Real estate is hot!

When Keith Breslauer took Patron Capital Partner’s second real estate private equity fund into the market to show to institutional investors at the start of last year, he was expecting, he says, that “it would be a year of hard work” He was wrong. Six weeks into the fund raising he had all the money he needed and a whole lot more besides, two-and-a-half times more to be precise. Breslauer did the smart thing; he took the money and signed all the legal documentation that meant his investors would not see their money drawn down nor would they be charged any fees until he was ready to invest it. This began in early 2005 after Patron had committed what remained of its first fund in the remainder of 2004.

How times change. When Breslauer went to market with his first fund, despite having earned his real estate private equity investing spurs already elsewhere, he spent more than a year trying to get investors on board. As with all investing, he was up against a timing issue. In 2000, when Breslauer was in the market, the boom was raging and the idea of a 20% return on a private equity real estate fund looked sober indeed to investors. A year later when the market crashed and investors would positively have salivated at the prospect of such returns, many found their trustees would not permit them to invest anymore money in illiquid assets, such as real estate. This was simply because they had become overweighted in illiquid assets relative to their liquid, listed equity positions, which had taken a nosedive.

Jonathan Short also hit the market with Primerica’s first European private equity real estate fund around this time and as a man who doesn’t appear to be given to exaggeration, he describes the fundraising process simply with one word: “horrendous” Although he hadn’t run a fund per se prior to this he had been involved in the real estate investment market in an advisory capacity for some ten years. But he acknowledges that today the market is completely different and for funds that have proven they can do what it says on the tin (generally speaking to produce returns of around 20%), the market is very good. Perhaps too good, although institutional investors in private equity real estate don’t seem to be of the opinion that you can have too much of a good thing where real estate is concerned. In fact there is a suspicion among firms that many institutional investors are employing a deliberate strategy of over-allocating to funds in the hope that when the inevitable scalebacks happen they are left close to the level of allocation they actually want.

The sales patter has changed this time around too. There is little talk of corporate divestitures of real estate and public-to-private transactions, which were used to raise funds in the 1999 to 2001 period but that happened infrequently in practice. Today’s patter is centred round growth capital for private companies with a strong real estate element, emerging markets and development opportunities. It’s not just talk, however, this is where many in the market expect the most lucrative investments to occur, but by the same token they doubt that much of the institutional investor excitement around the sector is appreciative of the inherently risky nature of such opportunities, which is surprising given that relatively high (20%) returns must come with a risk trade-off. “To get to those 20% returns you’ve got to go up the risk curve, do more development, go into emerging markets like the Accession countries, India, China and Russia, or take on emerging asset risk,” says Short.

But real estate is seen as a solid, and therefore less risky, investment because it involves asset ownership. But this is simplistic and probably a perception that has been given oxygen by the hype which saw million and billion dollar businesses disappear, literally overnight. While real estate won’t just vanish into thin air, buying it in emerging markets, for development and so forth involves complex and multi-layered risks such as currency, legal, regulatory, micro and macro economic factors that can’t be predicted with absolute certainty.

The interest in real estate as an asset might be seen as the pendulum swinging back the other way, now that the hurt of the early 1990s is unlikely to be repeated given different global economic fundamentals and the opening up of real estate markets thanks to legal and regulatory reforms. “Real estate allocation 20 years ago was around 15% to 20% globally. Over the last 15 to 20 years that has gradually been declining, and by 2000/01 real estate allocation was down to 5% after the tech bubble burst. Now real estate is seen as a hedge against inflation and it offers diversification because it has an income component and investors own a real asset. Today in Holland they have a 15% to 18% allocation to real estate, in the US it’s 10% to 11% and a bit lower than that in the UK. Across the board there has been an increase in allocation to real estate. The baby boomers are coming through to retirement and real estate provides a steady income. I think we are going to see more and more capital going into real estate,” says James Quille of Macquarie Global Property Advisors (MGPA.)

While real estate, by way of a fund or equity investment, is viewed by institutional investors as being very attractive right now, the debt markets too are clamouring to get a slice of the action. Many express surprise at the terms on offer and the multiples available, although interestingly most of the institutionalised side of real estate investing is perceived to be reacting sensibly to this. For the most part, it’s believed that the institutionalised side of the market is not gearing beyond what its real estate risk profile can realistically take. (Some private real estate investors, however, are known to be pushing their gearing and risk profile to the max, so this is where people expect fingers will really get burnt, should interest rates rise.)

Real estate risk profiles, explains Dan Larkin, a partner at Squire, Sanders & Dempsey, fall into four broad categories, known as; Core, Core+, Value add, and Opportunity, which gradually take on a greater risk and therefore greater return profiles. Core, for example, is what is typically referred to as plain vanilla property investing where assets bought, usually office buildings, are in key cities (London, Paris, New York etc), in good condition with incumbent, long and perceived to be high quality lessees. Core+ may widen the geographic remit and add a touch of refurbishment risk or include shopping centres as well as offices. And this goes on until you reach Opportunity funds, which is where private equity real estate comes in.

Private equity real estate in Europe is still a young business, which may be a reason why, unlike the non-real estate private equity market, there appears to be little uniformity of approach. Some funds, like Europe Property Partners, invested by Jonathan Short at Primerica, look and act in many ways like traditional private equity funds in that the fund backs businesses, but ones with a strong real estate component. An example being Big Yellow Storage, a self-storage business that was in the process of a sustained roll-out programme while being backed by Primerica.

Macquarie Global Property Advisers and Patron Capital Partners, on the other hand, while they will back businesses with a strong real estate component, the bulk of their deal flow results from individual property deals, generally that have a development or refurbishment risk attached. Palmer Capital Partners, however, only does single property deals (typically development or greenfield site builds), which are managed by one of the seven management teams it has a 30% equity stake in, and, says the firm’s founder Ray Palmer, would only do a deal that involved backing a business with a strong real estate component if it were to partner with a traditional non-real estate private equity firm.

