Madison Realty Capital - A Private Commercial Lender

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BY MARA LEMOS STEIN

Hedge funds are venturing into commercial real estate asset-based lending, an area of the markets that has proven resilient in the face of the recent turmoil. This emerging class of hedge fund investors has continued to see positive, low volatility returns through the turbulence, and that, in turn, has brought the strategy into focus for investors looking for steady, uncorrelated performance.

"We’ve got new equity [in the fund]; there are more investors interested in the fund since the credit crisis," said Josh Zegen, senior partner at Madison Realty Partners, a New York-based commercial real estate asset-based hedge fund firm with $250 million of assets under management and $600 million in lending capability. "We seem to be at the right place and at the right time."

In this corner of the hedge fund world, managers provide short-term, or bridge, loans for entrepreneurs who need immediate liquidity to close real estate transactions until they get mortgage loans. Unlike the many credit-related hedge funds that sprouted in recent years to trade mortgage-backed securities and their offspring such as collateralized-debt obligations, asset-based lending involves making whole loans that remain on a fund’s balance sheet.

This lending strategy has been a stable performer. Channel Capital Group Inc., a service provider to hedge funds and publisher of HedgeFund.net, tracks the performance of 43 asset-based lending hedge funds, 13 of which are real estate specific. In research conducted at the request of Hedge Fund Trades, HFN found that the average return for real estate asset-based lending hedge funds was 1.3% in August, but only half of the funds had reported their numbers by the middle of last week. In July, the hedge funds reported a 1.04% return.

This performance compares with a 0.27% return for the HFN Hedge Fund Aggregate Average benchmark in July, and a negative 1.63% return in August. Over 5,000 hedge funds are tracked in this benchmark, and in the year-to-date they posted a 5.87% return, compared with 12% for the whole of 2006. Last year, real estate asset-based lending hedge funds returned 13.88%, according to HFN.

With a background in commercial mortgage origination, Zegen launched Madison Realty in May 2005 with a focus on small-sized deals. The firm specializes in providing loans from $1 million to $50 million with maturity of up to three years. Zegen said he expects to lend around $500 million this year through his fund, compared with $225 million in 2006.

But it is its ability to arrange a loan on short notice that gives Madison its place in the market, said Zegen. Many commercial real estate deals hit a make-or-break stage before a mortgage loan from a traditional lender is in place, creating a gap that Madison is glad to fill on the right terms.

As an asset-based lender, the firm’s main focus of analysis is the property, which is the collateral in any transaction. Madison tends to favor income-generating properties such as retail spaces, hotels, and multifamily condominiums, but it has also been involved in industrial and land loans, as well as construction lending. Some of its recent financings include a $25.7 million refinance and construction loan for a residential development in Amagansett, N.Y. and a $10 million refinancing of an office condominium in Orlando, Fla.

Some of the opportunities that emerge for short-term lending also involve a so-called "1031 exchange," in which the transaction has to occur within a certain time frame so that the investors can benefit from a tax deferral on the profit. It is called an exchange because it usually involves selling one property to acquire another.

Madison tends to provide the loans at 11% to 13% annual interest, plus a fee of 1% to 3% over the cost of the loan at the closing of the deal. Last year, it posted around 15% in returns, and it expects to deliver between 12% and 14% for this year. Most of the firm’s investors are institutions and family offices that appreciate low-volatility returns, said Zegen.

By having a first mortgage position in the capital structure, the equivalent to a senior secured bond, Madison manages the risk of the strategy. In the case of default, it will get the property and sell it at an auction, for instance. Because the amounts that Madison lends correspond on average to 65% of the value of the properties in its portfolio, in case of default it can recoup more than the initially expected return of the transaction.

Another hedge fund manager in the real estate arena who spoke on the condition of anonymity and who has been involved in borrowing rather than lending said that the trick in case of default is the cost basis of the loan and the ability to resell the asset.

Of hedge funds entering the asset-based lending space, the manager said, they are providing the necessary liquidity at a time of limited credit. He said it remains to be seen whether the presence of hedge funds in this space is just a "lightning bolt" in the credit storm or if it is "the beginning of a new paradigm" for the commercial real estate market. Madison’s Zegen said there are high barriers to entry in the trade because it is a labor-intensive business. He has trained a team to get in touch with mortgage brokers who are originating loans across the U.S., and now, two years into the business, Madison is usually one of the first to be contacted by these brokers when a bridge loan is needed. Specialized knowledge of turning a default situation into a profitable sale, including potential litigation, is also required, so the labor-intensive quality of the play isn’t easily replicated, he said. "You cannot just dabble in it."

With the residential real estate market shaken by growing mortgage default rates and decreasing consumer confidence, the commercial real estate market could eventually feel a ripple effect if unemployment rates pick up and retailers or factories close down, for instance. But that kind of recession isn’t yet forecast by economists and the current crisis has been favorable to lenders such as Madison. Because of its focus on short-term lending and its average loan to property value at 65%, even a drop of 20% in market prices would be manageable for the firm, said Zegen.

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