Mortgage REITs Head to Europe as Barrack, Sternlicht Seek Distressed Deals
Colony Financial Inc. (CLNY) and Starwood Property Trust Inc. (STWD), the U.S. mortgage investors formed two years ago amid an expected surge of distressed debt, are turning to Europe as banks tighten lending and sell real estate loans.
Colony, a Santa Monica, California-based company led by Thomas Barrack, invested $30 million in July for a stake in five non-performing loans backed by buildings in Frankfurt and Berlin. Barry Sternlicht, the founder of Greenwich, Connecticut- based Starwood, calls Europe a “fertile field” and has made deals including a $71.5 million loan on a group of 45 properties leased by a unit of Metro AG, Germany’s largest retailer.
The real estate investment trusts are seeking transactions overseas on expectations that delinquencies will rise and banks will dispose of more bad debt and make fewer loans in a weakening economy. The two companies are trading below their 2009 initial public offering prices as competition for U.S. transactions increases and lenders work out more distressed loans, limiting the REITs’ buying and financing opportunities.
“It’s hard to find a rock that hasn’t been overturned in America,” said Dan Fasulo, managing director at Real Capital Analytics Inc., a New York-based research company. “It doesn’t surprise me that some of the major players here would turn to Europe, where there remains a lot of skeletons in the closet.”
European lenders have 151.4 billion euros ($210.1 billion) of commercial real estate loans in default, compared with $121 billion at U.S. banks, according to New York-based data provider Trepp LLC. Banks in the U.K. have the largest share of those loans, with 64 billion euros in delinquent debt.
Ireland, U.K. Defaults
Irish properties have Europe’s highest default rate with 30 percent, followed by the U.K. with 26 percent and Austria with 15 percent, Trepp said in a report on Aug. 17.
The euro region’s sovereign debt crisis may hinder an economic recovery as countries cut expenses instead of taking measures to boost growth, according to a report last month by CB Richard Ellis Group Inc. On Aug. 18, Morgan Stanley cut its forecast for 2011 global expansion, saying the U.S. and Europe are “dangerously close to a recession.”
Banks in Europe have been slow to unload bad debt as they examine their books and devise strategies to minimize losses, such as extending loan maturities, according to Natale Giostra, a senior director with CB Richard Ellis in London.
New capital requirements for European banks may push lenders to sell nonperforming loans to raise money, said Craig Guttenplan, a London-based analyst with CreditSights Inc.
Facing the Music
“Over time these banks are going to want to stop extending,” Kevin Traenkle, Colony’s chief investment officer, said in a telephone interview. “They’re going to want their borrowers to face the music.”
Traenkle predicts European banks will become big sellers of distressed loans within two years. He doesn’t have a dollar target for Colony’s deals in the region.
As of Aug. 5, European debt accounted for about 10 percent of the company’s $557.9 million in invested and committed funds.
While Colony focuses primarily on purchasing debt, Starwood expects to find opportunities to lend. Banks in Europe probably will tighten credit standards for borrowers in the third quarter, the European Central Bank said July 28.
“There is a lot of demand for money like ours in Europe, and it is going to be more originations,” Sternlicht said on an Aug. 2 conference call with analysts. “If the U.S. is in inning five of its recap, Europe’s in inning one or two.”
The REIT plans to hire an executive to shop for deals in Europe, Sternlicht said on the call.
Tom Johnson, a spokesman for Starwood, declined to comment on the company’s strategy.
International debt accounted for 9.7 percent of Starwood’s $2.5 billion in holdings as of June 30, when the REIT had $129.9 million of British-pound investments and $71.3 million in euro- denominated investments, according to a regulatory filing.
Starwood and Colony are part of a generation of REITs that had initial public offerings in 2009 as so-called blind pool companies, which seek to raise money before owning any assets. Starwood went public that August. Colony, Apollo Commercial Real Estate Finance Inc. (ARI) and CreXus Investment Corp. (CXS) sold shares the following month. All four are trading below their IPO price.
‘Painful’ Share Price
“It’s painful to see the stock down here,” Sternlicht said during the conference call on Aug. 2, when the shares closed at $19.20, 4 percent below their $20 IPO price. “It’s a marathon, not a bunny race, and we will get through it.”
By the time the companies went public, lenders that had frozen credit in the wake of the U.S. real estate crash got more comfortable financing deals and underwriting mortgages to be bundled and sold as bonds. Competition between financial institutions and investors for new U.S. loans intensified.
“The investing landscape got very, very crowded,” Joshua Barber, an analyst at Stifel Nicolaus & Co. in Baltimore, said in a telephone interview. “It got really crowded fast.”
As blind-pool companies, the REITs didn’t have any investments when they sold shares to the public. Building their portfolios took time, and that also hurt the stocks, according to Bose George, an analyst at Keefe Bruyette & Woods.
Difficulty Finding Deals
“It’s been difficult to get stuff to invest in,” George said in a telephone interview from New York. “The sector took a lot of time to deploy their capital.”
Starwood has lost 8.2 percent since its shares began trading, trailing a 22 percent gain for the Standard & Poor’s 500 Index in the same period. Colony is down 25 percent from its IPO price, versus a 14 percent increase for the broader gauge.
Commercial-mortgage REITs can make money on distressed debt by purchasing loans at a discount and working out new terms with the borrowers. The companies may also take control of the underlying properties, expecting to turn a profit on income from the real estate and an eventual sale.
The strategy carries hazards, according to Guttenplan of CreditSights. The economy may weaken and drag down income from the real estate, reducing the value of the mortgages.
“The risk is you overpay for the loans,” he said in a telephone interview.
“U.S. REITs may compete for a limited pool of distressed loan assets in Europe,” said Guy Langford, U.S. leader of distressed asset and debt services for Deloitte & Touche LLP in New York. “Banks in Europe have been slower in selling problematic loans than U.S. lenders, partly because of uncertainty over the economy, regulatory change and government support.”
Traenkle said he likes Colony’s opportunities in Europe because fewer investors are chasing deals there than in the U.S.
“In Europe you don’t have as many groups that have the expertise of buying nonperforming loans and nonperforming assets from the banks,” he said. “The competitive set is just much, much smaller.”
In 2010, private-equity real estate funds received $3.4 billion for Europe-focused investments, compared with $22.5 billion for North American transactions, according to Preqin Ltd. Through June 30, private-equity real estate funds for investing in Europe raised $2.3 billion, compared with more than $12 billion for North American investments, the London-based research firm said.
The REITs’ managers, Starwood Capital Group LLC and Colony Capital LLC, have operations in Europe and have done commercial- property transactions there.
Colony Financial frequently joins Colony Capital in its investments, taking a stake in ventures that buy mortgages and other assets. The companies teamed on the purchase of the five nonperforming German loans, which were bought for 19 percent of the unpaid principal balance.
Starwood’s Metro mortgage is backed by property that is 93 percent occupied with a weighted average lease term of 12 years. The debt has a loan-to-purchase value of 69 percent and matures in 2017, according to Starwood.
“They have a good opportunity” in Europe, Stifel Nicolaus’s Barber said of Starwood. “Ultimately it depends on the credit markets.”
Making “good, solid investments” -- in the U.S. as well as overseas -- will help Colony Financial’s share price, according to Traenkle.
“We do envision our European exposure to grow,” he said. “These debt buys and these workout scenarios will be as attractive in Europe as they are in the U.S.”
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