Occasionally real estate private equity funds and private equity funds do team up but in theory hedge funds could prove a more advantageous partner for the real estate fund, since with a circa 12% return expectation, which is about half that of a traditional private equity fund, a joint hedge fund and real estate private equity bid could go higher. In fact this seldom happens because to be the partner of choice because you’re prepared to accept a lower return expectation than your bid partner isn’t an attractive rationale in anyone’s book. Breslauer suggests hedge funds could enter the real estate market solo, on their own terms. “Hedge funds are a complete unknown, they have a lot of cash and need to do something with it and they have a lower return threshold. A hedge fund’s break even point is 12%, they could beat us if they got their act together. The only thing holding them back is resource.”

Under pressure

No matter what the approach, all are feeling the effect of the overheated real estate market and are doing their best to make sure they generate as much proprietary deal flow as they can. This is not surprising given the horrid stories emanating from this market about the auction process. Some sizeable Berlin real estate assets were reportedly auctioned this year garnering 120 expressions of interest, which went on to become 58 bids that resulted in a massive 12 bidders gaining access to the data room. (Admittedly, Germany is peculiarly overheated thanks to the Maastricht criteria on social housing that has effectively forced many of these sales.) But when you consider that on these mega deals, the abort or dead deal costs could amount to between €1m to €1.5m per bidder and that some of these bidders are going to have the same institutional investors in their funds, it just doesn’t seem right.

It may be that when the heat goes out of the real estate market, the auction process in turn gains some perspective, or it may need to take a leaf out of traditional private equity’s book. Traditional private equity auctions have turned many bidders off because they are so widely circulated, as a consequence there is currently a move among advisers to do more upfront due diligence to work out who might actually be a serious buyer and only circulating the information memoranda to a select group. And the adviser wins too because it collects the same fee for much less, albeit better targeted, running. But with Short commenting that when he has watched the auction process, he has always been surprised by who turns out to be the eventual buyer, this may be premature.

For the most part, once an asset is held by a private equity real estate investor it is reliant on equity and debt financing, much the same as a traditional private equity buyout does. The business models employed mean that the income element of an investment, if there is one, is not free cash flow and as a consequence there is very little securitisation at this end of the market. Although, obviously given the variety of players in the market, there are exceptions, such as Guy Hands’ Terra Firma Partners, which has bought into German residential real estate in a big way. Although securitisation per se does not register too highly with most real estate private equity investors they are keenly watching the pricing being applied to the commercial paper that is issued to investors on the back of these securitisations.

It’s cheap and many expect a price correction. Some fear this will be caused by defaults if interest rates rise or economic fundamentals deteriorate. Arguably the real risk is on single business securitisations, as happened when Welcome Break, the UK chain of service stations, went south. But, rightly, investors don’t really like single business securitisations, which has long placed a premium on their pricing. The fact remains though that if there were to be any defaults on real estate-backed paper, this would affect pricing, which in turn should have an impact on bank’s perceived willingness to lend against real estate assets.

But for now the demand for real estate goes unabated. And intermediaries, and indeed governments, are coming up with innovative ways for investors to access the real estate asset class. REITs, properly known as Real Estate Investment Trusts, although no one seems to use the full name, are one method. “REITs are defensive; governments are trying to keep that money onshore. If you are a private investor, it’s probably a better investment than a property fund, because of the proposed tax breaks,” says Larkin.

Larkin neatly sums up the gesture, which many believe are also, in the UK at least, a way for Gordon Brown, the UK Chancellor of the Exchequer, to capture more stamp duty tax. Properties sold for more than £0.5m, which frankly must encompass just about every commercial property transaction, attract stamp duty at 4%. (Given that property related stamp duty has recently overtaken the UK government’s tax receipts from beer and alcohol, it’s easy to understand the scepticism.)

But 4% is potentially a big dent in a fund’s profit margin, so common practice is for real estate assets to be bought by an offshore (typically Guernsey, Jersey or Luxembourg, for those operating in Europe) special purpose vehicle (SPV) so that when the asset, or SPV is sold it only attracts stamp duty at the rate of a company sale, which is a significantly lower 0.5%. It can also be advantageous from a corporation tax point of view to hold real estate assets in an SPV rather than directly.

REITs, though flourishing in the US, are still on the drawing board in the UK and Germany, withholding tax being a significant stumbling block. They are, however, being keenly watched by the market, which sees them as a potential exit route given that the untapped demand from private investors for real estate exposure is known to be huge.

Smaller institutional investors, who require real estate exposure but don’t have the €10m capital commitments capacity, at least not in a way that would sensibly diversify their exposure, are reliant on merchant banks, investment banks, and specialist groups that approach them with unit trusts for private placement that are backed by a pool of real estate assets. This seems to be an area of the market that has some serious development potential, if a group were to get the formula of transparency, ease of buy/sell and diversification right.

These are certainly exciting times for real estate investing, and particularly in the private equity segment of the market.

Breslauer notes that his fund documentation expects returns to be driven 60:40 by capital to income, in fact today it’s 90:10 in favour of capital, on top of that Patron is still achieving the same multiple (aimed to be between 1.7 and 2.2) over a two-year period. But the newness of private equity real estate investing is driven home when Breslauer confides that partnering is often important in order to be taken seriously in business negotiations. Quille tells a similar story when he explains that Macquarie Global Property Advisers was borne out of a management buyout of Lend Lease in 2004 but that on completing the buyout the nine partners of the business sought a joint venture with Macquarie because, as Quille puts it, they felt they really needed a “big brother” in order to get successfully into the market.