From real estate to riches

Most private equity real estate funds didn’t stray far from their home markets in the past, but now, to keep returns up, funds are looking at property or property funds from around the globe. Most of the investment is headed east, in the sense that Asia overall and Eastern Europe are among the two fastest growing markets. But there is renewed interest in the US and the UK as slowing economies have driven prices down and offered new opportunities.

“There is definitely a wider, more global perspective taking shape in private equity real estate investment,’’ says Nori Gerardo Lietz, a partner and chief strategist for Private Real Estate in the San Francisco office of alternative asset managers Partners Group. “In the past, most funds looked to the home markets because they were easy to understand. But it’s becoming clear to managers that there is a big world out there with interesting prospects.”

“Investors are clearly diversifying their risk on the international markets,” agrees Alasdair Evans, director of corporate real estate finance at the London-based fund manager Hermes Real Estate Investment Management Limited. Evans is in a position to know. His largest client, the BT Pension Scheme, announced a US$1400m investment programme in overseas real estate last November. Three investment managers from the Abu Dhabi Investment Authority have been recruited to lead the new programme. BTPS had hitherto invested strictly in UK real estate through Hermes to the tune of £4.2bn. Now about 2% of that will be invested primarily in Asian and Continental European opportunities.

Evans says that changes on the UK market are part of the reason for this move abroad. “The sub-prime debacle simply underlined a trend that had been going on for about a year previously. Yields had been out of sync with debt costs for about that period of time; the sub-prime crisis simply crystallised all of that.’’ Evans expects a price correction on the UK market, which may make it more interesting once again.

“Nonetheless, it’s obvious that we have to look abroad, both to maintain a high level of return, and to take advantage of the best opportunities,” Evans adds.

There are 106 funds investing approximately US$67bn in real estate in 2007, roughly the same levels as in 2006, according to Ignatius Fogarty, head of real estate at London-based Private Equity Intelligence. Of funds on the road, an increasing number are targeting European and Asian markets. “There are a substantial number of funds on the road in real estate at the moment, and the level next year may be expected to be somewhat higher,” Fogarty says. These are in the process of raising about US$100bn at this writing. The East is really hot, meaning both Eastern Europe and Asia, and we expect interest in these areas only to grow.”

The level of reorientation is demonstrable. Today, according to Private Equity Intelligence, for funds which have reached a final close 2007 YTD, 15% of funds with a primary focus on America will be investing in other parts of the globe, and 3% of funds with a primary focus on Europe will be investing in other parts of the globe. For funds which are currently in the market, 12% of funds with a primary focus on the US will be investing in other parts of the globe, and 1.3% of funds with a primary focus on Europe will be investing in other parts of the globe.

The trend is a marked change from previous investor attitudes. “There has been a sizeable increase in the allocation of pension funds to real estate, and an increasingly large part of that is going to international markets,” says Serge-Alexandre Lauper, head of real estate/infrastructure at the Zurich-based advisors/gatekeepers SCM Strategic Capital Management. “In the past five years, for example, US pension funds have increasingly shifted investment to real estate and are now looking abroad as the home market slows. The same is happening with Swiss funds: while there was a sufficient yield from assets they stayed in Switzerland. Now the entire market is becoming less regionalised, and there is a growing appetite for this kind of investment.’’

There is a broad split in private equity real estate investment between the larger funds, which tend to invest in property directly, and the smaller ones which tend to make indirect investments via non-listed funds. The latter approach spreads and controls the risk better, but returns are better where direct investment is possible, says Fogarty. Investors have a widening choice of both listed and private property funds that they can use to access real estate.

“It’s the logical choice of entry to the asset class for smaller investors, especially outside their domestic market,” says John Forbes, real estate industry leader with PriceWaterhouseCoopers in London. “These investors go indirect to get access to skills, or particular assets, or more rewarding parts of the market.” Forbes points out that the amount of money going into property vehicles is now an important part of the real estate universe. At the latest count, there are some 400-plus private property funds available. They come in all shapes and sizes, from small ones investing in UK convenience stores or car parks in Central Europe to giant, diversified pan-global ones.

