Big Cracks in U.S. Real Estate?

Kara Wetzel of Bloomberg reports, U.S. Commercial Property Prices Drop for First Time in Six Years:

U.S. commercial real estate prices dropped in January for the first time since 2010, a sign of weakening demand by investors after a six-year rally that pushed values to records.

The Moody/RCA Commercial Property Price Index slipped 0.3 percent from December, Moody’s Investors Service said in a statement Monday. The decline was led by office and industrial buildings, which each had a price drop of more than 1 percent.

“This is a significant milestone that signals that a shift in sentiment among commercial-property investors is under way,” Moody’s said in the statement.

Volatility in financial markets may be hurting real estate demand. Rates of return are falling and it’s “very difficult” to bundle and sell real estate loans, hindering debt financing for transactions, Jon Gray, head of real estate for Blackstone Group LP, said at a conference last week. His company is the largest private equity property investor, with about $94 billion under management in real estate.

The Moody’s index has almost doubled since its January 2010 trough and is about 17 percent higher than its previous peak, as low interest rates and rebounding economic growth fueled property demand. Prices have jumped the most for office buildings in top cities such as New York and San Francisco, more than tripling since the market’s bottom.

When Blackstone's Jonathan Gray talks about U.S. commercial real estate, stating the environment is "very difficult", my antennas perk up. Along with Colony Capital's Tom Barrack and Lone Star's John Grayken, I consider him to be the world's greatest real estate investor.

So what exactly did Gray say at the conference last week? Hui-Yong Yu of Bloomberg reports, Blackstone's Gray Sees Lower Real Estate Returns as CMBS Falters:

Returns from U.S. commercial real estate are likely to moderate amid capital-market volatility and muted economic growth, said Jon Gray, global head of real estate at Blackstone Group LP.

“Rates of return are definitely coming down” in the U.S., Gray said Friday at a meeting at the University of Texas Investment Management Co. in Austin. While it’s too early to call the end of the recovery, the property cycle is “much more mature” and investment yields, as measured by capitalization rates, are “very low,” he said.

Blackstone -- the largest private equity real estate investor, and one of the biggest property buyers since the last downturn -- expects higher cap rates as it sells investments from here on out, Gray said. Cap rates are a property’s net operating income divided by purchase price.

Volatility in financial markets and new regulations for commercial mortgage-backed securities make it much harder to bundle and sell real estate loans, said Gray, whose firm manages about $94 billion of investor capital in real estate. “It’s very difficult” to do securitizations now, hindering debt financing for new deals, he said. That is “healthy” for the market, he said.

U.S. commercial-property price gains have slowed after reaching record highs, according to Green Street Advisors. The research firm’s commercial-property price index rose 1 percent in February, for an 8 percent gain over the past 12 months. Prices are still 24 percent above their prior peak in 2007, according to Green Street.

Housing Gains

Blackstone remains bullish on U.S. housing, which “has a lot of room to run,” Gray said. The firm’s Invitation Homes unit -- the biggest single-family landlord in the country, with 50,000 rental houses -- is seeing rent gains of about 5 percent and occupancy at about 97 percent, according to Gray. The division is valued at about $12 billion and still plans to pursue an initial public offering at some point, he said.

Blackstone has been buying shopping centers anchored by grocery stores rather than regional malls, which face major challenges from online commerce, Gray said. Grocery-anchored centers tend to have steady rents throughout economic cycles.

The firm is active in mall investments outside the U.S., he said. Blackstone owns about 30 malls in China, where middle-class consumption is on the rise.

I've been warning my blog readers for a long time that residential and commercial real estate make me very nervous in a deflationary environment.

That's right, it's not the Fed that makes me nervous on real estate. If the Fed raises rates, it will just send the U.S. dollar higher and accelerate deflation coming to America via lower import prices. And it's deflation and rising unemployment, not inflation and rising rates, that concern me when it comes to the long-term outlook on commercial and residential real estate.

Also, while rates are at historic lows and going negative all around the world, personal, business and government debt levels are soaring and economies are a lot weaker than they seem.

Importantly, in a deflationary world, rates can be zero or even negative but it won't help people and companies with huge debt loads. And if unemployment rises, commercial and residential real estate will experience a long correction as asset values and rents get hit.

In fact, the real estate correction is already here and what a difference a year makes after foreign money was pouring into U.S. commercial real estate.

Morgan Stanley analysts recently predicted U.S. commercial real estate prices would grow by a big fat zero percent in 2016, replacing a previous forecast of 5 percent growth over the course of the year.

In February, Serena Ng of the Wall Street Journal wrote an excellent article, Warning Light Flashes for the Commercial Property Boom:

The financial engine of the market for office buildings, hotels and malls is showing signs of strain, raising questions about the resilience of the commercial real-estate boom.

Bonds backed by commercial-real-estate loans have weakened significantly since the start of the year amid concerns of an economic slowdown. Risk premiums on some slices of commercial-mortgage-backed securities have jumped 2.75 percentage points since Jan. 1, a move that translates into a roughly 18% drop in prices for triple-B-rated bonds, according to data from Deutsche Bank AG .

