There has been little clarity to the US real estate markets in the past year, however things have started to change. At the recent Urban Land Institute conference in San Francisco, PERE assembled a cross-section of industry professionals to gauge their thoughts on the state of the market and the future for private equity real estate. PERE magazine December 2009-January 2010 issue.
After more than a year of suspended animation, commercial real estate investors are beginning to sense some movement in the US property markets.
Deals are, slowly, being closed; new financing is, slowly, becoming available; prices are, extremely slowly, being agreed. It may not be much but in the past two to three months there has been a palpable shift in both the transactional side of the business, and perceptions of the business. The fog, it appears, seems to be lifting.
Fog in San Francisco
However, just like the weather in San Francisco, where PERE met with senior professionals at the end of October, there is still a long way to go before clarity returns to the US real estate markets. Questions still abound about when the US recovery will happen, what form it will take and how private equity real estate will have to position itself when it does.
To debate just a few of these issues, PERE invited 16 key professionals to a special breakfast on the outskirts of the Urban Land Institute annual fall conference taking place in San Francisco. Gathered at Café Lulu, a five minute walk from the city’s Moscone Center, these veterans exchanged their concerns and hopes for the asset class over yoghurt, orange juice and plenty of cups of strong coffee.
One of the overwhelming issues voiced at the breakfast – and more widely at the ULI conference – was that of jobs growth, and exactly where it would come from.
PERE Breakfast Club: ULI 2009
On the final day of ULI’s week-long event, the US Bureau of Labor Statistics revealed national unemployment had breached the psychologically important 10 percent mark – its highest rate since 1983 – with even President Barack Obama predicting there would be more pain “in the weeks and months to come”.
For our gathered real estate investors, such macro-economic concerns are a central tenet to their ability to make money from property. As Shorenstein president Glenn Shannon explains on p. 31: “The real estate recovery isn’t just about the economic recovery, it is about job growth and where we expect those jobs to come from.” After all, without jobs there is no new demand for real estate.
The breakfast revealed numerous challenges facing the industry, from fund model structures, GP and LP relationships, alignment of interests, financing, future opportunities and future concerns. However, just like San Francisco’s famed climate, there is a sense that the weather is beginning to change. That the dense fogs of uncertainty are lifting: somewhat.
All our participants agree it will take time to assess just how badly the US real estate market, and the US economy, has been affected by the credit crisis of 2008. All agree there will be opportunities for private equity real estate. Not all agree, though, where – and the scale to which – those opportunities will emerge. Over the next four pages, you will find distillations of their intelligence.
Jeffrey Barclay, Managing Director, Head of Acquisitions and Development, ING Clarion
“Here and then gone”: Could the maturing balloon of commercial real estate debt represent a systemic risk
to the US economy? That’s certainly been a focus for US government officials this past year as they try to judge between systemic and non-systemic risks facing the country. At ULI it was also a matter of intense discussion, according to Jeff Barclay, who says efforts to keep the largest banks afloat have been largely successful, and therefore won’t – as a consequence – offer “tremendous opportunities” for investors. When it comes to the US’ smaller banks, Barclay sees a “different story”. The issue facing investors though is the sheer amount of capital sitting on the sidelines. “Many investment firms have dry powder, so I believe that the opportunity will be here and then gone. Everyone is waiting, so when someone drops the shoe, we may reach a pricing equilibrium more quickly than most observers expect.”
Ed Casal, Chief Investment Officer, Real Estate Multi-Manager Group, Aviva Investors
“Difficult to plan”: There have been few points in history where investors have had to plan for the dual
likelihood of inflation and deflation. But that’s exactly what’s happening to US real estate investors today, according to Ed Casal: “It’s probably one of the most confusing of times. As a long-term investor that makes it very difficult to plan.” Concern at the macro-economic outlook for the US was palpable at the ULI conference. “It boils down to rents, occupancy and concessions,” Casal says, adding that part of the reason for the current “gridlock” in the US property transactions markets is the level of distrust in the system. “No-one trusts the banks, no-one trusts the tenants because they wonder if they are credit worthy, no-one trusts the landlords because they wonder if tenant improvements will be done, the leasing agents are worried about getting paid. It’s all about who can perform.”
Jack Chandler, CEO, Asia Pacific, LaSalle Investment Management
Asian fundamentals: Charles Dickens’ novels have been employed numerous times to describe the crisis
facing today’s global real estate markets. Jack Chandler though, the most fitting analogy has to be that of A Tale of Two Cities. Splitting his time between Asia and the US, Chandler has a bird’s eye view of the two regions and how each are handling the financial crisis. “There is an awful lot of speculation about the distress in the US and what the financial institutions will do in relation to their assets. No-one is really sure what happens next and most people have been surprised at how little has been done to date.” Asia, however, is a completely different story. “Fundamentals have held up a lot better than in the US, vacancy rates are much less and we are seeing a lot more domestic capital come back into the Asia markets. There is a local perception that real estate is cheap.”
