance that Starwood could manage was approximately $40 million. The addition of LNR’s Archetype Mortgage Capital and other businesses, however, will allow Starwood to easily make $15 million loans, increasing its lending capacity considerably.
As for Blackstone, “Capital Trust gives us a presence in high-grade real estate debt business and the ownership of a special servicer,” said Hamilton ‘Tony’ James during an earnings call last year. Although Blackstone already had many of the same limited partners as Capital Trust, “they bring us some new relationships where Capital Trust is managing money,” he added, noting that the hope is to have the new limited partners invest in Blackstone’s other products.
Indeed, while Blackstone has raised a large amount of private capital for its BREDS business, acquiring the investment management business of a publicly-traded REIT “potentially gives us another distribution channel,” along with a strong management team, says Nash.
Special servicers are key
It’s no coincidence that the platforms that have been acquired all have special servicers as a component of their businesses. Indeed, demand for special servicers has risen sharply in tandem with the high volume of commercial mortgages expected to mature through 2017.
“In 2009, special servicing wasn’t particularly robust because there weren’t a lot of defaults,” says Robert Lie, executive managing director at C-III Capital Partners, which bought the special servicing and CDO businesses of JER Partners in 2011. “Since then, the momentum on the defaults has been dramatic.”
For example, an estimated 10 percent to 15 percent of outstanding commercial mortgage-backed securities (CMBS) loans are in special servicing today. Meanwhile, a total of close to $100 billion of such loans either have been or currently are in special servicing – up from approximately $10 billion just a few years ago, according to Lieber.
Special servicers can resolve loans in a number of ways, including foreclosing on the asset; selling the loan to a third party; negotiating a modification and extension or discounted payoff with the borrower; executing a deed in lieu of foreclosure; and selling the real estate-owned to the market. The business generates both base fees of about 25 basis points per year and success fees that average about one percent of the recovered loan balance.
With such a fee stream, special servicers are cash flow-generating businesses at a time when many investors are seeking more yield in their real estate investments. However, given that a significant amount of loans mature by 2017, firms have just a narrow window of time to take advantage of the opportunity – hence the interest in buying an existing platform that has its special servicing designation and infrastructure already in place.
“Once you’ve laid the track, it matters not whether you’re pulling one or 100 cars on the train,” says Lieber. “Today, it would be a very difficult business to start de novo but, if you have the existing infrastructure and scale, it can be rewarding.”
Finite opportunity
Nash, however, doesn’t anticipate many more acquisitions of specialty finance platforms will occur because there was a limited number – about five to 10 – of these businesses to begin with. “We’re in the 7th, 8th and 9th inning of resolving this,” he adds.
That said, even as the funding gap eventually may narrow, “there’s always a role for well-run, disciplined specialty finance companies,” Nash says. “There’s always a limit to the risk-taking capability of portfolio lenders like banks and insurance companies, and CMBS is a cyclical business.”
Overall, the recent acquisitions will benefit the market by creating more liquidity and transparency for the market. “There was a pretty dark period in capital availability for a long time,” says Nash. “Hopefully, there will be new teams and capital that take the industry to a higher, better level.”
A few key hires
For those firms that cannot acquire a finance business, hiring former bankers may be the next best thing
While some of the largest managers in the industry have been acquiring finance platforms, some nascent firms are building their own – and hiring former lenders to help them launch these efforts.
Federal Capital Partners, a Chevy Chase, Maryland-based real estate investment firm, has brought on two finance people in the last six months to start up its structured finance platform. Interestingly, spearheading the new business is Edward Corwin, who had been the firm’s lender at Wells Fargo Bank. At the bank, Corwin managed a $1.2 billion portfolio of nonperforming loans nationwide and originated more than $800 million of structured loans. He will work with Jason Ward, who previously managed a commercial real estate debt portfolio at specialty finance company CapitalSource.
“It made sense to find someone who could be dedicated to financing and had a creditor’s eye,” says Esko Korhonen, Federal Capital’s co-founder and managing partner. He notes that the firm’s competitive advantage as a lender will be its “operational viewpoint. We’re not looking at an asset purely from a financing standpoint.”
Federal Capital will provide mezzanine debt and preferred equity, typically in the $5 million to $20 million range. Two recent investments, both announced in January, include a $10 million mezzanine loan for the development of a 240-unit apartment community in Alexandria, Virginia, and a $5.15 million mezzanine loan for the development of the 214-unit Midtown Green apartments in Raleigh, North Carolina.
Meanwhile, AllianceBernstein hired Roger Cozzi, former chief executive of Gramercy Capital, earlier this year to head its real estate group’s new senior debt business. The real estate group, which was formed in 2009, has a number of other staff who came from commercial real estate finance firms, most notably its co-chief investment officer Jay Nydick, who served as president of iStar Financial for five years before joining AllianceBernstein.
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