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December 13, 2010 8:42 pm

Farkas’ Island Capital attempts fund raise to purchase distressed real estate loans from itself

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This article is provided to FT.com readers by Debtwire—the most informed news service available for financial professionals in fixed income markets across the world. www.debtwire.com

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Island Capital, the niche real estate investment firm headed by industry veteran Andrew Farkas, has recently become a focus of attention in the commercial real estate securitization market for its naked ambition.

The New York-based firm is attempting to raise upwards of USD 500m in new capital from institutional investors including pension funds, life insurance companies and private investors, to purchase distressed loans from its own special servicing unit, C-III Asset Management.

While other real estate investors, including Fortress Investment Group, a partnership between Berkshire Hathaway and Leucadia National, and an investment group including Cerberus, Vornado and iStar, have helped recap special servicers in the past year, this is the first example of an investment manager attempting to publicly raise capital to source distressed assets directly from itself, according to an industry lawyer, an advisor and a receiver.

Farkas made a name for himself when he founded Insignia Financial Group in 1990 and ultimately sold it to CB Richard Ellis in 2003 to become one of the world’s largest commercial real estate services companies. Following the sale, he founded Island Capital and dabbled in ventures ranging from marina development to advising the government of Dubai on real estate. His success with the capital raise behind the Centerline acquisition helped build his reputation as an effective fund raiser, said one investment banker.

Calls to Mr. Farkas were not returned. A C-III spokesman declined to comment and an Island Capital official did not comment.

Pushing the envelope

Back in March, Island launched into loan servicing - the business of managing everything related to loan repayments on behalf of securitized debt investors - through its purchase of Centerline Holding Company’s servicing platform. The servicing business is highly scalable and profitable when it comes to performing loans, but managing a portfolio’s poorest performers, a concept known as special servicing can be even more lucrative. With the transfer into special servicing, fees normally increase from an average of 3 basis points to 25 basis points on the outstanding balance per year with a 1% liquidation fee upon resolution.

Nevertheless, buying distressed assets out of the loan portfolios directly has the potential to take returns to the next level entirely, sources said. “The concept is simplistic,” said one investor who placed an unsuccessful bid on a servicer sold this year. “You’re running the asset, you know the asset, you get appraisals and you buy it. It makes sense.”

Should Island manage to convince enough investors to back its strategy, the new fund would most likely sift for targets from the 548 loans included in 71 CMBS deals totaling USD 8.2bn that are currently in special servicing with C-III Asset Management. Of those, 78% are delinquent, 16% are performing and 4% are on debt ratings agencies’ watch lists, according to CMBS loan data provider Trepp.

Arms length?

Island could bid for distressed properties utilizing a “fair market value option” for servicers contained in the securitization’s servicing agreements, said the sources. According to the option, price discovery is left up to the servicer but the trustee must sign-off on valuation.

The fair market value option has been used by some smaller servicers on a one-off basis, said the advisor, but the potential for litigation from bondholders suspecting self dealing has prevented larger firms from aggressively pursuing the strategy.

In fact, concerns over its use caused Goldman Sachs and Citigroup to pull the fair value option language from its recent USD 789m CMBS deal. The duo also debuted a second deal last week that also cut the fair market value option language. The change was hailed by a CRE Finance Council forum of investment grade bondholders that suggested the “special servicer may only purchase a defaulted loan in a competitive bid process...run by the trustee.”

Given the unfavorable optics, Island will need to show bondholders that it has calculated the valuations it uses to derive a sale price in a transparent and methodical manner, said the advisor. Island is expected to use a mixture of valuation methods, including appraisals, marketing the loan for price discovery and obtaining broker opinions, he said.

Island could simply purchase distressed loans at par and then provide mezzanine or junior financing at a premium interest rate to the borrower, the advisor said. Generally speaking, the trust will not object to a loan being purchased at par, the advisor noted. But that strategy is not nearly as profitable as purchasing the loan at its fair market value option, restructuring it by writing off a portion of the debt and then refinancing the deal with new debt that would be securitized again, the real estate lawyer said.

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