But for those investors who go directly into private equity real estate investment, there are more and more opportunities. Value-added investors think their strategy of buying problematic stock and fixing it will yield better results. “It’s more defensive to be in the value-added space,” says Forbes. “You’re more protected if yields start moving the other way.”

This kind of deal is gaining in popularity over debt-based deals which were popular before the liquidity crisis hit world markets. “Highly geared deals are clearly of less interest now, so the returns from value-added are attracting more investors,” says Forbes.

Many investors in the past found it safer to invest in a special purpose vehicle (SPV) created for implementing a number of projects. Using an SPV made sense, because it permitted the vehicle to take on debt, which then assured the earnings flow from all the investments.

In some markets, particularly in Europe, there are also significant tax savings offered by the use of SPV and debt. However, for the time being, the current liquidity crisis has significantly reduced the number of deals of this kind.

Instead, investors are moving into new types and new areas of direct real estate investment. “This kind of core value-added investment offers significant opportunities,” says Lauper, “if management is prepared to make changes to the entire business attached to the real estate, i.e., the hotel, or the nursing home rather than just acquire the property and make sure the building is sound.” Lauper points out that Blackstone has been very successful in putting this strategy to work illustrating its success with the Hilton hotel brand as an example.

Healthcare in Europe is clearly an area where this strategy is also being put to work. As Lauper points out, investment in the area should pool not only the real estate management but also the business management. If a group of healthcare establishments is acquired, the management should combine logistics and purchasing as well as property upkeep to maximise value.

So funds are moving into these new areas of investment in search of higher yields. “You have to look beyond traditional sectors, to others that have real estate and create value from that,” Forbes continues. “Formerly fringe real estate – once the preserve of opportunity or private equity capital – is making its way into the institutional mindset.” This includes property as varied as petrol stations, student accommodation, marinas, motorway services, trade parks, prisons, car parks, and windmills. “Anything producing income.” he adds.

Forbes comments that investors have checked out the demographics and decided there will be good money to be made out of “silver industries.”

In Europe, for example, the population is ageing and older people need seniors’ housing, nursing homes, clinics, and hospitals. These sectors require operating know-how, but increasingly mainstream real estate investors are teaming up with the operating company partners to run the businesses while they work the property company angle.

According to Emerging Trends in Real Estate Europe, a study by PriceWaterhouseCoopers, a significant minority of investors said they are seriously considering the silver sector. They are looking at the health sector. It uses a lot of real estate and there’s an opportunity to unlock value, according to the study. A handful has already taken the plunge and is building up their portfolios seeing it as an opportunity to diversify.

However, nursing homes and seniors’ housing are not for everyone. They require specialist skills and there is reputational risk.

Leisure is another sector that is getting ever-more serious interest, according to the PwC study. Hotels are already virtually mainstream investments. Resorts and second-home developments in Europe’s Mediterranean sunbelt are still considered to have good prospects, as tourists are trying out many new areas with cheaper and more accessible air travel. Demographics will push people in Europe to continue to use Spain over the long term for a second home or short break, according to the study. Golf courses, fitness centres, and spas are other leisure assets that private equity investors are also starting to collect.

The sources of this kind of investment are also far more global than before. The PwC report predicts a continuing surge of Asian, Middle Eastern and Australian money into European real estate funds and direct investment.

The PwC survey suggests every type of investor will be pumping more capital into European real estate next year. It will come from a wider range, including institutional equity investors, wealth managers, and retail investors. Opportunity funds top the table: not surprising, given the massive amounts of money that they raised in 2006. Although many of the global ones are now switching their focus to Asia, Europe still figures prominently in their investment targets. Private investors, partnerships, and pension funds are also high up the league table of equity investors for the coming year.

The result will be increased competition from both private equity and other investors for prime real estate investment targets around the world.