“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
Sarah Mulholland, Heather Perlberg, September 19, 2016.
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Heightened scrutiny of U.S. commercial real estate lending is paving the way for lightly regulated investors to gain a bigger toehold in lucrative deals.
Private funds are seeking a record $32 billion for commercial-property debt as buyout firms, real estate investment trusts and hedge funds expand lending. These companies, which typically charge higher interest rates, can move quickly on large loans that may be seen as too speculative for banks.
With banking regulators warning of a potential real estate bubble, firms such as Blackstone Group LP and Starwood Property Trust Inc. stand to become an even larger force in the market. So-called shadow banks — lenders that fall outside of the industry’s oversight — are able to take on more risk amid calls for caution in an area that melted down during the 2008 financial crisis.
“These guys aren’t scared of an empty building,” said Steven Delaney, an analyst with JMP Securities LLC. “These are the loans banks don’t want. There is a tremendous opportunity and a need for commercial-property owners for more types of financing than the commercial banking industry as a whole is willing to provide.”
The record capital being sought by U.S. private funds for real estate debt investment as of July was up almost 40 percent from a year earlier, according to data researcher Preqin Ltd. Banks, by contrast, are pulling back as slowing global economic growth, uncertainty over interest-rates increases and pockets of overbuilding spark concern that commercial real estate prices are due for a fall after almost doubling in six years.
The Office of the Comptroller of the Currency has been warning banks since last year on rising risks in commercial-mortgage portfolios, while the Federal Reserve has repeatedly flagged the property market as a potential bubble.
A market collapse may be better absorbed by investors in private funds than by companies that were deemed too big to fail in the 2008 crisis, leading to a taxpayer bailout, said Scott Rechler, chief executive officer of RXR Realty. Rechler, whose firm owns about $15 billion of real estate throughout New York, New Jersey and Connecticut, began focusing on the lending business last year.
“We’re using private capital,” Rechler said. “We would lose our money and our investors’ money. It’s not systemic.”
Banks still play a role by lending to investment firms. Commercial loans of all types by regulated banks to nondepository financial companies rose by almost 23 percent, or $41.2 billion, in the fourth quarter from a year earlier, one of the fastest-growing categories, according to the OCC.
Extending credit to other lenders is less risky for banks than making loans directly to property owners, according to Delaney. The non-regulated firms will absorb losses first if a project sours, protecting banks from deeper losses, he said.
“In a disaster scenario, the banks could possibly have some exposure, but the banks today are safer than they have ever been,” Delaney said.
The regulatory scrutiny of banks will be a boon for real estate investment firms for the foreseeable future, according to Barry Sternlicht, chief executive officer of Starwood Property Trust, a Greenwich, Connecticut-based mortgage REIT.
There are “capacity issues when your Office of the Comptroller of Currency is staring at you the whole time,” Sternlicht said on a conference call with analysts last month. “We like them to keep staring. That’s fine with us, and we want to be a beneficiary of this climate.”
The OCC said in a July report that banks still aren’t doing enough to offset risk. Banks with assets greater than $1 billion increased their total reserves for commercial loan losses in the second quarter by 2.2 percent, or $787 million, data from the Federal Deposit Insurance Corp. show. They tightened real estate lending standards in the second quarter, particularly for construction, land development and multifamily projects, according to the Fed’s senior loan officer survey, released in July.
Nonbank lenders have more flexibility in managing and evaluating risk. While banks are required to hold a certain amount of cash against the commercial real estate assets on their books, investment firms make their own rules when it comes to setting aside reserves for potential losses. They use internal rating systems to analyze the soundness of their loans.
Companies such as Blackstone and Starwood make significantly larger loans than banks, meaning they are more exposed to problems at individual projects, said Jade Rahmani, an analyst with Keefe Bruyette & Woods Inc.
In Manhattan, where a surge of construction has led to a glut of luxury apartments, Blackstone extended a mortgage originally made for $285 million on a condominium tower being built by Gary Barnett’s Extell Development Co. when the developer couldn’t pay off the loan on its Aug. 9 due date. Barnett, juggling financing for multiple high-end developments, struck a deal with China’s SMI USA to buy extra time to secure a construction loan for the Central Park tower, slated to be New York’s tallest residential building.
Michael Nash, chairman of Blackstone’s real estate debt strategies division, declined to comment on the Extell deal. He said property-debt investments now include more equity and aren’t as risky as in the previous boom, when there was too much leverage and thinly capitalized deals.
“We feel pretty good about where we are, with persistently low rates, a good growth profile in most asset classes and this relatively benign economic environment,” said Jonathan Pollack, global head of Blackstone Real Estate Debt Strategies.
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Nonbanks also make smaller loans that can be troublesome. Apollo Commercial Real Estate Finance Inc., managed by an indirect subsidiary of Apollo Global Management LLC, last quarter recorded a $15 million loan-loss provision tied to a mortgage on apartments, rental homes and land in Williston, North Dakota, the epicenter of Bakken shale drilling. Rents for apartments in the area have plunged after a slide in crude oil prices.
Though the $58 million loan made on the property, which is owned by private equity firm KKR & Co., hasn’t gone into default, the cash reserve isn’t expected to last through the end of 2016, Stuart Rothstein, CEO of Apollo Commercial Real Estate, told investors during a conference call in July.
Charles Zehren, an Apollo spokesman, wouldn’t comment.
Starwood Property sees an advantage in its ability to underwrite large loans individual banks can’t match, said Chief Operating Officer Andrew Sossen. In 2013, Related Cos. was weighing a loan from a collection of banks for its Hudson Yards development in New York before it got $475 million in debt financing from the REIT to start construction of the first tower.
“A borrower finds it much easier to transact with a single lender versus having to negotiate with multiple banks,” Sossen said.
Betting on Related and their partners turned out to be a worthwhile gamble. The debt on 10 Hudson Yards was paid off last month when Related and its partners recapitalizedthe property, which is now fully leased. The financing, underwritten before the foundation was poured, carried an interest rate of about 8 percent.
Starwood’s outlook is cautious on certain property types and areas of the country, according to Dennis Schuh, head of originations. It turns down multiple condo projects every week, though it doesn’t rule anything out, he said.
Nonbank lenders “trust their own instincts,” said JMP’s Delaney.
“Blackstone is the largest owner of real estate in the world,” he said. “They don’t need regulators and the Fed to tell them what the state of the real estate market is.”
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