Kathryn Corro, Principal, Rockpoint Group
“Understand the pressures”: If investors and fund sponsors had to take one thing away from the PREA
and ULI conferences last month it was the need for dialogue, and more of it. Already more communication is taking place between GPs and LPs but, as the industry looks to 2010, Kathryn Corro says now is the time to also be “constructive”. Broad sweeping assertions, such as giving all LPs more control over investments, are not necessarily a panacea – some LPs would simply be overwhelmed by the workload. With GPs and LPs at various stages of acceptance in relation to the events of the past year, Corro adds: “We all have to be proactive in committing to an ongoing dialogue that assures that both GPs and LPs understand the pressures each is experiencing. We should work together to jointly engage in problem solving.”
Kelly DePonte, Partner (Due Diligence and Research), Probitas Partners
“In triage”: There has been much debate as to when real estate prices will reach the bottom. For Kelly
DePonte, that time could be towards the end of 2010. If so, the coming year of continued distress will have major implications for the industry, he says. “There is a realisation that more and more fund mangers cannot hold on anymore as there won’t be a bounce back to valuation levels that could make them whole again.” There are already estimates that up to 30 percent of GPs could disappear in the next few years. Although 2010 could prove to be the “best vintage year” for those that survive, DePonte notes that LPs will not rush to re-up with managers. “The industry is in triage and some very hard decisions are going to have to be made by LPs and GPs. For LPs it now comes down to who do I back?”
Dan DiLella, President and Chief Executive Officer, BPG Properties
“Bumping along the bottom”: There were few attending PERE’s breakfast club who haven’t seen at least
one real estate crisis before the dislocation of 2008. Dan DiLella admits he’s now on his fourth go-around. What is interesting this time, he adds, is that distressed assets are coming to market only on a “very selective basis. You don’t see banks foreclosing on much product”. As a result, US real estate markets appear to be “bumping along the bottom”. There is, however, private capital sat on the sidelines. “There are plenty of active funds out there,” DiLella says. The question is, with such little deal flow, will private equity real estate investors be able to achieve returns of 20 percent-plus again? “Being realistic is the name of the game. In today’s market unlevered returns of between 8 to 10 percent, and levered returns of between 12 and 14 percent are good.”
Record secondaries: In late 2008, the industry was filled with speculation about the threat of defaulting
LPs thanks to the denominator effect, declining distributions and a severe lack of liquidity. It was expected to mark a wave of secondaries activity. As the denominator effect eased over the following 12 months, that wave failed to appear, but, as Robert Dombi says, many will still be surprised by the level of activity that did take place in 2009. “This year has set a new high watermark in terms of secondaries volume.” The real estate secondaries market is still nascent, but Dombi says Landmark currently has $4 billion of potential secondary deals “on pipeline”. Many have a “long gestation period”, and coupled with the uncertainty of the past year, the decision-making process for a lot of LPs has been slow. But he adds: “That uncertainty will ease. I think 2010 will be an absolutely record year for secondaries activity.”
Jeff Giller, Former Managing Principal and CIO, Liquid Realty Partners
“Massive restructurings”: Unlike Dombi, Jeff Giller believes that the bid-ask gap prevalent in today’s
secondaries market will continue to keep transaction activity muted during 2010. Indeed Giller argues that many recent vintage real estate funds have little to no equity value remaining after managers purchased assets at the peak, applied aggressive leverage and then saw falling valuations wipe out their equity. “Before a meaningful amount of equity is rebuilt in real estate funds, there needs to be massive restructurings in certain key aspects of real estate funds,” he said. “That restructuring could involve large scale property foreclosures, debt write-downs or discounted debt buy-backs, preferred equity recapitalisations and in certain extreme cases, fund manager removals, and fee and fund structure renegotiations. Until these things happen, there will be little in the way of equity for limited partners to sell to secondaries buyers.”
Alison Hill, Managing Director, AMB Property Corporation
“All about focus”: “Investors want to put their capital with a firm that knows what its doing in a given
sector or region.” If there has been one oft-repeated complaint from LPs about some GP behaviour during the past few years it’s that of strategy drift. And it’s a behaviour that won’t be readily forgiven in future, as Alison Hill notes. “They don’t want someone easily distracted by the opportunity of the day, which they may know little or nothing about. Investors are assessing if GPs did what they said they were going to do. If a GP adopted a different strategy during the investment period, then investors will not look favourably on those managers,” she says. Going forward, Hill argues that strategy and expertise will be a key consideration in an LP’s choice of a manager. “It’s all about focus and executing on the plan.”
John Kessler, Managing Director and Chief Financial Officer, Morgan Stanley Real Estate Fund Global VII
“Financing is hard”: Debt is the new equity, and there’s not a week goes by when, apparently, a new
debt-focused fund isn’t launched. Despite the talk though, John Kessler believes the amount of debt capital actually sitting on the sidelines ready to deploy isn’t as great as anticipated. What he does agree with though is that “debt is a real opportunity”. With the contraction of the real estate financing market, and the shut down of the CMBS market, “financing is hard to secure and I don’t see the CMBS markets opening up anytime soon”. As a result, Kessler says the opportunity to take advantage of this dislocation could be “around for a while. In the US there is a decent opportunity in terms of debt-related investments. Some assets have been taken back, some sold, but there is still a lot of inaction. That will start to change, but the opportunities could be there for a while.”
