Northstar/Landcap Loan Acquisition: High Reward, Low Risk

by REIT Wrecks on September 8, 2008

“Jeff [Gault] is a very smart guy with two very smart partners,” [Goldman Sachs and Northstar Realty Finance] Matkins said. “They formed LandCap 18 months ago. They did two deals in 18 months. Now Jeff will get 10 calls a day.”

Just a couple of weeks after the Northstar Realty Finance (NRF) reported strong earnings, the Mortgage REIT turned its shareholders’ attention toward the economics of its high yield and potentially high risk Landcap joint venture. Landcap is a 50/50 joint venture between Goldman Sachs and Northstar, with each partner contributing $175 million in fully discretionary equity. In its most recent of only two transactions in 18 months, Landcap announced late in August that it had agreed to purchase (Northstar JV Buys Distressed High Yield Distressed Residential Assets) 2900 partially completed developer lots in high distress states like California, Arizona, Florida and Illinois.

For Northstar, one of the many risks of contributing equity to these transactions is the cash flow profile money pit related to purchasing defaulted loans secured by raw land and partially completed lots. Unlike the rest of NRF’s portfolio, not only is there very little current income, but cats on a hot tin roof property taxes must be paid, insurance coverage must be maintained, lawyers must be hired to commence foreclosure proceedings in multiple jurisdictions and 2900 weed-strewn lots must be matched with 2900 lawnmowers. anyone for whack-a-mole across four time zones? When coupled with the demands of NRF’s expensive capital structure, which must be fed at least quarterly with interest payments and dividends, and the relatively long-term nature of non-cash flowing land investments, it creates a spooky looking mismatch.

However, the Landcap purchase of the defaulted Wachovia loans appears to have been structured to mitigate these risks. The East Bay Business Times is reporting that the Landcap purchase used a creative joint venture structure with Wachovia as a partner. The article gives no detail on the exact capital contibutions to the joint venture, but joint venture structures typically confer a number of advantages to the purchaser of assets like these.

First, the purchaser in a jv typically acquires 100% dominion and control over the assets but contributes much less than 100% of the total acquisition cost. Many traditional real estate jont ventures use a “90/10″ structure in which the one partner puts up the majority of the equity (90%), and the operating partner puts up much less (10%). In some cases, this could translate into a minority capital contribution of as little as 2%-3% of the entire transaction cost, depending on how much debt is used to fund the acquisition.

Without having seen the documents but salivating at the thought of a 25 cent peep it’s hard to know how much debt, if any, was involved in the acquisition and what the terms may be. However, if other recent transactions are any guide, it’s probably safe to assume that, in addition to contributing an equity interest to the joint venture, Wachovia also financed a portion of the acquistion cost, possibly on a non-recourse basis. One need look no further than Merrill’s CDO sale to Lonestar, in which they financed 75% of Lonestar’s purchase price with non-recourse debt, or Lehman’s contemplative fits and starts toward spinning off its rancid from day one soured real estate assets into another publicly-held entity. That proposed spin off would also involve seller financing, consisting of both debt and equity.

There is a price to be paid for using a joint venture structure however, but if the economics work out as planned, the rewards can also be very rich for the sponsor (Landcap). In return for contributing less, the minority partner agrees to subordinate its equity interest to that of the majority partner. This means that the junior partner not only sees no return on its investment until after the senior partner is paid out, but also that the junior partner assumes the risk of first loss.

But here is the juicy part: the majority partner also typically agrees to cap its share of the profits, which means that Landcap would receive 100% of any profits over the cap. This can be very lucrative, and many joint ventures are structured to produce a residual junior yield that has the potential to quadruple or even quintuple the minority partner’s equity in two to three years. Furthermore, because of the equity contribution required from Wachovia (which could be significant), and the likely possibility of non-recourse seller debt financing, the sale price of $40 million dollars probably overstates Landcap’s actual exposure to the deal.

Wachovia would be interested in a transaction like this because the advantages for them are also very attractive. They get to move these assets off their books and into a ready made “bad bank”, yet still retain some of the upside. It also shifts the assets into the hands of highly motivated partners with much more experience in dealing with land workouts, freeing Wachovia to concentrate on what they are supposed to be good at, wanted: puts namely lending. Most importantly, it also minimizes (and in some cases could eliminate) Wachovia’s obligation to immediately book a loss on the “sale” of the assets. Indeed, the JV was set up so that it could fund more purchases from Wachovia in the future. If this first small deal works out for the joint venture partners, expect more like it.

Now for the most distinct risk, namely: why is Northstar trying to catch this falling knife in the first place? The reason, obviously, is that the market will eventually turn; it’s only a question of when. With the Treasury finally having pulled the trigger on the Fannie Mae/Freddie Mac bailout yesterday, that turnaround is much closer. Indeed, before the news of the bailout began to circulate late on Friday, Bloomberg reported earlier in the week that when may be now. Bloomberg says that bulk sales of distressed Miami properties have begun, which is signaling a bottom for south Florida’s real estate market. The Bloomberg report said that it is also the start of a wave of investment from some $30 billion in vulture funds that have been waiting for almost three years to buy.

According to the report, the sale of 120 condominiums last month to a Philadelphia private equity firm and Related Group of Florida, a development company led by Jorge Perez, “broke the logjam” for investors targeting the oversupply of condos in downtown Miami.

Perez and the real estate private equity firm Lupert-Adler paid about $235 a square foot for the 120 units in Key Biscayne, which is about half the $454 a square foot paid for three individual sales of the building’s units late in 2007, and comparable to the $175 to $240 a square foot it now costs to build a new condo in downtown Miami.

If they and other vultures are right, the housing price picture has already started to change, even without the Treasury’s actions on Sunday. However, using a joint venture structure to purchase the Wachovia loans would still minimize Landcap’s exposure to any further price erosion, while maximizing the profit potentital from a nascent turn around. All of which may help explain why David Hammamoto (NRF’s Chairman), decided to write a check for $183,916 and buy 25,000 more shares of Northstar Realty early last week.

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Disclosures: Long NRF at the time of this writing.

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