Real estate and private equity: the synergies

With the launch of successor European private equity real estate funds alongside an explosion of new non-listed real estate vehicles, the marriage of private equity disciplines with real estate opportunities is a fast growing feature of the European alternative investment market. Joanna Gant reports.

Doughty Hanson (DH) was one of the earliest private equity entrants into the European real estate market with its US$630m Doughty Hanson European Real Estate Fund I. This closed in 2000 and is now 70% invested. DH is expected to launch Fund II in the first half of 2005.

Carlyle Europe Real Estate Partners raised its first European real estate fund of €430m in 2001. It has set a first closing for early next year on its new fund which is raising north of €500m. Similarly, the €800m Blackstone Real Estate Partners International fund, raised in 2002 for property investment in Western Europe, will soon be due for replenishment.

This summer Patron Capital closed its second private equity fund for investment in undervalued and distressed property assets in the UK and western Europe at €303m, succeeding the US$152m Patron Fund I, raised in 1999.

The top end of the market remains dominated by US investment bank funds such as Goldman Sachs’ Whitehall funds and Morgan Stanley Real Estate Private Equity, which took over Canary Wharf in a £1.7bn deal in May this year. Yet myriad new private equity funding structures are also emerging as new teams, spin-offs and joint ventures enter the field.

The French investment group Eurazeo teamed up with US real estate investor Colony Capital last year to launch Colyzeo Investors, a €400m European real estate fund, for example. In September this year Nord Europe Private Equity and the property group UFG launched Diademe Innovation I, France’s first investment fund to combine both property and private equity investing.

Those investing on the fringes of the property market include PRICOA Property Private Equity, which targets public and private property and real estate-related operating companies with management already in place. Innisfree, the infrastructure investment group, recently raised a £360m private equity fund for primary investment in UK and European PPP and PFI projects. And Hamilton Bradshaw, a private equity firm founded in April 2004, has property and property services as one of its focus areas.

According to the European Association for Investors in Non-listed Real Estate Vehicles (INREV), the non-listed fund market is now estimated at over €250bn in over 400 different vehicles. This compares with a value of less than €50bn in 1993. With the size of the total European property market generally put at around €1.5trn, the non-listed fund market’s share now stands at over 15%.

Given the synergies between private equity and property investment models, more mainstream private equity firms might have been expected to join the party and raise dedicated property funds. As one player explains, however, many of the obvious candidates such as Cinven, CVC, KKR and Permira are smaller and more centralised than a sector pioneer such as Carlyle. “Carlyle has more breadth than nearly any other private equity group in the world. It has a family of funds that give it both asset class and regional diversification,” he says.

John Howard, chief operating officer of Doughty Hanson Real Estate, points out that the property business is fundamentally different to mainstream M & A. “Although real estate requires a similar skills set to private equity and the fund raising process is much the same, it is labour intensive, demands a local presence and the asset quality is dramatically different,” he says. “Real estate investing is actually not that easy and there can often be a lot of risk that many investors don’t recognise,” he says.

Some UK players may have been deterred by Mercury Private Equity’s (now HgCapital) backing of the £283m public-to-private of Greycoat Estates (G2) in 1999. Over-exposed to City office development at the wrong time in the cycle, the company was eventually broken up and effectively trashed Mercury’s property fund returns.

Many firms are pursuing deals with a substantial property base rather than pure-play real estate opportunities. Cinven’s £820m buyout of National Car Parks and Permira’s £712m LBO of Travelodge in 2002 both led to lucrative sale and leaseback agreements, for example. Property has also been used extensively in pub deals with the assets securitised against rental income.

“Investors know they can generate an income stream from the operational business and also gear up and arbitrage the underlying property assets,” says Simon Cooke, formerly chief executive at Deutsche Property Asset Management and now managing director of Hotbed, the private investor network.

“We see strong overlaps between our private equity and real estate practice areas,” notes Simon Clark, head of real estate at Linklaters. “Often private equity targets are sized up as real estate plays with property accounting for an increasing part of the overall opportunity to unlock value,” he says.