John Kukral, President, Northwood Investors
“Contrary to public opjnion”: It’s the only real question on property investors’ minds: where do I find
the next big opportunity? Like John Kukral, many see the US as one of the best risk-adjusted opportunities globally. “Over my career, I’ve been US-centric, and feel that you can always find opportunities in the US,” he says. But as the eyes of the world turn to North America, Kukral advises that the scale of the opportunity won’t necessarily be gigantic or that quick to materialise. “There are currently a lot of people chasing very few assets and contrary to popular opinion the commercial real estate markets are extremely liquid”. The US government is doing a good job in keeping loans performing, he says, but only slowly addressing the valuation problem. “Today it’s about restructuring the debt and the recapitalisation of equity.” For Kukral, the window for that opportunity may not be wide, but he adds: “It will all depend on job creation.”
“GPs will be surprised”: Debate has raged about the commingled fund model for months now, namely
about whether LPs will increasingly levitate towards more club deals, joint ventures or even separate accounts offering greater control. Nori Gerardo Lietz says investors are not traditionally confrontational, but will “vote with their capital. I believe many GPs will be surprised that they cannot re-up with existing LPs as easily as they anticipated. Investors want more control, and the industry will find that larger plan sponsors will eschew the commingled fund format, as they have the capability to run separate accounts”. However, Gerardo Lietz says there is one fundamental issue facing GPs and LPs alike, the need for a “better alignment of compensation. Fund sponsors should get paid when the LP gets paid. The era of pre-paid carried interests and high annual cash compensation without regards to performance is not working.”
Sharon Ann M. “Samm” Miller, Managing Director, Rockwood Capital
“True opportunities”: Out of crisis comes opportunity, and as GPs and LPs work their way through the
bursting of the real estate bubble everyone is trying to work out how to thrive, not just merely survive. But there are “two sides of the coin”, even for established GPs with “dry powder” in their new funds, Samm Miller says. “It’s not just about going out and finding the right transactions to spend the dry powder on; it’s also about proactively managing your existing assets by focusing on optimising value and preserving capital. In terms of future opportunities, though, the US is heading into one of the best investment periods we’ve seen in over a decade especially when it comes to potential debt opportunities.” Miller notes that without government pressure to force the “big” banks to deal with their legacy loans at a greater pace, “uncertainty will remain” as to when the “true” opportunities will emerge.
Kenneth Picache, Principal, Apollo Global Real Estate
“Keeping LPs informed”: Coming straight off the back of the annual Pension Real Estate Association
conference in Beverly Hills, there was a lot of reflection taking place at the ULI event, not least in terms of future fund structures. LPs have spent the past year reassessing their investments and portfolios, with many concluding that a greater level of control is needed. As Ken Picache says: “Various LPs are articulating this in different ways.” That’s not to say the commingled fund model doesn’t have a future. Picache says not all LPs have the “resources and on the ground relationships to identify and manage discreet investment opportunities in the same way that a commingled structure provides”, but he adds: “GPs need to improve communication and allow their LPs the opportunity to discuss current market trends and the types of opportunities that they are participating in. It comes down to keeping LPs informed and maximising transparency.”
William Scully, Managing Director, Cerberus Real Estate Capital Management
“Much less clear today”: Government intervention has been a keyword for economies worldwide for the
past year; the US perhaps more so than most. Yet despite that help, the US real estate industry hasn’t seen the repricing of commercial assets it had hoped. For William Scully that’s one of the main differences between today and the 1990s. “In the early 90s you had the RTC and you had two large players, GE and Goldman Sachs, with their cheque books open and who were buying pools of assets. It helped reprice the system and it became very clear to a number of us how the rest of the system was going to re-price. It is much less clear today how that process is going to unfold.” Part of the solution, he says, could be for the FDIC to take over more troubled community and regional banks. “It is going to happen,” Scully says, “but whether that translates into movement in larger institutional assets because of the added complexities of securitisation, is difficult to predict.”
Glenn Shannon President, Shorenstein Properties
“Making sure you have the capability”: As the ULI conference was wrapping up in San Francisco, the
US government revealed the unemployment rate had jumped to a 26-year high of 10.2 percent. Such figures are not good news, as Glenn Shannon says: “The real estate recovery isn’t just about the economic recovery, it is about job growth and where we expect those jobs to come from.” A failure to recognise the fundamentals, Shannon argues, is a failure to understand real estate: “Real estate isn’t a trading business, it’s about owning things, cash flow and value at the property level.” As such there will be greater emphasis in the future on a GPs ability to actually operate an integrated portfolio of assets. “This is not about aggregating assets and waiting for the next guy to come along to buy them from you, but about making sure you have the capability to run the assets once you’ve acquired them.”