New REITs Pounce on Distressed Mortgage Assets

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Here come the vultures.

A flurry of private-equity players are turning to IPOs to capture what they believe could be the biggest buying bonanza of troubled real estate assets since the early 1990s.

Since June, at least eight entities, including such high-profile names as Apollo Global Management, Colony Capital LLC and Starwood Capital, have filed with the Securities and Exchange Commission to launch initial public offerings of new real estate investment trusts (REITs). The plan is to use proceeds from the IPOs as well as government financing programs to either purchase or originate real estate loans and mortgage-related securities on the cheap.

Some industry experts believe that returns from these investments could rival the huge profits pocketed by investors during the Government Resolution Trust Corp. bailout of the savings-and-loan debacle of the late 1980s and early '90s. Back then, vulture investors picked up distressed assets at pennies on the dollar, and returns often exceeded 100%.

"The similarities are huge, except this time the opportunities seem to be on the debt side as opposed to the equity side," says Bob Bach, chief economist with Grubb & Ellis Co., a commercial real estate services and investment company.

Many players believe there's opportunity now for similar triple-digit returns. "I think several hundred percent [return] is possible" if leverage is used, says Anton Schutz, portfolio manager of the Burnham Financial funds, which have been investing in the sector since last fall. However, he believes the biggest buying opportunities are still six to 12 months away.

"I think you're seeing the cycle repeat itself all over again, and Starwood and all of these guys are seeking to capitalize on the dislocation in the credit markets and purchase distressed debt that's out there," says Fox-Pitt Kelton Cochran Caronia Waller analyst Matthew Howlett.

The benefits of using a REIT structure are threefold: private-equity firms can access equity capital quickly, use shares as currency in making future acquisitions and distribute a dividend to attract investors, says Steven Marks, managing director at Fitch Ratings.

Also, many private players plan to take advantage of federal financing programs, such as TALF (Term Asset-Backed Securities Loan Facility) and PPIP (Public-Private Investment Program), which will give them low-cost financing when acquiring troubled assets, making their potential returns even frothier.

Mortgage REITs make money through spreads: the wider the spread — or gap — between funding costs and yields on mortgages they purchase, the bigger the profit.

Currently, there is $978.9 billion in commercial mortgage-backed securities (CMBS) and $6.65 trillion in residential mortgage-backed securities (RMBS) outstanding in the U.S. market, according to Dealogic. Of those, more than $90 billion in CMBS and more than $110 billion in RMBS will mature within the next three years, the firm says.

Private-equity players are betting they'll be able to snap up the securities at bargain-basement prices. After all, the debt will come due amid rising unemployment and a deepening meltdown in the commercial real estate market.

Bach expects the jobless rate to top the 10% mark, office rents to plunge another 5% to 10% and vacancies in commercial real estate to exceed 20% by the middle of 2010 — surpassing the 18% vacancy peak hit during the early 1990s crisis. The doom-and-gloom scenario will likely lead to higher default rates on commercial property loans held by banks and those pooled into mortgage-backed securities.

All of this has private-equity players salivating.

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