Debt Funds Multiply, But Are Slow to Invest

Fund operators continue to pour into the high-yield debt market, but few are pulling the trigger on investments so far.

A review of high-yield real estate funds by sister publication Real Estate Alert identified 73 active or planned debt vehicles, up from 54 a year ago. The funds are seeking to raise $48.4 billion of total equity, up from $28.8 billion (see list of funds on Pages 10-13).

The sponsors are attracted by opportunities created by the credit crunch. Given the level of distress in real estate markets, many investors think debt plays offer better potential returns than property investments - the reverse of traditional thinking.

While the annual review found that property funds remain by far the dominant type of real estate vehicle, debt funds are clearly on the rise. Vehicles focusing on debt investments account for 16% of the combined equity goal of the 466 total funds identified by the review, up from 9% a year ago. And many property funds have increased allocations for debt plays, further boosting the potential demand for debt.

The pure debt funds to date have managed to raise almost half of their aggregate equity goal, or $23.8 billion. But much of that equity was lined up before the financial crisis worsened last September. Since then, many institutional investors have pulled back from new commitments. That raises questions about whether the 46 funds that are still seeking to raise capital will be able to meet their goals.

"I don't think it's possible for all these to succeed," one fund operator said. "Not with where we sit in the world today."

There's already evidence that the operators face a tough road. Separate from the 73 identified funds, eight other planned debt vehicles were canceled or put on hold in the past six months.

Operators of debt funds have two broad strategies: acquiring distressed debt or originating loans. In some cases, they combine the two.

But so far, the pace of investments has been slow. Of the $23.8 billion of equity already raised, only $4.4 billion - less than one-fifth - has actually been invested. Many fund operators have been reluctant to push ahead with purchases of distressed debt, fearful the real estate market still hasn't hit bottom and uncertain about what steps the federal government will take to spur sales. And few funds have started originating loans to any degree, partly because of the huge gap in the yields required by lenders and the rates that borrowers are willing to pay.

In what everyone agrees is a tough market for soliciting capital, name-brand operators appear to have an edge. For example, the list of operators that completed raising equity for large funds over the past year or have almost finished marketing campaigns includes Goldman Sachs ($2.5 billion-plus), Morgan Stanley ($1.5 billion) and Colony Capital ($900 million). What's more, veteran operator Lone Star Capital is seeking to raise a whopping $10 billion for a fund that would target distressed debt around the globe.

On the other hand, many first-time sponsors are having a harder time. Operators that have shelved debut funds include Infinity Funding, Rushmore Properties and TriStar Real Estate Partners.

In the battle for capital, newer operators often tout themselves as free of the legacy assets that have dragged down established managers, some of which have taken big losses on vehicles that invested while the real estate market was peaking. Veteran sponsors counter that their experience is more valuable than ever amid all the turmoil.

"I don't know how investors are going to react to giving money to a group that lost 60% in their last fund," one operator said. "Other people might say, 'Everyone got hit . . . and we're going to go with the horse we know.' "

The review tracks closed-end real estate funds that have raised or are seeking to raise at least $50 million of equity and that shoot for a return of at least 10% net after fees. Included are funds that have invested less than 75% of their equity, as well as vehicles that are currently raising equity or plan to start doing so by midyear. Vehicles that invest overseas were included if they raise capital at least partly from U.S. investors.

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