Three’s Company: 3650 REIT Built Its Business For This Exact Moment
By Cathy Cunningham May 2, 2023 8:00 amreprints
Iceberg! Right ahead!” said a lookout on the RMS Titanic as the white, shimmering behemoth came into view out of the night sky.
While some lenders were caught off guard and left without life jackets in this past year’s market version of that iceberg, others saw it coming well before the Titanic even set sail.
The tip first came into view in 3650 REIT’s binoculars last summer.
“We started saying, ‘OK, if the banks have $6 trillion of securities, and the Fed raises interest rates — about 300 basis points at that point — what will happen to the capital position of banks, and is that something that will flow into the liquidity space?’ ” said Justin Kennedy, a co-founder of 3650 REIT. “We should have asked an additional question about the regional banks, which had vastly more securities this time around, and were buying big books of mortgage pass-throughs, not hedging and just assuming they could go in the in the held-to-maturity (HTM) book — which obviously wasn’t a very good strategy.”
For his firm, a non-bank lender founded in 2016 that today has offices in Miami, L.A., Atlanta, Dallas and New York, it’s a perfect opportunity.
“We built the firm for this moment,” Jonathan Roth, co-founder of 3650 REIT, said. “We have a team of seasoned professionals that understand real estate from A to Z, understand the capital markets better than most, and have lived through multiple cycles knowing how to put Humpty Dumpty back together again when times get difficult.”
While several financiers are struggling just to stay afloat today or sitting on the sidelines waiting for the waters to calm, 3650 REIT came into this crisis ready to transact with a clean book behind it.
“Right now, we’re not spending any time on legacy issues, because we didn’t use leverage,” Roth said. “Our entire portfolio is performing, our servicing portfolio is about $13.5 billion, and we don’t have any loans in default or special servicing.”
Still, the firm is being prudent while surveying the current landscape and choosing its targets carefully.
“We’re very well capitalized right now. We have lots of dry powder,” Roth said. “When we launched our first product in 2018, we thought about what we wanted to be like when we grew up — and we’re doing exactly what we wanted to do.”
Zero to 3650
First off, what’s the 3650 name about, and how should one pronounce it? Is it 3,650? Nope. 3-6-5-0? Nope. It’s “36-50,” and it encompasses the 365 days in a year over a 10-year loan term in terms of how many days the co-founders intended to be there for their borrowers when they launched the firm — in other words, for the life of the loan from cradle to grave.
“We built the firm to touch the loans for 3,650 days — so every day we can be there to help borrowers create value or make the best out of a tough situation,” Roth said.
The three co-founders first sat down together in 2016, and asked what was important as they built a new force in non-bank lending.
“We all knew that owning and operating a firm with people who can asset manage and loan service through the life of a loan was absolutely critical,” Toby Cobb said.
As such, the co-founders spent a lot of time — and money, Cobb noted — building that very company.
“We started 3650 with a fundamental vision of being a firm that can touch assets in their local markets, work with borrowers that are constantly adding value to their properties, and creating financing to help them do that,” he said. “We asked, ‘How do we asset manage our loans in a way that makes it as easy as possible for them to continue investing?’ ”
They also built a firm that could be active in all market times, with lessons learned coming out of the Global Financial Crisis top of mind, Kennedy said.
Cobb and Kennedy were the co-heads of U.S. real estate and real estate capital markets, respectively, at Deutsche Bank through the GFC, before becoming co-CEOs at CMBS special servicer LNR Property. Roth was president of L.A.-based hedge fund Canyon Partners. Between them, they had the “whole market spectrum capability set,” Kennedy said. “It’s a key part of our business today.”
Cobb and Kennedy’s asset management and servicing experience is particularly handy in this environment. They brought experience working out roughly 1,800 loans at LNR.
“When you look at our firm of 77 people that’s now rated as highly as [special servicer] Situs in the special servicer rating, we’re way ahead of some firms that have been in the business a lot longer than us in creating a service that can handle distressed credit environments,” Kennedy said.
The iceberg approaches
Certainty of execution in lending is always important, but it’s become a hotter topic in the past year as borrowers found themselves frequently hung out to dry by their lender as credit tightened.
“We’re a provider of capital, and when we say we can do something, we show up and we do it,” Roth said. “One of the statistics that I am most proud of is that 75 percent of everything we originated in 2022 was either with a repeat borrower, or a borrower with whom one of us had a prior relationship. I think, going forward, the universe of folks like us is going to get smaller and smaller.”
The have and have-not gap will also only widen for certain asset types.
“The required capex is the issue for many of these properties [requiring refinances today], especially office and older hotel assets,” Kennedy said. “Capex is the issue for each of those property types and the question is, ‘Is it going to be worth it to put in the capex that’s necessary to keep these properties alive?’ And the answer with a lot of properties is going to be ‘No.’ ”
As such, 3650 is focusing its efforts on “dynamic regional economies” within markets, or the place where everybody wants to have their office in that particular market, leading to higher rents all around, Kennedy said: “The idiosyncrasy of asset classes has become more pronounced than it’s ever been in the past.”
As a result of the ongoing market turmoil, 3650 REIT’s founders have been fielding calls from panicked borrowers left and right.
Roth breaks them down into a few categories.
