One of the reasons that investors commit to pay high management fees to hedge funds is the agility of hedge funds to adapt to developing opportunities. One such investment opportunity that is currently attracting hedge funds is commercial real estate debt. Lured by the potential to earn returns as high as 15 percent, hedge funds such as Axonic Capital, LibreMax Capital and Saba Capital are turning their focus to provide mezzanine loans to commercial real estate borrowers such as malls and hotels. It is worth noting that in the event of a borrower default, mezzanine loans are repaid only after the traditional commercial mortgages. This makes them riskier, but the appeal for hedge funds that are known for rigorous due diligence is the higher yields.
Risky Real Estate Lending Doubled in 2013
According to data compiled by Bloomberg, commercial real estate loans that are backed by commercial mortgages are expected to climb to $100 billion in 2014. It was $80 billion in 2013, double that of 2012. The data found that in 2013, half of all commercial real estate loans were interest-only loans which are riskier in nature, subject to a higher than normal interest rate, and require little to no down payment.
It is interesting to note that hedge funds are taking interest in such a risky product. It is likely that their decision is influenced by the availability of cheap money due to the near zero interest rate policy of the Federal Reserve, as well as the expectation that the economy will recover and result in a further rise in prices of commercial real estate properties.
Over $1 Trillion in Commercial Real Estate Loans Due
According to a report by Morgan Stanley, roughly $350 billion in commercial real estate debt is due every year, through 2017, leading to more than $1 trillion in loans due over the next three years. Among hedge funds tapping into this requirement of real estate borrowers are Axonic Capital, LibreMax Capital and Saba Capital.
Axonic says it will focus on providing loans on properties beyond major metropolitan areas such as New York and San Francisco. Chris Seay, a managing director at Axonic says he sees better opportunities in smaller markets.
Former Deutsche Bank AG trader Greg Lippmann, who runs the $2.7 billion LibreMax, is known for his timely bets against subprime mortgage bonds before the collapse of the housing market. Lippman now has made commercial real estate a key part of his strategy and has 25 percent of the fund’s assets in commercial real estate.
Hedge fund Saba Capital, which has $3.9 billion in assets under management, is a recent entrant into mezzanine real estate lending, making its first deal in 2013. Commenting on hedge funds entering the mezzanine market, Harris Trifon, a debt analyst at Deutsche Bank AG says the funds are primarily driven by the yields.
Impact on the Job Market
The willingness of hedge funds to commit to risky investments is a sign of confidence in the stability of the economy. This is definitely an encouraging sign for the job market. But the Bloomberg data also points out that this trend of a spurt in the high risk, interest-only commercial mortgages also prevailed just before the financial crisis peaked in 2007. Given that experience, it remains to be seen what the net impact to the job market will be as a result of increased hedge fund participation in commercial real estate lending.