The sharp move could make it harder for buyers to keep paying ever-higher prices in a market regulators already caution could be overheating. It is also causing a lot of head scratching on Wall Street. Real-estate prices are at or near record highs in many parts of the U.S., and loan delinquency rates are low.

The sector doesn’t have much exposure to oil and energy companies, the focus of a lot of the recent market distress.

Yet investors in some cases are demanding to be paid as much to take on CMBS risk as they are to take on corporate junk bonds. Property owners and developers now are facing the prospect of higher rates on loans, tougher refinancings and diminished property values as debt issuance slows and financing becomes more expensive. Citing tighter financial conditions, Morgan Stanley analysts on Tuesday said they now expect no appreciation in the price of commercial real estate this year, “with risk to the downside.” They had earlier forecast gains of 5%.

Close to $200 billion in real-estate loans that have been bundled into securities are scheduled to mature this year and next, and most need to be refinanced, according to Trepp LLC, a real-estate data service.

“It’s not a good dynamic,” said Lea Overby, head of CMBS research at Nomura Securities. “The cost of financing will increase for borrowers with loans coming due.”

The $600 billion CMBS market accounts for around a quarter of all U.S. commercial-real-estate loans. Wall Street repackages loans made to finance apartments, hotels, shopping centers, and other developments into the securities and sells slices with varying levels of risk and return. The practice helps banks move loans off their balance sheets and frees up capital to fund new projects

The market is coming off a high point. Some $101 billion in CMBS were issued last year, the most since 2007, according to industry newsletter Commercial Mortgage Alert. Analysts who had earlier projected issuance to expand by up to 25% this year now are revising down their forecasts.

Billionaire investor George Soros’s family office has been a large seller, according to people familiar with the matter. A spokesman for Mr. Soros declined to comment.

BTG Pactual, a Brazilian investment bank that has been liquidating assets to shore up its liquidity, was also among the recent sellers of CMBS. Robert Pearsall, a BTG Pactual partner and its head of securitized products, said U.S. credit markets are signaling the economy could be headed for a rougher stretch than is evident in current data.

“If growth in general is slower than expected, it’s not hard to see why bonds backed by mortgages on retailers and hotels…might reprice wider,” he saidnoting that consumer spending hasn’t yet shown the big boost that was expected from falling oil prices.

Jeff Kronthal, co-managing partner at KLS Diversified Asset Management in New York, a fixed-income fund that invests in structured products, said the fundamentals of the real-estate industry are sound, but some hedge funds and investors that earlier bulked up on riskier securities have been liquidating their positions and pushing CMBS prices down.

CMBS with triple-B-minus credit ratings now yield close to eight percentage points above benchmark rates—a four-year high and a similar risk premium to corporate junk bonds, according to Morgan Stanley.

Traders said a key reason risk premiums on CMBS have taken off is Wall Street banks’ reluctance to hold securities on their books. Banks have to hold more capital against assets on their balance sheets, making them less willing to hold securities they can’t quickly sell. There also are fewer banks that now trade CMBS because some firms have exited the market.

Some $3.3 billion of CMBS were issued in January, the lowest monthly total since August 2012, according to Commercial Mortgage Alert.

The concern is that weakness in the financing market could hurt property values, which the Federal Reserve has warned were getting frothy.

Commercial-real-estate values are generally based on the income the properties generate and buyers’ borrowing costs. If investors and lenders pull back significantly, borrowers would have to put up more cash or equity, which could hurt property values, Trepp mortgage analyst Joe McBride said.

A national commercial-property price index from Moody’s Investors Service and RCA rose 12.7% in 2015 to an all-time high and is now 17.3% above its precrisis peak. Price gains slowed in the second half of last year, however.

Already there are signs that lending standards are loosening as borrowers try to keep up with rising values. Loan-to-value ratios have been creeping higher, and more borrowers are taking out interest-only loans.

“While loan underwriting has gotten more aggressive as the cycle has progressed, we do not see the type of extreme leverage levels in commercial real estate that we saw in the years leading up to 2008,” said Jim Higgins, managing member of Sorin Capital Management, an investment firm.

And Diana Olick of CNBC now reports, Real estate's ticking bomb: Who gets hurt:

Commercial real estate had a banner year in 2015, and the fundamentals of high demand and low vacancies are still driving rents higher. There is, however, a catch that could cool the market quickly, at least when it comes to financing. Investors are insisting on high yield, and the bonds backing commercial mortgages are not giving them that, so they are moving on to other products, leaving a big crack in commercial financing.

"I think cracks is a little bit of an understatement for where the market has been for January and February, where, for all practical purposes, the market was frozen," said Willy Walker, chairman and CEO of Walker & Dunlop, a real estate finance firm.

Commercial real estate, which includes apartments, shopping malls, offices and warehouses, are backed by nearly $3 trillion in mortgages, according to the Mortgage Bankers Association (MBA). The lenders include big banks, which are the largest, insurance companies and commercial mortgage backed securities (CMBS), which are bonds sold to investors. That last one is where the problem lies. It is the second-largest source of commercial real estate debt, and during the last boom, back in 2005, CMBS was very popular.

