Real estate investment funds have been on a capital-raising binge for the past two quarters, drumming up in excess of $20 billion in the first quarter of 2008 alone.

Private equity giant Blackstone Group led the charge by pulling in a handsome $10.9 billion for its Blackstone Real Estate Partners VI fund, setting a new industry record.

With this much capital committed to the sector, why is there talk of a liquidity crisis in commercial real estate? The short answer is that much of the new capital is sitting on the sidelines waiting for select, value-add opportunities — code language for higher risk. And lenders are being cautious.

Fund managers are waiting for clarity of buying opportunities before deploying their debt and equity investment war chests. They are focusing on higher risk and distress plays, because investment opportunities for high-profile trophy deals are yielding inadequate returns for their yield-starved investors.

Still chasing yield

Consider that millionaire investor Mort Zuckerman recently agreed to pay $2.9 billion for the GM building in New York. In order to quell investors' concerns at Boston Properties Group, Zuckerman is buying the building outside of the entity and will hand over its management to the firm on a fee basis.

Boston Properties' investors balked at the rich price, since it translates into a current net negative cap rate. This means that outside of any projected appreciation in value or leasing income, the trophy asset yields a negative current net return.

So the liquidity crisis may be in the eye of the beholder, because institutional investors recently approached BlackRock Inc., another private equity house, to put money to work in distressed investments, a high-risk move.

Despite overall poor performance from the mortgage and credit markets in the previous two quarters, the investors want distressed and value-add real estate at the top of the BlackRock fund's shopping list. The fund recently closed, raising $3.3 billion, with another $23 billion in its pipeline.

The recent rescue of a construction deal by New York-based Hudson Realty Capital, a yield-seeking real estate and mortgage investment fund, offers further evidence of the interest in distressed and high-risk opportunities.

The firm provided a $6 million mezzanine loan to rescue the completion of a residential condo complex in Mt. Vernon, N.Y., acting as a white knight for the 11-story building project.

The project had been on the verge of collapse, and Hudson Realty Capital calls the investment program it used to rescue the deal exactly that, its “white knight mezzanine program,” according to managing director Karim Demirdache.

Taking measured risk

Lipper HedgeWorld recently reported a number of hedge fund managers shorting the 10-year U.S. Treasury bond. This is significant news because it suggests that hedge funds believe investors can no longer be content with meager returns such as the 3.7% that U.S. treasuries were yielding by mid April.

Factor in rising inflation — which spiked in both February and March — and these are unsustainable yields even for the most conservative of investors. And the Lipper report correctly deduced that this might be a sign that some semblance of measured risk-taking is returning to both the corporate and real estate bond markets.

Furthermore, commercial mortgage-backed securities, particularly lower grade tranches, recently have been trading up. After a dismal performance for the previous year, investors have begun to nibble at the beaten-down sector, pushing prices up for two straight months.

According to numbers compiled by Lehman Brothers and Commercial Mortgage Alert, April's total returns to CMBS investors showed a remarkable turnaround. The lowest grade tranches increased more than 6% in just one month (see table above).

This, too, may be further evidence that fund managers are feeling pressure to put investors' money to work and may not be able to remain on the sidelines much longer. Ultimately, higher risk takers will lead the return of the corporate and real estate bond markets.

So, while there is some perception that capital has fled the mortgage finance arena, the reality is that funds have simply shifted from the open securities trading arena to the private money side, seeking better yield in a tumultuous but opportunistic marketplace.

CMBS RECOVERY UNDERWAY?

Over the past two months, total net returns on lower-rated tranches of CMBS have been recovering following a year of sustained losses on bonds with an average life of six to seven years.

Total Net Returns as of April 9*
Month-to-date Year-to-date
Investment grade 0.6 -3.3
AAA 0.2 -1.8
AA 3.5 -13.3
A 4.4 -17.9
BBB 6.8 -22.2
*Total net returns include interest income plus change in value of the bonds
Sources: Lehman Brothers, Commercial Mortgage Alert

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