“One is, ‘Hey I’m a borrower, I’ve topped off my multifamily building, and the lender that I went with just called me up and said that they’re no longer able to fund the loan,’ ” he said, adding that sometimes — because we live in a litigious world — lenders will tell borrowers their loan is out of balance and make a request to restore said balance, knowing full well the borrower is incapable of fulfilling the request. (Shame!)
Some lenders are being brutally honest with borrowers, even while delivering unwelcome news.
“They’re basically saying, ‘Sue me,’ ” Roth said. “They’re telling borrowers, ‘I can’t fund your loan, I’m not going to close your loan, I’m not going to continue funding your loan.’ ”
And some of those borrowers are then calling 3650 for help.
3650 REITs approach is different from the aforementioned lenders — whom Roth was too much of a gentleman to name — and emphasizes relationships, human decency and good old fashioned manners.
“Lending is as much about human nature as it is real estate,” he said. “It takes a long time for trust to build up, and that’s why it’s critically important that we create a relationship with our borrowers on the front end — because when something goes bad, you’re not just getting to know one another. You already know each other, and you can sit down and have a constructive conversation.”
A crisis unlike any other
The comparisons to the GFC have been reused like subway cards these past two months, but “it feels better this time around,” Kennedy said. “While clearly there were some misjudgments and maybe non-judicious investment decisions here, there wasn’t the smoke and mirrors that existed last time around. This is here in the open for everybody to see.”
Plainly, “the cost of capital doubled, and we are an asset class that uses a lot of capital, particularly debt capital,” he said. “As such, that repricing has fundamentally changed the situation in the market. It’s not so much a case of people doing things that were not hunky-dory.”
Cobb agreed that this time is different in that nobody was particularly greedy or utilizing the heady world of financial engineering this time around, but rather he blames carelessness around the mismatch between banks’ assets and liabilities. “That makes it feel a little bit more like the savings and loan crisis,” Cobb said. “I think we’re going to find out more and more that banks were lending or investing long, fixed-rate, and they now have this mismatch in their book.”
As such, Cobb predicts a new regulatory regime is on the horizon which could look a lot like what Dodd Frank was originally written up to look like.
“Risk retention [in CMBS] got watered down so badly,” he said. “It was just a bad decision for the regulators to allow vertical risk retention [which requires a CMBS issuer to retain 5 percent of each tranche of securities as skin in the game],” he said.
“It was also a horrible decision to not continue to do stress tests and have more of these midsize regional banks go through tests to determine whether or not they were making this mismatch happen,” Cobb continued. “Frankly, we still don’t know the extent of the damage, because the opacity of the bank balance sheet is such that nobody really knows what’s on it anymore.”
As such, Cobb describes the fear that has been whipped up by bank failures as “well founded — what do the banks have in their HTM book that is walled off and not being looked at by anybody, including bank analysts?”
Contrasting that doomed asset-liability mismatch, 3650’s model aggregates capital that is long dated and patient — an approach that logically fits commercial real estate as an asset class better than the deposits banks depend on.
“Our liabilities are aggregated through firms that expect to be investing for five, seven, 10 years. They go into the expectation that their capital is going to be deployed, and be outstanding for a long term,” Cobb said. “For that reason, I see the alternative lending universe having more relevance, just as it did in the wake of the GFC.”
This approach to its capital sources was something that was also decided as the three co-founders mapped out 3650’s blueprint in 2016.
Looking at the characteristics of the most successful real estate coming out of the GFC, the clear answer was the insurance companies in terms of their patient capital and also approach to lending. “They create loans on their balance sheet they manage, they only do loans with people they have relationships with, and they manage those loans throughout their life by managing the relationship with the borrower,” Roth said.
While banks have historically claimed the “relationship lending” reputation corner of the market, rightly or wrongly, 3650 REIT is one non-bank giving them a run for their money — no pun intended.
While Roth was creating a business in L.A at Canyon Partners, and Cobb and Kennedy, as “bankers to the stars” at Deutsche Bank, wanted to bank him, Cobb started calling Roth. Eventually they did some business together, but they were also friendly competitors.
“Every time I talked to a potential borrower, I’d ask, ‘Who else are you talking to?’ and they’d say ‘Deutsche Bank,’ ” Roth said. “I’d then hit my head against the wall because they had much cheaper capital than we did, so I would have to then sell our creativity and the fact we weren’t shackled by all the constraints that banks are shackled by.”
But, timing is everything. Roth left Canyon in 2015 with an intention to build a 3650-esque platform of his own and was having a drink with Miami Worldcenter developer Nitin Motwani one night shortly thereafter. Motwani was rushing off somewhere as drinks concluded.
“I said, ‘Where are you rushing?’ and he was rushing to go have dinner with Justin and Toby,” Roth recalls. “I said, ‘Give them my regards, and what are they doing these days, by the way?’ ”
Motwani told Roth they were launching a lending platform. “Have them call me,” Roth replied.
Roth’s phone rang 19 and a half minutes later. It was Cobb: “Hey brother, let’s meet for a drink.”
The three ended up meeting at 10 that night, and, on the back of an envelope, they mapped out a plan for 3650. The rest is history.
“It was about a shared sense, or collected beliefs around really what is core to success,” Cobb said. “We also believe that each of us is a fundamentally good person, and we trust each other. Those are the things that make for good partnerships, whatever the market.”