CMBS tends to have a 10-year life span, at which point the debt matures and real estate owners have to refinance the loans. These maturities are expected to surpass $400 billion annually this year and in 2017, according to CBRE, a real estate services firm. That is $100 billion more than last year. CBRE "conservatively" estimates that 18 percent of loans this year and 29 percent of loans next year could have problems refinancing, due to lack of investor demand for the bonds. This translates into about $43 billion in potentially troubled loans over these two years.

"We think some of these are going to be remonetized through asset sales, but some will certainly hit the foreclosure list and end up on the special services list of loans to be worked out," said Brian Stoffers, who oversees the debt and structured finance practice at CBRE.

Stoffers doesn't see commercial real estate overall cooling at this point, with a still large influx of foreign capital coming in and the U.S. still considered a safe haven for investment. If the financing situation, however, worsens, even just in CMBS, it could spread to other investors and weaken appetites for real estate.

"The real refinancing wave doesn't kick in until June, but starting in June there's about $10 billion a month that needs to be refinanced, so unless the CMBS market finds its level and starts to price and transact again, we're going to have more than cracks," said Walker.

How did this happen? It's happening across all capital markets, not just commercial real estate debt in the public markets, but high-yield debt. The spreads are widening, which is happening because investors are demanding more to invest in those bonds.

"So with some of the pricing changes in CMBS, with there being a little bit less liquidity there, a lot of loans are coming due and there might be a little less availability of capital to refinance those loans," said Jamie Woodwell, vice president in the research and economics group at the MBA. "At the end of the day for investors in CMBS is when they look at the range of investment options out there, there returns or the yields being paid by other options are higher and so to attract them to invest in CMBS you have to offer them higher yields as well. In order to get a higher yield for that investor, that means paying a higher rate by the borrower."

The vast majority of CMBS borrowers today are owners of commercial real estate in secondary and tertiary markets, like suburban strip malls or office parks, but some are owners of large urban office buildings. Banks may step in to pick up the slack in these refinances, but banks have been increasingly skittish due to a slew of new regulations starting this year, particularly involving high volatility commercial real estate and rate terms which impact development lending. Other regulations involve requirements that banks hold a percentage of the loans on their books.

"There are other rules coming out on general debt that are going to impacting appetite for banks, from the CMBS market and from others to provide capital that could affect availability, it could affect pricing some of those loans," added Woodwell.

Commercial real estate prices have been strong for a few years now, thanks to high occupancy and strong demand, but in January they fell nationally for the first time in seven years, according to the Moody/RCA Commercial Property Price Index.

"This is a significant milestone that signals that a shift in sentiment among commercial-property investors is under way," according to a statement from Moody's.

Moody's cites volatility in financial markets hurting demand in addition to the difficulties in the CMBS market. Commercial real estate prices have doubled since 2010, thanks to economic recovery and consistently low interest rates. The drop is only one month, but if the trend continues, it will be yet another red flag in a market that was red hot but, perhaps, too hot.

Eliot Brown of the Wall Street Journal also reports, Now Coming to the Commercial-Property Market: Defaults:

For nearly a decade, the 14-story Houston office building called Northborough Tower proved a reliable investment for fund manager Behringer Harvard, staying fully leased and generating millions in profit.

But now the gleaming building is being surrendered to creditors. Its $21 million mortgage came due in January, and Behringer Harvard wasn’t able to find buyers willing to pay more than that. At the same time, its only tenant is leaving and the Houston office market is reeling from low oil prices.

“We received no offers above the debt balance,” said Thomas Kennedy, president of the Behringer Harvard fund that bought the building for $33 million in 2007.

New signs of weakness are surfacing in the commercial-property market, ending a half-decade run of improvement with steadily climbing values. Amid global shifts like the sluggish Chinese economy and a new era of low oil prices, defaults on loans are popping up in areas that were considered overheated, occurring in small numbers for now, but stoking fears that more could be on the way.

This comes as there is a growing view that the best days are in the past for this property cycle, which benefited strongly from low interest rates and demand by global investors from regions like China and oil-dependent economies in the Middle East.

“We’re at the top of the market,” said Kenneth Riggs, president of Situs RERC, a real-estate research firm that advises investors on property values and market direction. “There’s going to be a market correction.”

If there is a downturn, few expect it to be severe because the economy is still creating a healthy level of jobs and lending has been far less aggressive than in past booms like 2007, when highly leveraged developers defaulted as the market slowed. Developers back then were routinely able to secure debt for more than 90% of the value of a building, compared with less than 80% today.

Any correction now, Mr. Riggs said, will be “let’s call it, manageable.”

Still, there are several pockets of concern.

The Northborough Tower is one of numerous office buildings in which debt is coming due in the Houston area, where the amount of office space vacant or soon to be available for lease was 23% at the end of 2015, up from 17.8% a year earlier, according to real-estate services firm Savills Studley. With vacancy expected to rise further still, investors are staying away from the area and lenders have grown particularly wary.

