The size of offerings for commercial mortgage-backed securities and collateralized debt obligations has been growing by leaps and bounds during the last year. Until mid-2006, the average offering ranged between $400 million and $800 million. But then a LaSalle Bank consortium issued the first-ever $1 billion fusion CMBS deal.

In June, a Goldman Sachs syndicate grabbed the spotlight with a whopping $7.6 billion CMBS deal. The overall volume of issuance has grown, too. Through mid-June, CMBS issuance exceeded $113 billion compared with $90 billion for the same period in 2006.

Hedge funds have been one of the key drivers behind the growth. Known around the bond trading pits as high-volume arbitrage traders, hedge fund managers have been scouring the financial markets for real estate-related investments.

As they seek investments on a wide spectrum of risk, hedge funds have driven issuers to create risk classes unseen in the marketplace until last year. Some recent issues contained tranches written for the risk-embracing hedge fund community. Securities often make it to market or fail based on the interest of hedge funds.

Risk à la carte

Hedge funds are pooled investments from a variety of sources — ranging from high-net-worth individuals to institutional investors — accustomed to making large high-leverage purchases, much like private equity. The funds' street name reflects their investment objective of hedging bets through holding counter-risk assets that offset any potential losses. Depending on the level of risk real estate hedge fund managers assume, they typically set goals to provide investors with returns from 1.3% to 3% monthly.

Wall Street's rating agencies have scrambled to develop new methods for presenting the various risk levels found in the complex real estate-backed securities structures issued over the past 15 months. Both Moody's Investors Service and Fitch Ratings recently rated their first offerings of a “super-duper senior” class of CMBS. This is an ultra risk-adverse portion of bonds.

But as securities issuers seek to separate the well-secured portions of their bonds from the more risky portions, these issuers have been looking for ways to please both their ultra risk-adverse institutional investors, and their more risk-embracing hedge fund counterparts. So where do hedge fund managers look next? The answer rests in the availability of high-risk leveraged investments such as mezzanine, bridge, and transition property loans.

Investment clout

For the past several years, hedge funds have been dominant investors in major real estate-related operations, including the shares of commercial and residential REITs. The National Association of Real Estate Investment Trusts (NAREIT) has acknowledged the role of hedge funds in driving how REITs conduct business and manage their balance sheets.

As early as the fall of 2004, NAREIT put members on notice that real estate-focused hedge funds were likely to begin trading large blocks of REIT shares as an arbitrage play. Some of the names that surfaced at that point included GEM Value Partners, Trilogy Real Estate Partners Fund, and Helix Realty Funds.

So, while hedge funds are likely to continue fueling commercial real estate, it is noteworthy that they were also major suppliers of capital to the now troubled subprime residential space. CMBS has become a prime target for fund managers. That's reason enough for anyone depending on hedge fund capital to be concerned about the source suddenly drying up.

The strategies of hedge fund managers have become commonplace among real estate investors, securities analysts, bond traders, and even among some institutional real estate operators. But not all real estate investors have the option of pulling large amounts of capital away from the sector in short order, as hedge funds do.

The dominance of hedge funds has reached beyond the real estate business into the bond trading pits. So much so, that many traders and analysts now measure the viability of announced bond issues based on the level of buying interest received from hedge fund managers.

Because of the emerging trend, investment vehicles such as CDOs must now contain some aspect of synthetic securities, such as credit default swaps, foreign exchange forward contracts, and Treasury swaps. These must-have features were foreign to real estate investment until hedge funds appeared on the scene.

W. Joseph Caton is managing director of Oxford, Conn.-based Hartford One Group, a real estate finance consultant.