The highly anticipated barrage of commercial real estate notes at steep discounts turned out to be just a trickle for much of 2009. Aside from the recent sale of mostly high-quality mezzanine and unsecured notes, many investors still anticipate distressed note buying opportunities in 2010.

But others have done well to change course and become creditors for struggling properties instead of investors.

In one case, CIM Group came to the rescue of New York developer Harry Macklowe to help retake control of his defaulted high-profile hotel development in New York City. CIM, a Los Angeles-based private equity real estate fund, agreed to purchase Macklowe's debt of $440 million from Deutsche Bank.

The note relates to Macklowe's original purchase of the Drake Hotel — a property it has already demolished. The plan calls for the site to be redeveloped into an office tower with retail space.

Macklowe defaulted on the original note in the fall of 2008. Like most deals today, CIM is seeking control of the property by purchasing a preferred position at the decision table for the asset. This move involves paying off a number of creditors at a discount, and virtually extinguishing Macklowe's $675 million first mortgage from Deutsche Bank.

Similarly, Blackstone Group is aiming for control of hotel owner Highland Hospitality Corp's $1.7 billion in debt. Blackstone bought the most senior tranche of Highland's mezzanine debt from Wachovia Corp. with a face value of about $320 million.

Wachovia and Barclays Capital still hold Highland's secured debt. But Blackstone now ranks ahead of the rest of Highland's $867 million of mezzanine debt, behind only its $900 million of secured debt.

Creditor strategy

These transactions reflect the willingness of real estate owners to work with investors-turned-lenders despite the hefty price. Owners prefer this strategy to raising expensive additional equity to prevent foreclosure against reappraised or otherwise struggling properties.

With banks holding back on providing financing, high-yield investment funds like CIM and Blackstone have been picking up the slack through strategic note purchases.

Another area in which investors are choosing to wear the creditor's hat instead of the equity investor's hat is in the high-yield debt market. Real estate-related companies like Toys R Us are tapping the high-yield debt market to refinance maturing real estate debt.

The Wayne, N.J.-based retailer and real estate holding company has $1.3 billion in outstanding senior notes, and is ditching the expensive equity route for now in favor of debt financing. It recently increased the size of a proposed $650 million bond financing that morphed into $725 million of senior notes due in 2017 with a coupon rate of 8.5%.

Higher cost of credit

Toys R Us is paying more than 400 basis points in interest above its nearest maturing debt, and a whopping 1,200 basis points above its longest-range, lowest-cost facility right now.

Last summer, the company issued $950 million in senior notes due in 2017 that have a coupon rate of 10.75%, priced to meet investors' demand for a total yield of more than 11%.

These developments suggest that while real estate fundamentals may appear cloudy, investors who are willing to become last resort lenders believe they are poised to rack up substantial gains.

There has been recent concern among analysts that the high-yield debt market is heating up too fast. The concerns were raised after several covenant-light bond issues came to market.

Covenant-light loans and bonds are transactions in which borrowers are granted credit with few or weak repayment conditions. In real estate, these loans and bonds can be used to retire debt provided by rescue partners like CIM Group and Blackstone.

Some investors are concerned that these loans and bond proceeds are being used to pay off equity holders disguised as creditors, often leaving real estate assets saddled with debt.

With these levels of potential returns within reach for secured investors, there is reason to believe lenders will continue to trump the efforts of distressed property investors for the foreseeable future.

Considering that the cost of debt financing even at elevated levels is still only a fraction of the cost of raising equity, capital providers will flock to high-yield debt.

With owners like Macklowe and Highland in the hunt for such financing, this move is equivalent to lending at lower leverage and higher returns.

MAJOR MOVES UP THE CAPITAL STACK

Borrower Buyer Seller Face Value Type
Macklowe Properties CIM Group Deutsche Bank $440 million Mezzanine
Highland Hospitality Corp. Blackstone Group Wachovia Bank $320 million Mezzanine
Glimcher Realty Trust Blackstone Group Various Lenders $320 million Unsecured
Sapir Organization SL Green Realty SL Green Realty $85 million Mezzanine

Source: Wall Street Journal & Bloomberg News

Joe Caton is a South Florida journalist who provides training and development services to real estate finance professionals.