Worse yet are the oil-drilling boomtowns in west Texas and North Dakota, where apartment rents have plunged thanks to a growing level of new supply hitting the market at the same time that low oil prices have sapped demand.

A similar effect can be seen in New York, where the condominium market aimed at the superrich has slowed just as a wave of towers are hitting the market.

“The for-sale condo business has dramatically slowed at all price points and in all neighborhoods,” said Steven Roth, chief executive of Vornado Realty Trust, during an earnings call last month. The company is building a 950-foot condo tower on Central Park South.

In turn, lenders have eschewed the sector, leaving developers who paid high prices for land unable to pay off their debts.

Such is the case for the Bauhaus Group, a developer that had planned a slim, tall condo tower on Manhattan’s East Side but is now fighting in court with lenders seeking to foreclose after the owner didn’t repay $147 million in debt.

Another developer, Ian Bruce Eichner, is facing a similar attempt to seize his site in Harlem, where he had planned a 680-apartment rental project.

A spokesman for Mr. Eichner has previously said the capital markets have retrenched and the timing is unfortunate. The developer has been seen as something of a canary in the coal mine. He was among the early, high-profile defaults in 2008, when he lost control of a $4 billion Las Vegas casino project.

Meanwhile, loans are becoming harder to secure even for safe investments such as well-leased buildings. That is because broader market volatility has caused lenders who sell off their loans via bonds known as commercial mortgage-backed securities to grow wary. While the segment made about $100 billion in loans last year, it has come to a virtual halt today, lending executives said. If that continues, it will become more difficult for landlords who took out 10-year loans in 2006 to refinance today.

The pullback might bring back business for so-called workout specialists, who help landlords escape foreclosure by modifying their debt.

With more debt coming due and other conditions, defaults are bound to increase, said Robert Verrone, a veteran lender whose Iron Hound Management Co. also helps borrowers modify troubled mortgages.

“The amount of inbound phone calls has definitely increased,” he said.

In terms of New York City, Konrad Putzier of The Real Deal reports, See you later, CMBS?:

Over the past few years, as New York’s commercial real estate market kept trying to outdo itself, CMBS lenders provided a big portion of the money fueling the boom. But in early 2016, new commercial mortgage-backed securities have largely retreated from Manhattan, leaving property investors with fewer financing options and further spooking an already nervous market.

Manhattan CMBS issuance has been declining since mid-2015, after a strong start to that year and hit a two-year low of $40 million in January before recovering slightly in February, according to CMBS research firm Trepp. Uncertainty in global bond markets was the main reason for the slump.

On Feb. 9, mid-sized CMBS lender Redwood announced it would stop issuing new loans. “We have concluded that the challenging market conditions our CMBS conduit has faced over the past few quarters are worsening and are not likely to improve for the foreseeable future,” the firm’s CEO Marty Hughes said in a statement. Others may soon follow suit.

“2016 kind of began with an air of pessimism,” said Sean Barrie, a research analyst at Trepp, adding that he expects small CMBS lenders to be hardest hit. “A couple of small [CMBS] shops had started to kind of close up and that’s going to happen more with players with very little skin in the game,” he said.

CMBS 101

First, a quick primer on how securitization works: CMBS firms issue real estate loans, repackage these loans as bonds and then sell them off to investors. The yield (return on investment) bond investors are willing to accept determines the interest rates CMBS lenders can offer to their borrowers.

For example, if a CMBS issuer believes that investors will buy CMBS bonds at a yield of 6 percent, it will have to charge its borrowers an average interest rate of at least 6 percent for the underlying loans. Any rate lower than that, the issuer would lose money.

Over the past couple years, bullish bond investors were willing to accept extremely low yields on CMBS, in part because loose monetary policies around the globe had pushed down interest rates. This in turn meant CMBS lenders could offer borrowers low interest rates on loans, expanding their market share and offering real estate investors a cheap way of funding acquisitions and refinancing their existing portfolios.

The recent global stock and bond market turmoil, which began in mid-2015 but really accelerated over the past few weeks, put an end to the party. Over the past year, the average spread between five-year AAA CMBS bonds and U.S. Treasury notes grew by 75 percent. In other words: bond investors spooked by the worsening global economic outlook are now willing to pay less for CMBS and demand higher yields. By extension, this means CMBS lenders have to charge borrowers higher interest rates, making them a less competitive source of real estate financing.

Frequent changes in bond yields have added another challenge. “There’s no stability in the market, it’s just so hard for people to price loans accordingly,” said JLL’s Kellogg Gaines. In order to price a loan, CMBS issuers need to have a sense of what kind of yields the bond market will command weeks or months from now, when the loan gets securitized. Volatility makes that tough, leading some to hold back on issuing loans. “Certain lenders have trouble understanding the market,” said Gaines.

And finally, under new federal rules that kick in at the end of the year, CMBS issuers will have to keep a portion of the loans they issue on their own balance sheets. This so-called “risk retention” policy, designed to discourage reckless lending, increases issuers’ cost of capital, and Trepp’s Barrie called it a “main impetus” behind the CMBS slowdown.

What does all this mean for the New York real estate market?

