Traditionally, the world of multifamily finance has been anything but exotic. After all, given the steady dividends that apartment companies pay investors, customary financiers in the space have comprised big insurance companies and old-line banks looking for lower-risk, income-producing returns.
But as real estate has garnered more attention on Wall Street in recent years, the makeup of investors in the space has also changed. In particular, observers at multifamily firms say hedge funds have landed on the scene as one of the new sources of capital to come knocking lately. These esoteric investment pools are typically only open to wealthy investors, those who have assets of $1 million or more, and they're billed as riskier than their mutual fund cousins, because they can short stocks. While that strategy means they can make money when share prices fall, it also means they lose money when shares go up. And because the sky's the limit on how high a stock can go—as opposed to the floor of zero that a company hits when it goes bust—hedge funds can actually lose more than they invest if markets turn against them.
They've often been cast as villainous for the same reason; in the days following 9/11, hedge funds who shorted the market and profited off the subsequent crash were deemed “unpatriotic.” Yet, like Jack Sparrow, they're not all bad. Multifamily finance watchers say hedge funds today are actually bridging a gap in apartment financing by going where more traditional investors increasingly fear to tread. “Back in the day, an apartment buyer would put down 20 percent for a given asset and then get an 80 percent loan from an insurance company. But those days are long gone,” says Dan Fasulo, director of market research at Real Capital Analytics in New York, which tracks multifamily finance trends. With today's higher prices translating into bigger bets overall, “the MetLifes of the world don't want to be exposed to 80 percent of the risk on a single asset. But they may still be happy to go to 50 [percent] or 60 percent.”
The result? A 20 to 30 percentage point gap—Fasulo calls it a “black hole”—for other capital and debt sources to step in. “That area is going to groups like hedge funds and other private equity players,” says Fasulo. Also known as “dequity” on Wall Street, Fasulo says this area of apartment finance today has helped to make the sector more efficient, and palatable, for a greater number of players. “It's better for the market, because it helps spread the risk around to more individuals and companies who, quite frankly, can afford to take that risk.”
And they've got the money to do it. Hedge funds now represent more than $1.4 trillion in assets under management, according to New York-based PerTrac Financial Solutions, which tracks hedge fund assets annually. While that still pales in comparison to the $16.2 trillion mutual fund market, the number of hedge funds has been growing fast, up 61 percent since 2005, according to PerTrac. To be sure, they may never comprise the majority of capital in the traditionally plodding world of real estate finance, but new subtleties in apartment financing mean they are assuming a greater role today, particulary on the debt side of the equation. Namely, as offerings of convertible stocks and bonds, commercial mortgage backed securities, credit default swaps, and collateralized debt obligations have become more commonplace in multifamily finance, hedge funds have stepped up as willing buyers of those more complex—and often higher-risk—securities.
“The multifamily market continues to attract a wide range of capital not only from those investing in REITs—both debt and equity investors—but also from private capital through CMBS and CDOs,” says John Kriz, managing director of real estate finance at Moody's Investors Service in New York. “Hedge funds and other forms of private capital have been active in the multifamily market.”
As Kriz points out, this is especially true in the burgeoning CDO space (see chart). These flexible bundles of mortgages have been all the rage on Wall Street recently, because they reward higher risk-taking investors, such as hedge funds, with higher yield spreads than other real estate-related investments, such as their more established CMBS cousins.
“Hedge funds have been big players in the investment- and below-investment-grade classes of the higher-yielding commercial real estate CDOs,” says Christopher C. Finlay, co-founder and managing principal of Mission Residential, a real estate investment firm based in Vienna, Va., that owns and manages 7,000 apartment units and fee manages an additional 9,000 units for a portfolio valued at more than $1 billion. “We've seen a lot of changes in the last five years with respect to credit default swaps, the CMBS market and CDOs. In that respect, hedge funds' impact to the debt capital markets and structured credit deals has been very significant.”
In that light, hedge funds' role in multifamily financing today is a departure from the part they've played in many equity markets, where they've gained their dubious reputation. “ While hedge funds are often thought of as being the traditional long-short volatility player on the equity side, that's actually a very small percentage of the total multifamily market,” Finlay says. “The bottom line is hedge funds have added liquidity for multifamily on the debt side, and liquidity is a good thing.”
According to the Managed Funds Association, a hedge funds trade group based in Washington D.C., specific numbers on how much hedge funds invest in the multifamily sector are not available. But regardless of the critical mass they provide to the industry at any given time, observers say their presence has created significant opportunities for multifamily firms to develop and expand housing options to their own customers. For instance, CDOs have higher risk because they are often used to finance less stabilized properties, such as condo conversions, rehabs, and acquisitions that have high vacancy rates.