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Loaded hedge funds return to crowded commercial property marketplace

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NEW YORK -- Fewer opportunities in the stock market have prompted some hedge funds to bolster returns by making loans for commercial real estate such as office buildings.

The arrival of the funds, lightly regulated groups of investors that cater to wealthy individuals, comes at a time when there are plenty of U.S. and non-U.S. investors willing to finance purchases, construction and refinances of mortgages for office buildings and malls.

The hedge funds are also getting into the market at a time when lenders are making increasingly risky loans such as interest-only mortgages, a trend already evident in the residential market.

"There are a lot of hedge funds sitting on billions of dollars that they need to put to work. So, they are putting it to work in other types of investment strategies that we have not seen them traditionally in," said Mary Ann Bartels, an analyst at Merrill Lynch & Co. Inc. who tracks hedge fund investments.

Hedge funds look for unusual trading opportunities in everything from commodities to foreign exchange, as well as stocks. They often increase their returns by borrowing, or leverage.

According to Bartels, hedge funds are being forced to try new investments because volatility in stock prices has dropped, making it tougher to make money on sharp price moves. Also, there are "too many players (hedge funds) in the field," she said.

According to HedgeCo.Net, which tracks the hedge fund industry, there are over 8,500 hedge funds today and they manage $1 trillion in assets.

While hedge funds have made their presence known in the last 12 to 18 months, they are not newcomers to commercial real estate. They were a dominant force in commercial property finance until the hedge fund Long Term Capital Management collapsed in 1998.

Within the world of real estate finance, lenders who underwrite mortgages for commercial real estate purchases repackage their loans into mortgage-backed securities, which are then purchased by insurance companies, mutual funds and banks. Hedge funds have purchased some of these securities, but lately they have actually teamed up with banks to help finance the purchase of a commercial property like a shopping mall or an office building in a bid to boost returns for their investors.

"People looking for yield have found commercial real estate investment as very attractive," said Lisa Pendergast, analyst at RBS Greenwich Capital Markets.

Hedge funds have moved in a time when there are many deals to be made. According to Pendergast, the number of properties changing hands nearly doubled between 2003 and 2004.

While the hedge funds are welcome, Brian Baker, co-head of commercial real estate at JP Morgan (NYSE: JPM), warned that the froth in commercial real estate is fueled by competition for properties and the cash available to borrow against them.

Lenders have been increasingly concerned that the influx of money has eroded lending standards, allowing borrowers to pay more for commercial real estate properties that may not bring in as much income as they expect.

Reselling pools of monthly mortgage payments for commercial real estate properties dates back to the early 1990s, when the U.S. government's Resolution Trust Corp. managed the savings and loan crisis by selling off bad or late loans.

By the mid-1990s, reselling commercial mortgages became a steady source of income on Wall Street, where banks lent money to investors buying commercial properties and these loans were then resold as securities.

Today the loans have become larger. So firms like RBS Greenwich Capital or JP Morgan like to split up a loan, allowing others like hedge funds to step in.

For example, a property sold for $100 million typically requires a buyer to put a down payment of $20 million. A lender would then put up $80 million for the purchase, of which $70 million would then be resold into a pool of other loans to create a security. The remaining $10 million is financed by investors like hedge funds.

Hedge funds buy a portion of the loans not going into securities, said Pendergast, adding that many prefer large, trophy properties.

While some hedge funds may keep the debt in their portfolios, many fund managers pool these loans and eventually resell them as securities known as collateralized debt obligations.

This practice, common among many banks, allows the hedge funds to spread out the risk they take on. Also, many actually profit by reselling the loans because there are many other investors like insurance companies who want to buy a security backed by a pool of monthly loan payments.

Lenders like Baker aren't sure just how much hedge funds have helped drive costs down for borrowers. But Pendergast pointed out that so much money has come into the commercial real estate finance world that investors are actually getting slimmer returns for the risk they take on.

In 1998, investors holding AAA-rated securities with a 10-year term backed by commercial real estate loans could get returns of two percentage points over comparable Treasury yields. With so many willing investors, that return has withered to about three-quarters of a percentage point over Treasury yields.

"It definitely lowers borrowing costs ... it creates more stable financing," Michael Higgins, head of commercial real estate at CIBC World Markets in New York, said of the hedge funds.

But not everyone is convinced that being a direct lender is such a great thing.

Lending directly may not be worth the effort for everybody, said Mike Vranos of Ellington Management Group in Old Greenwich, Conn. The hedge fund manager has extensive experience in securities backed by real estate debt and an affiliate that did direct commercial real estate lending.

Vranos reasoned that even if one loan out of 10 goes bad, that is too much trouble for some lenders because they end up spending time fighting over the unpaid debt in a courtroom.

And that may not pay, he said, because it takes hedge fund investors away from where they should be: the trading floor.

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