For these reasons, CMBS lenders have lost much of their glitter in Manhattan. Avison Young’s David Eyzenberg said he is currently arranging financing for a retail property that in the past would have been a shoo-in for CMBS. But now, no bids from CMBS lenders came in.

If bond markets stabilize, CMBS could yet make a triumphant return. But for now, the city’s real estate players will have to look elsewhere for funds.

Since January 2014, $26.7 billion worth of CMBS loans for Manhattan properties have been issued. Conventional wisdom holds that fewer sources of funding will ultimately lead to higher debt cost and lower commercial real estate prices.

“Spreads have widened out. If your debt is more costly it will affect the pricing of equity,” said John Kukral, CEO of Northwood Investors and former head of real estate at the Blackstone Group, speaking generally.

Still, observers argue that the impact on Manhattan real estate will likely be limited, provided other sources of financing are still available. Most major commercial real estate loans in New York City are issued by balance-sheet lenders, such as insurance companies or banks, according to Gaines. Eyzenberg echoed the point: “It’ll affect maybe a small portion of market but for the most part the New York City market will be unaffected.”

We shall see how "limited" the impact of this CMBS hiccup will be on Manhattan real estate. When you see big banks firing traders and big hedge funds reeling in this market, you know the party in real estate is over for now and it can take a long time to recover.

In fact, I see activity picking up at a lot of real estate funds focusing on distressed investing. Distressed specialists like John Grayken of Lone Star Funds, Howard Marks of Oaktree Capital and Leon Black of Apollo Group have become a new powerful class of “shadow” bankers.

Among them the most shadowy is John Grayken:

PRACTITIONERS OF “DISTRESSED investing” are a special Wall Street breed: bottom-fishers with steel constitutions and a penchant for rushing into fire sales. Like short-sellers, they are often despised because they prey on the weak–companies and individuals who made bad bets or got in over their heads. “Distressed investor” is a sanitized version of less flattering terms from bygone Wall Street eras: vultures, grave dancers, robber barons.

Among the robber barons of the new millennium, few are as secretive–or as loathed or as successful–as John Grayken of Lone Star Funds. The 59-year-old debuts on the FORBES Billionaires list with a net worth of $6.3 billion, making him the second-wealthiest private equity manager in the world, behind Blackstone’s Stephen Schwarzman. Lone Star has amassed assets of $64 billion, and since its inception in 1995 its 15 funds have logged average annual net returns of 20%, without a single year in the red.

Schwarzman’s Blackstone, which has assets of $336 billion, has comparable average annual returns of 17%.

However, unlike Schwarzman, who employs a small army of professionals to help him and his firm burnish their image through various benevolent causes, Grayken appears to care little about getting good press. You won’t find any libraries or schools or hospitals with his name on them. He hasn’t signed Warren Buffett’s Giving Pledge. And he’s anything but a patriot: In an effort to avoid taxes, he renounced his U.S. citizenship in 1999. You’ll find him on our list as a citizen of Ireland.

Since the Great Recession Grayken has made a specialty of buying up distressed and delinquent home mortgages from government agencies and banks worldwide. He’s also picked up a major payday lender, a Spanish home builder and an Irish hotel chain. Regulators hassle him, and the homeowners whose mortgages he owns or services despise his tactics. In fact, he has become accustomed to taking shots from detractors and has been the subject of protests from New York to Berlin to Seoul. Last year New York Attorney General Eric Schneiderman reportedly opened an investigation into Grayken’s heavy-handed mortgage-servicing tactics, including aggressive foreclosures, which have unleashed widespread outcries from homeowners, housing advocates and trade unions.

“There are real questions about the human costs of Lone Star Funds’ business practices,” says Elliott Mallen, a research analyst for Unite Here, a union representing 270,000 hotel and industrial workers.

It’s even doubtful Grayken, who refused to comment for this story, is well liked within his own firm. According to pension fund documents, he is the sole owner of Lone Star and its affiliated asset management firm, Hudson Advisors. Unlike other major private equity firms, which generously share equity among partners, Grayken has a tight grip on his firm’s ownership. While his top employees have become multi millionaire-rich, a number of key lieutenants have departed as Grayken has apparently never valued anyone enough to offer significant ownership in his operation.

The one group that loves Grayken: pension fund managers, who consider him an alpha god and who happily overlook his sins. “Over the decades John has had phenomenal returns and executed a very disciplined investment strategy–he is in a league of his own,” says Nori Gerardo Lietz, a Harvard Business School professor who ran one of the largest firms that advise pension funds on their private equity investments. “Many of the other real estate and private equity players are really jealous of John Grayken.”

The Oregon Public Employees Retirement System has invested $2.2 billion in many of Lone Star’s funds. In 2013, for example, it committed $180 million in Lone Star Fund VIII and has already posted annualized net returns of 29%. A $4.6 billion fund Grayken raised in 2010 has returned 52% per year to Oregon pensioners.

With regulators all over the world forcing big banks to deleverage and retreat from various risky businesses, hedge funds and private equity firms like Lone Star have stepped in and are making a killing buying assets from banks on the cheap. Distressed specialists like Grayken, Howard Marks of Oaktree Capital and Leon Black of Apollo Group have become a new powerful class of “shadow” bankers. Among them the most shadowy is John Grayken.

