Goldman Raising Commercial Real Estate Fund

By Emma Trincal, Senior Financial Correspondent Friday, May 09, 2008

NEW YORK ( Sachs Group Inc. is raising a new fund that will invest in commercial real estate mezzanine loans, one of the bank's senior executives said at a recent conference.

Goldman is raising the new fund in conjunction with Whitehall Street Real Estate Funds, Goldman Sachs' primary real estate investment vehicle, said Joshua Easterly, director of Goldman Sachs' specialty lending group, at an Argyle Executive Forum conference on Wednesday [May 7] in New York.

"We think there is a pretty big opportunity coming in commercial real estate although valuations in commercial real estate still have some way to go," Mr. Easterly said.

Since 1991, Goldman has invested approximately $14 billion worth of equity in real estate and other derivative instruments at Whitehall. The new fund will invest in mezzanine loans, a term that in real estate finance designates loans used to secure the financing of a commercial property, such as office buildings, malls and hotels. These loans pay a higher interest rate than the senior debt.

Hedge Funds Join the RMBS Fray

Goldman Sachs is not the only manager setting up commercial real estate funds. Opportunist investors, including hedge funds and distressed investors, are buying up commercial real estate loans at discounts from banks such as Wachovia Securities and Lehman Brothers Holdings Inc. that are eager to move those assets off their balance sheets.

While those discounts are not as attractive as those offered for residential mortgage-backed securities-a sector undergoing much greater stress-commercial real estate loans offer good value with, so far, less risk than residential mortgages.

The most successful hedge fund buyers of commercial loans are those who already have experience as lenders in this sector.

"While many hedge funds are in real estate, there is really a short list of people who know what they're doing in this space," said Joel Holsinger, managing director of Atalaya Capital Management LP, a $400 million special opportunities and asset-based lending hedge fund based in New York and Atlanta. Speaking at the Argyle conference, he said firms such as Goldman Sachs and Fortress Investment Group LLC "know what they're doing." Conversely, two kinds of hedge funds fail in this sector, he said. "Either they're taking on too much leverage, or they're traders and not lenders. They don't get the right covenants."

Knowing the commercial loan market as a lender is a huge plus for managers buying those assets. When managers are not just loan buyers but also lenders, they know better than anyone else how best to price those assets. Mr. Easterly said that as a mezzanine lender, his group is now lending money at much more attractive spreads over the London Interbank Offered Rate than a year ago. "While we got paid LIBOR plus 65 basis points last year for a financing, we now can get LIBOR plus 800 basis points along with warrants," he said.

Fortress Investment Group is an active player in the commercial real estate market through its Newcastle Investment Corp. vehicle.

Last month, The Blackstone Group LP closed Blackstone Real Estate Partners VI with capital commitments totaling $10.9 billion, creating the largest-ever real estate opportunity fund. The fund invests in most real estate categories, with a large component in commercial properties, including hotels and offices.

On Tuesday [May 6] Blackstone announced that it raised $1.3 billion to invest in high-quality mortgage loan assets Previous Reuters Story. In a bold real estate and distressed play, the firm recently merged its collateralized loan obligation management group with a team from GSO Capital Partners LP, a $10 billion hedge fund it bought in January Previous HedgeWorld Story.

Good Value With Less Risk

The commercial real estate sector is appealing for distressed investors who do not want to take as much risk as residential loan investors. Commercial real estate loans-though far from risk-free-have not been hit by the same wave of defaults seen with residential loans, simply because subprime loans, the riskiest types of mortgage debt, are residential mortgages.

According to Fitch Ratings, the delinquency rate for U.S. commercial real estate loans is only 0.33% compared to up to 20% for residential subprime.

"It's hard to find anything more distressed than residential mortgage real estate, a market clearly hurt by subprime," Patrick Blott, founder of Blott Asset Management LLC, a New York special situations and distressed hedge fund, told HedgeWorld. "The commercial real estate market has not collapsed like the residential market, and my investors are looking at it now."

"There is little evidence of excess oversupply in commercial real estate, which leads us to have some degree of confidence in the sector," wrote Rob Haines, senior analyst at CreditSignts Inc., an independent fixed-income research firm, in a recent note.

In addition, commercial real estate is still enjoying increases in rents, which is good for the valuation of the underlying loans. Harris A Trifon, a credit analyst at Standard & Poor's, wrote in a recent note that he expected increases in rents, albeit not at the pace experienced during the bubble period from 2003 to 2006.

The Worst is Yet to Come

Commercial real estate investing is not without its risks. For one thing, it remains illiquid, which is fine for long-term investors looking to buy and hold assets with a good fundamental value, but not for a hedge fund seeking to trade the paper. "We're betting on loans but quite frankly, we haven't seen a lot of trade," said Mr. Easterly.

Some experts say it won't take long before the commercial real estate loan market catches up with the rest of the mortgage sector and starts showing signs of weakness.

"Commercial real estate has not been hit as much as it should be," said Mr. Holsinger. "And since it's been driven by leverage, this market is going to be hit a lot. I'm always amazed at valuations in this sector given everything else that's going on."

Another factor of uncertainty is the economy. Commercial real estate is tied to consumer spending and economic growth. Without shoppers spending money at the malls and workers occupying office space, those loans are due to perform poorly. "Absent a prolonged, severe recession, we think that the commercial real estate market is likely to avoid a 1989-1992 type 'disaster' scenario," said Mr. Trifon.

But this is based on the assumption that the economy is not going to go through a recession, but many doubt that a recession can be avoided. "This is a sector where the prospect is tied to your belief on the economic outlook," said Mr. Blott. "If you think that things are going to be bad, that people will lose their jobs and stop spending, then it will become a big problem. Combine that with inflation and you have an even bigger problem."

Some market observers, such as S&P, predict a rise in U.S. vacancies for retail and office space over the next few years, based on the assumption of an economic recession or even just a slowdown.

Commercial real estate offers another risk, which is common to loans in general: The paper is interest rate-sensitive.

Mr. Blott said it's best to avoid short-duration because benchmarks on the short-term are volatile. "Short-term interest rates have been moving all over the place," he said. For instance, the federal funds rate has dropped by 3.25 percentage points from 5.25% last summer to 2% today. In addition, LIBOR "is still not down" and the spread between LIBOR and U.S. Treasuries has not been compressed, said Mr. Blott.

One way to protect against this interest rate risk is to invest in long-duration commercial debt instruments, said Mr. Blott, in particular, loans with a duration of 10 years or more.

However, even long-term commercial real estate paper is not entirely safe. "You're in better shape if you can buy long-term CMBS," said Mr. Blott. "But even there, you have the inflation risk. If inflation continues to increase and those long term rates start to come up you have a big problem," he said.

A spokeswoman at Goldman did not return a call.

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