US property lenders prepare for the next bubble

Heightened caution in the face of increased competition

Major debt players are clinging to real estate fundamentals and calling upon lessons learned during the last cycle as concerns begin to arise in the US debt market about a new bubble.

A debt panel at PERE New York Summit today wrestled with how to continue to make strong returns and lend sensibly in the face of continually increasing competition.

bubble“The business is very granular and it starts at the asset level and the demographics of local area,” said Peter Gordon, a managing director with Angelo, Gordon & Company. “If you start there you sleep at night because you believe you’re subordinated enough that you can weather a storm.”

Peter Sotoloff, who helped build Blackstone’s Real Estate Debt Strategies platform, and who recently joined Mack Real Estate Group to launch a similar platform, said he jumped at an opportunity to build a debt business at a firm with a significant equity arm.

“On the equity side we are building 5,000 multifamily units across country… not in a fund format,” he said. “We’re adding value and we thought that was the highest return for unit of risk on the equity side.”

“Debt is a different animal,” he said. “We want to get returns on underlying assets, not on financial engineering. But we’ll use those equity relationships to be a true value-add partner in complex debt transactions with considerable risk-adjusted returns.”

Gordon also touched on the synergies existing between his firm’s debt and equity businesses, also describing it as a smooth spectrum.

“There are heavy synergies between the different groups,” he said. “When we see that the opportunity is better in equity, we say, ‘you guys should do it,’ and vice versa.”

That’s become increasingly important with the influx of competition into the debt space, said Ryan Krauch, a principal at MesaWest Capital, noting that 10 years ago virtually “no one had debt in their portfolios.” More recently, as debt investing has become more prominent, spreads have “definitely tightened,” but it’s still an attractive alternative to equity.

“Debt is like a bond: if you can generate current income that makes investors happy and you’ve underwritten the asset, you’re going to get paid back,” Krauch said. “On the equity buy side, a two-cap is not a bond. It’s highly unlikely that you’ll sell it for a two-cap… and those percentage changes on the cap rates are so dramatic right now that it makes me very nervous on the equity side.”

As competition heats up, investors and their fund managers may need to set their own limits in order to prevent this bubble — if it is indeed one — from bursting sooner than later. Matt Salem, a managing director with Rialto Capital Management, said he is systematically declining b-piece deals that he feels are getting too risky, claiming that others will ultimately follow suit.

“We had a long, hard conversation with a senior lender about why a loan didn’t make sense for us,” he said. “We’re trying to push back and hopefully the market will stabilize, but with the FED policy as it is it will definitely be an uphill battle.”

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