LAST YEAR THE BRITISH TABLOIDS wondered who had purchased one of the U.K.’s most expensive homes in London’s Chelsea district. The nine-bedroom, nine-bathroom, 17,500-square-foot brick mansion with a glass elevator, basement pool, cinema and Japanese water garden was purchased for $70 million by a Bermuda company. Evidence of the mysterious buyer can be found in a Massachusetts state court, where the home is listed as Grayken’s address in a probate filing. Grayken is also the owner of a 15-bedroom manor house on 20 acres outside of London that was featured in The Omen, a 1976 horror film starring Gregory Peck. Corporate records also show Grayken owning a massive Swiss estate overlooking Lake Geneva.

Though Grayken’s firm is headquartered in Dallas, he lives in London because he can’t spend much more than 120 days a year in the U.S. without having to pay the U.S. taxman. People who know him say he likes to summer close to his family in Cohasset, Mass., the Boston suburb where he was raised. In Cohasset, the small, private White Head Island, which dances in the Atlantic Ocean, cut off from the mainland by a small bridge, belongs to a Bermuda company controlled by Grayken, which purchased it for $16.5 million in two transactions in 2004 and 2007.

Grayken grew up in a less rarefied section of Cohasset, where he excelled at school and on the ice rink. He studied economics at the University of Pennsylvania, where he was a defenseman for the hockey team. In a nifty bit of foreshadowing, he broke the team record for penalty minutes. After Penn he got his M.B.A. from Harvard Business School in 1982 and then landed in investment banking at Morgan Stanley.

Grayken wanted to be a real estate developer and eventually found a job working for Texas billionaire Robert Bass on an office-tower deal in Nashville. The project wasn’t a huge success, but the Tennessee experience cemented Grayken’s relationship with Bass and introduced him to his first wife, a Nashville native.

At the time the billionaire Bass brother had been successfully investing his inherited fortune with the help of a talented group of future Wall Street titans that included David Bonderman and Thomas Barrack. These were the days after the junk-bond-fueled S&L crisis, when the government-sanctioned Resolution Trust Corp. was liquidating hundreds of failed institutions.

In 1988 one of the largest, American Savings Bank of Stockton, Calif., caught the eye of Bass, who bought the thrift and with the help of Barrack began selling its assets at a big profit. At Bass’s direction Grayken was dispatched to southern California to join the team and work with Barrack at a Bass affiliate that would become Colony Capital.

Barrack and Grayken did not get along, say people who know both men. Next, Bass put Grayken in charge of a $130 million partnership called Brazos (named after a Texas river where the Bass family is based) that worked with the FDIC to purchase 1,300 “bad bank” assets. Grayken quickly flipped them, making tens of millions of dollars in profits. Bass then backed Grayken in a bigger bad-loan fund, which Grayken transformed into about $160 million in profits. Most of the benefits, however, went to Bass.

When Grayken and Bass couldn’t agree on how to share the profits for the next fund, the duo parted ways in 1996. Grayken stayed in Dallas, raised some $400 million and called his new operation Lone Star Funds. His specialty was buying non performing mortgage loans, but he started to originate some mortgages and directly purchase real estate. Starting with Canada, Grayken also ventured into international markets.

Early on he made several strategic decisions that would define his success and differentiate him from competitors. Unlike Colony, Apollo and other opportunity funds that grew out of the S&L crisis and expanded into other areas, Grayken stayed focused on distressed assets linked to real estate, like delinquent mortgages. When the U.S. economy was doing well, he would set his sights on countries where tough times meant easier pickings. By 1998 Lone Star was in Japan, where ravaged banks preferred selling troubled loans at sharp discounts privately, in order to save face, rather than hold embarrassing public auctions for potentially higher prices. By the end of the 1990s Grayken had moved into troubled European nations like Germany and France.

Grayken also developed a reputation as a flipper. The life cycle of his funds is short–investment periods of about three years or less. The assets come in, are worked out and sold. Buying and holding à la Buffett is for suckers, according to Grayken’s philosophy. At Lone Star there are no pretenses about longer-term investing or any sentimental attachments to assets, even in cases where more profit can be squeezed out over a few more months or years. Leaving meat on the bone for others is fine. For Grayken the key part of any transaction has always been a cheap purchase price, not any magic that happens afterward. Others can find ways to spruce up assets if they like. “We do our profit on the buy” is how Lone Star’s president, André Collin, described the strategy in a February 2016 meeting. “We do some of the value-add stuff from time to time if it’s there and part of the plan, but if I have an opportunity to sell and I get a good price for my investor, I sell.”

Quick turnarounds work wonders in goosing the all-important internal rates of returns on Lone Star’s funds. Shorter holding periods mean more distributions to investors, who reward Grayken by investing in his next fund. The fees Grayken charges are rich. A typical Lone Star arrangement calls for a fee of between 0.6% and 1% of assets under management. Lone Star then keeps 50% of all profits once the fund’s return hits 8% and until it reaches 20%. Beyond 20% Lone Star reaps between 20% and 25% of the profits.

