Saturday 24 February 2018

US private equity firms lend more as Fed warns of bubble

As banking regulators warn of a potential real estate bubble in New York, firms such as Blackstone Group LP stand to become an even larger force in the market
As banking regulators warn of a potential real estate bubble in New York, firms such as Blackstone Group LP stand to become an even larger force in the market

Sarah Mulholland and Heather Perlberg

Heightened scrutiny of US 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 $32bn 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 US private funds for real estate debt investment as of July was up almost 40pc from a year earlier, according to data researcher Preqin Ltd.

Banks, in contrast, are pulling back as global economic growth slows, 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 (OCC) has been warning banks since last year of 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 deemed too big to fail in the 2008 crisis, leading to a taxpayer bailout, said Scott Rechler, CEO of RXR Realty, a firm that owns about $15bn of real estate throughout New York, New Jersey and Connecticut.

"We're using private capital," Rechler said. "We would lose our money and our investors' money. It's not systemic," he said.

Banks still play a role by lending to investment firms. Commercial loans of all types by regulated banks to non-depository financial companies rose by almost 23pc, or $41.2bn, 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 lending 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, CEO 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 told analysts last month.

"We like them to keep staring. That's fine with us, and we want to be a beneficiary of this climate."

Non-bank 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 analyse 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 $285m on a condominium tower being built by Gary Barnett's Extell Development Co. when the developer couldn't pay off the loan on its August 9 due date.

Barnett 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 capitalised 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.

Non-bank 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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