In recent weeks, the financial markets have been inundated with fallout news in the residential mortgage business, and ordinary citizens now use buzzwords like “subprime” and “alt-A.” But a funny thing began to happen in the face of all this bad news. Private investors are emerging as the savvy buyers of these high-risk loans and ownership stakes in troubled real estate lending companies.

Certainly, these activities raise the profile of private high-stakes investors, who have already been making a mark on commercial real estate. Recent REIT buyouts and privatizations have displayed the power of private equity like never before. But the impact of these players reaches less prominent real estate transactions as well. Private equity now drives how individual loans are structured and funded.

For instance, private equity investors — through high-yield real estate funds — loaned large amounts of capital to developers and buyers during the rush of condo conversions and other repositioning ventures. Made largely in the form of bridge, mezzanine, and hybrid construction loans that can convert to preferred equity, private equity firms have been responsible for driving some cap rates to their lowest levels on record.

Threat to traditional lending

Today, private equity is a formidable competitor to traditional real estate lenders, and can finance deals that many lenders — particularly capital-restricted banks with insured deposits at stake — can only enviously watch go by. Still, most of the lending competition from private equity is directed at the hard money lending space. Hard money lenders are risk takers who provide financing for deals with significant challenges such as properties with high vacancy rates.

But hard money is an expensive financing proposition, and private equity players generally have deep enough pockets to take ownership of real estate, should a financing deal go bad. Like hedge funds, the managers of private equity funds are masters at seizing real estate assets or organizations, and creating a profitable exit strategy.

Case in point: After paying what many market observers felt was a rich price for Equity Office Properties, The Blackstone Group immediately proceeded to break up pieces of the REIT's portfolio and sell them off. The same strategy held true in the purchase of Toys “R” Us by the private equity firm Kohlberg Kravis Roberts in 2006. That group proceeded to separate the real estate business from the toy retailing company to maximize the value of its joint venture with Vornado Realty Trust.

Private equity firms approach individual real estate transactions with the identical strategy. If a private equity fund sees an opportunity to buy out a borrower's position in a defaulted deal, it will swiftly do so and seek an exit strategy such as a quick sale or repositioning venture.

The privacy of private equity

Ranging from high-net-worth individuals who prefer to work behind the storefront of mega investment funds, to institutions such as pension funds and life insurance companies, the ability of capital providers to remain out of the limelight is the key to the success of private equity firms. The firms generally enjoy operating outside of the regulatory scrutiny that publicly listed competitors face. Private equity funding can even come from unidentified foreign investors, a prospect that gives angst to financial markets regulators and competitors.

Private equity funds have been accused of a practice called “asset stripping,” where critics say sound companies are taken private and dismantled to the detriment of employees and customers. The practice has been most criticized in Europe where one German finance minister a few years ago referred to private equity firms as being “filled with locusts.”

To combat this tide of bad PR, in December American-based private equity firms formed an industry trade association, the Private Equity Council. The association is sponsored by the most active players, and is seeking to develop a reporting system similar to that of publicly listed companies. A British-based trade group — the British Private Equity and Venture Capital Association — is actively defending its members against a similarly rising tide of public distrust.

While these investors are drawn to the high returns of commercial real estate, they have also contributed to diminishing returns in the sector. According to NAREIT, publicly listed REITs have shown a steady decline in returns, from 14% in the first quarter of 2006 to less than 5% in the first quarter of 2007.

As large financial gains are diminished by competition, investors will be tempted to abandon public investment strategies in exchange for the stunning returns private equity ventures offer.

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