“Grayken, to his credit, has a masterful way of simplifying the process of both buying and selling assets,” says David Hood, who helped found Lone Star and worked there for six years. “He has always bought in volume to create liquidity when it wasn’t otherwise there, and he doesn’t mince words. Just like a hockey player, he is ready to take the gloves off.”

One key aspect of Lone Star’s superior returns: Grayken’s Dallas-based asset management and due diligence arm, Hudson Advisors. Teams at Hudson are responsible for performing full financial analyses and reviews of investment opportunities after Lone Star’s managers have identified them. After a deal closes, Hudson works out and services the loans. It also steps in with legal and accounting help. Hudson now has 865 people, offices around the world and only one client: Lone Star. In the subprime-mortgage business having good data on pools is critical in pricing assets, so Hudson acts as Grayken’s valuable database, giving Lone Star an “edge.” It’s also a backdoor way for Grayken to personally extract extra profits from Lone Star’s hefty asset base. He owns 100% of it and charges Lone Star Funds an average annual management fee of 0.55% of assets.

WHILE PENSION MANAGERS eagerly await distribution checks from Grayken, tenants and owners of the real estate he sets his sights on dread their new landlord. After he bought the discounted mortgages of ten apartment buildings in the Washington Heights section of Manhattan from Anglo Irish Bank following the financial crisis, residents flew bedsheets out their windows that said, “Speculators Beware.” When Lone Star started doing deals in Japan, it was locally referred to as part of the h agetaka, or bald hawks. In South Korea Lone Star is known as meoktwi, eat-and-run capital. The German press called Lone Star “the Executioner from Texas” after the firm bought a boatload of non performing loans that resulted in homeowner foreclosure proceedings.

Things got hot enough in Germany that Grayken conducted a rare interview with a German publication to explain his side of the story. “No matter where we are active, we adhere to applicable laws,” he said. “Lone Star has no interest to propel someone into insolvency. We prefer when people meet their payment obligations. If not we will take appropriate action.” After the interview Grayken spent $775 million in 2012 to buy TLG Immobilien, an East German owner of 800 buildings held by the government. Within three years Grayken flipped the property for a profit. German politicians argued that taxpayers had been “cheated.”

Germany’s disdain for Grayken is nothing compared with the reputation he has forged in South Korea. In the aftermath of the late-1990s Asian financial crisis, Lone Star bought a controlling share of Korea Exchange Bank (KEB) in 2003 for $1.8 billion. By 2007 Lone Star had received multiple offers for its KEB stake, one as high as $6.4 billion. The deal produced outrage in Seoul, where the perception was that the most painful parts of the Asian financial crisis were the fault of foreign interests. There were legal and regulatory investigations into whether the stock prices of KEB and a separate credit card operation were manipulated downward to enable their discounted purchase. The Korean government blocked the sale, and Lone Star’s man in Korea, Paul Yoo, was convicted of manipulating the stock of the credit card unit and sentenced to three years in jail. To make matters worse, another Lone Star employee in Korea was caught embezzling $11 million from the private equity firm.

Grayken denied any wrongdoing and argued that the Korean government’s actions were arbitrary and discriminatory and ignored Lone Star’s role in rescuing a big bank. Remarkably, Grayken persevered in Korea and ultimately was able to sell his KEB ownership to Hana Financial in 2012, booking a reported $4 billion profit. This, of course, wasn’t enough for Grayken, who is now pursuing arbitration to recover billions more in profits he believes he would have gotten in the original deal.

And if you thought banks behaving badly in America were a thing of the past, Grayken's Texas mortgage company, Caliber Home Loans, has become infamous for its tactics as a servicer of subprime loans, some dating back to before the financial crisis. Caliber is one of the largest and fastest-growing mortgage companies in the nation, managing more than 325,000 mortgages and worth some $70 billion. A good number of Caliber’s mortgages were purchased by Lone Star Funds at a deep discount–70 cents on the dollar–during auctions held by wards of the state Fannie Mae and Freddie Mac and the Department of Housing & Urban Development.

In a stroke of brilliant financial maneuvering Lone Star bundled some of the mortgages into bonds and sold them to investors, immediately booking large profits. At the same time Caliber offered “temporary” loan modifications to distressed borrowers that consisted of five-year interest-only payment plans but failed to offer the homeowners any permanent relief through principal reduction. At the end of the five years these loans would revert back to the original payment terms, with all the deferred payments added in.

“Lone Star has bought these loans at a discount from the government–in effect, they got principal reduction. But they are not passing this benefit on to homeowners or communities,” says Lisa Donner, executive director of Americans for Financial Reform.

Technically speaking, the federal government does not require Grayken’s operation to offer principal reduction, but there has been a roar of voices claiming that Lone Star is abusing the situation. In February the National Housing Resource Center released a survey of non profit housing counselors that showed Caliber was the nation’s lowest-rated big servicer and among those doing the “worst job of complying with the servicing rules.” A labor union is accusing Caliber of building a new Countrywide Financial, given that its CEO and top executives are refugees from that hotbed of housing-crisis instigators.