Timothy Spangler, a partner at Berwin Leighton Paisner, observes that institutional property investors have become more willing to pay conventional private equity management fees and support private equity reward structures at those firms which can deliver the desired returns.

“The private equity culture and approach, the investment vehicle and its risk and return profile are much the same as for a property fund. The only real difference is the need for well-honed property investment skills,” he says.

Spangler also notes a broadening in the approach of institutional investors to alternative assets. “They are increasingly seeing alternative investments as a single category taking in hedge funds, property and private equity. Private equity firms could lever off the relationships they have with their fund investors and direct capital into property alongside traditional private equity situations,” he says.

Real estate covers a wide range of risk/reward appetites. Core vehicles target established property sectors with reliable income-producing assets and achieve returns of sub 10%. The core-plus (value-added) funds generally invest in established and improving property sectors with returns ranging from around 10% to the high teens.

The opportunity funds, which is where the private equity funds fit in, have a high risk/return profile and routinely target distressed assets and developments as well as new locations and sectors. Leverage is typically 75% or more, gunning for returns of 20% plus.

Carlyle recently completed six sales, in Paris and Milan, from its European real estate fund for a total of over €200m, generating an average IRR of 36%.

The first six realisations from Doughty Hanson Real Estate Fund I have averaged three times its money and achieved an IRR of 50 plus. Of its 22 European real estate investments, DH has now sold three, refinanced two and contracted to sell another one, returning 70% of the invested capital.

On the exits front, in September last year DH sold the landmark Bodio Centre office development in Milan to a German open end fund in a €200m-plus transaction. Since acquiring the site in December 2000, DH had redeveloped it into a leading business centre.

In December 2003, DH sold the L’Oreal Italia headquarters building in Milan, again to a German open-end fund, for over €70m. Acquired in a liquidation auction in February 2001, DH transformed the derelict site, in partnership with L’Oreal, into a superior office complex.

In March this year, DH divested the Broad Street Mall, a shopping centre and office property in Reading, for over £70m. Acquired in June 2001 for £48m, DH completed a £6m refurbishment programme, rebranded the centre and added new tenants.

As these deals demonstrate, private equity real estate investors aim to add value by carrying out renovation and refurbishment work, improving rental income and yield and generally increasing operating efficiency.

Half of Carlyle’s 25-strong European property team is devoted to the management and improvement of its investee properties. “Because the assets don’t come with management we have to be more hands-on and stay close to our investments,” says Eric Sasson, managing director of Carlyle’s property team, which is headquartered in Paris.

DH runs a solutions for corporates programme which focuses on creating value by partnering corporates, such as L’Oreal, to solve complex property or occupancy problems.

Private equity real estate funds will generally adopt a pan-European investment strategy as demonstrated by Blackstone’s purchase of 51 properties in nine European jurisdictions from Deutsche Bank in a €1bn property sale and leaseback at the end of last year.

Carlyle’s 17 European real estate investments to date include the acquisition of 53 properties in France, Germany, Italy, Denmark and the UK. The firm made its first UK property investment through its European property opportunity fund in September 2003 into 107 Cheapside, acquired from Axa Sun Life for £67m.

Fifty per cent of Carlyle’s second European property fund is likely to be invested in France, Germany and Italy. The firm’s commitment to the UK property market will also grow with Carlyle planning to put a property team into its London office within the next 12 months. The group is currently split between Paris, Frankfurt, Milan and Luxembourg.

Doughty Hanson European Real Estate Fund I has been investing throughout Europe, with a special focus on the German-speaking, Scandinavian, Italian, UK and Central European markets. Germany is generally a popular investment destination as illustrated by the recent €3.5bn acquisition by Fortress Investment Group, a US alternative investment and asset management company, of Germany’s fourth largest residential housing company, GAGFAH-Housing Portfolio from the German federal government.

However, investors may pull back from the market until the scandal gathering steam this year, which has implicated some of Germany’s largest real estate investment funds in a system of bribes linked to large property purchases, has lifted.