In September the New York Times reported that many of the delinquent mortgages Loan Star bought have ended in foreclosure. Its editorial board went on to accuse Lone Star of relying on the “foreclosure and resale of the homes to make money.” New York Attorney General Eric Schneiderman reportedly opened an investigation. Lone Star and Caliber declined to comment.

None of this has slowed Grayken, who has gobbled up $120 billion in assets since the financial crisis, including Home Properties, an apartment REIT in Rochester, N.Y., for $7.6 billion in October. His latest Lone Star fund is now raising $5 billion trained on real estate in Europe, where banks are still rapidly deleveraging. Grayken has personally invested $250 million in the fund, his 16th, adding to the $1.3 billion he already has invested in Lone Star’s other funds.

His pension clients, including the Employees’ Retirement System of Rhode Island, the New York State Teachers ‘Retirement System and Dallas’ Fire & Police Pension System, have yet to make a peep about Grayken’s sleazy subprime mortgage operation. If they have any concern about their American-born Irish golden goose, it’s over Lone Star’s succession and Grayken’s health.

Over the years a parade of talented partners, almost anyone Grayken has ever worked with closely, have left the firm because they either felt shortchanged financially or had disagreements with Grayken. His long time number two, Ellis Short, who helped found Lone Star, left in 2007. Short did well enough at Lone Star to buy Sunderland, an English Premier League soccer team. The divorce case of another former exec, Randy Work, revealed that he had accumulated a $225 million fortune (also see An Apology to Lone Star Investors).

Still, their riches pale in comparison with those of Grayken, who rules with an iron fist and has little tolerance for mistakes. “He felt in many cases that the people beneath him were inter changeable,” says one former top Lone Star manager. (Grayken has also had turnover in his personal life. He divorced his first wife shortly after becoming a tax refugee, changed his mind, got her to take him back within a month of the final divorce decree and then got redivorced six months after that. He eventually married his secretary in London, and the couple have four children.)

Grayken recently flew to South Dakota to visit with a pension client and allay succession fears. As a South Dakota Investment Council member recently put it, “I am concerned about what happens when John passes away. It might just all end.”

But until that happens, the pension funds are happy to deposit more retirement money in the Irish billionaire’s shadow bank. Shortly after the meeting, South Dakota agreed to invest $300 million in Lone Star’s newest investment fund.

After reading this article, I now understand why John Grayken promoted André Collin to the position of president of Lone Star Funds. André loves taking huge risks in opportunistic real estate, made big bonuses at PSP trouncing his bogus benchmark precisely by investing billions in opportunistic real estate deals and funds like Lone Star (read this Oaktree primer on real estate to understand these risks).

He also set himself up nicely at Lone Star Funds and is now "Grayken's top man", becoming richer, more powerful and more famous than he could have ever imagined (I'll give the man credit, he can give Donald Trump a lesson in negotiating "great deals").

And while John Grayken is no Jonathan Gray or Stephen Schwarzman when it comes to charity, he's undeniably one of the world's best real estate investors and charges hefty fees for the honor of investing in his funds which is why he's one of the world's richest private equity fund managers (still needs to work on better governance at his fund and succession plans).

If there's going to be a real estate debacle or correction anywhere in the world, I guarantee you John Grayken and his team at Lone Star Funds are going to be there to profit from it through intense distressed debt investing (they've been poaching talent from investment banks over last few years). They won't be able to print 20% or 30%+ returns of the past but they will still make exceptional double-digit returns, making a killing in fees in the process.

Below, around $400 billion in commercial mortgage-backed securities are set to mature in 2016 and 2017 but spreads are no longer favorable to investors, reports CNBC's Diana Olick.

Also, Tom Barrack, founder and CEO of Colony Capital LLC, talks about the U.S. economy, housing and Federal Reserve monetary policy. He spoke with Trish Regan on Bloomberg Television's "Street Smart" (read more on Tom Barrack and the rise of a titan here and how he's skipping drama for boring old mortgage debt here).

Third, a rare glimpse of the shadowy billionaire, Lone Star founder and chairman John Grayken, arriving at court in South Korea last summer to testify in a high-profile trial involving allegations his fund engaged in stock price manipulation. He denied the fund did anything illegal.

Lastly, I embedded a discussion between Blackstone's Jon Gray and Howard Lorber, President and CEO of Vector Group, at the University of Miami Business School's 2016 Real Estate Impact Conference.

This is a great discussion where you'll see why Jon Gray is one of the world's best real estate investors and the next in line to take over the helm at Blackstone when Stephen Schwarzman steps down (I'd love to talk to him, Barrack or Grayken about following Prem Watsa investing in real estate opportunities in the Banana Republic of Greece).

On that note, I remind all of you, including Jon Gray, Stephen Schwarzman, Tom Barrack, John Grayken and André Collin that it takes a lot of time and energy to write these comments, so please do the right thing and subscribe or donate to my blog on the right-hand side via PayPal. I thank all of my supporters at Canada's Top Ten pensions and wish all of you a great weekend!