DH did anticipate being more active in Central and Eastern Europe (CEE) but has, so far, made only one investment there. “Deals are smaller and the risk-adjusted returns are not so attractive in CEE,” notes John Howard “We have not precluded the region from the scope of our second fund, but it is not quite the investment heaven the industry once thought,” he says.

DH’s second European property fund is likely to be slightly broader, geographically, than the first. “Our first fund did not invest in France, for example, because our fund investors already had sufficient exposure there. But we have now opened an office in Paris and may also include Spain in the portfolio,” says Howard.

Sector-wise, the European office segment is seen as a consistently good bet. Industrial properties are generally less popular with private equity funds since the sector is more specialised and can carry environmental risks. Some investors are targeting hotels while the housing and retail markets are buoyant, although fiercely competitive.

Eric Sasson says that while the prime office property market remains strong, Carlyle plans to diversify its first European real estate portfolio, in the last stage of investment, into other assets including residential, retail and hotels.

Over the last 36 months, DH has also been moving away from the European office sector. “Office investments accounted for 80% of our portfolio, but we have now reduced this to 60% with more investment in the residential and retail segments,” says Howard.

The UK hotels sector has lately been attracting considerable private equity interest with Whitehall and Blackstone among the opportunity funds tabling first round offers to buy Intercontinental’s £1.4bn UK hotel portfolio.

Despite the wall of money chasing commercial property investments, Eric Sasson remains confident of his team’s abilities successfully to deploy capital. “While new funds are constantly entering the sector, many major corporations are seeking to divest real estate assets and this is heightening activity throughout Europe,” he says.

“We have made great returns in the past two years even though the economy hasn’t been at its best. Now the climate is easier and we don’t see it as being that much more competitive. The European real estate market is big enough and often newcomers will provide exits for us,” he says.

“There is no question that the property market is now far more difficult than it was a few years ago. Everyone is chasing deals. But much of this capital is directed at core-plus returns. For us, this facilitates exits,” agrees DH’s Howard. “With regard to new deals, we believe that there are still good opportunities for real estate teams which can implement high value-added strategies,” he says.

However, Simon Cooke of Hotbed, which focuses on the UK, admits he is nervous. “Property is such a well-trodden market yet money continues to pour in. There are opportunities with buildings which need to be turned around or redeveloped, but these situations can be quite risky and demand highly specialised skills,” he says.

This summer Hotbed exited its first property investment, in Bristol, for £3.1m, generating a 67% uplift in just over a year. The firm recently bought a £17m office building in Southampton. “It is relatively cheap space, and the rents are low but we expect demand to increase. This is the fundamental of real estate investing, but these situations are quite hard to find,” says Cooke.

Even ahead of the introduction in the UK of tax-efficient US-style real estate investment trusts (REITs), many new collective, indirect property investment vehicles are also becoming available to retail investors. “But most are being launched too late in the cycle and some may well end in tears,” warns Cooke.

Investment Property Databank (IPD) now puts yields for UK commercial property at 6.1% (6.6% in 2003), the lowest level since 1990. Property prices have risen by almost 10% over the last year driven by increased investment demand while rents have barely changed.

Equivalent yield, which also takes into account a property’s future cash flows, was 7.1% in September 2004. This is the lowest figure since IPD data began in 1987. Yet thanks to capital growth as opposed to income return, total returns from UK commercial property for the 12 months to September 2004 were 17.1%, making it the best performing asset class.

Many experts predict that increasing capital growth cannot continue and may peter out as early as next year. CB Richard Ellis is forecasting average total returns of 8% or 9%, derived mostly from rental income, over the next three years.

Simon Cooke says: “The established players which pioneered private equity real estate investment five years ago have been successful but the chances of them replicating this success with their new funds are getting narrower.”

“The general perception is that while achieving opportunity fund rates of return these days is not impossible, the risks are far greater now than they were,” adds Simon Clark of Linklaters. “Firms will have to really work at it, think laterally and creatively in terms of targets and financing structures, and make big hits,” he says.

“The best operators out there will find interesting deals but they will need to dig a lot deeper,” agrees Cooke. “And those that succeed will be the firms that really understand the market and what makes a building tick,” he says.