Opportunity flocks

Peter Cluff of London-based real estate investor Europa Capital Partners knows a thing or two about private equity. Prior to joining Europa on its establishment in 1999, Cluff was finance director for nine years at Morgan Grenfell Private Equity, the private equity arm of the UK merchant bank that was acquired by Deutsche Bank. While there, he was a member of a three-man investment monitoring committee with responsibility for, among other things, fundraising and structuring.

Reflecting on how real estate was viewed at the time by a mainstream private equity investor, Cluff says: “We'd often buy a subsidiary of an industrial conglomerate and as part of the deal there would be this huge chunk of property that would continue to sit on the balance sheet throughout the period of ownership because no-one knew what to do with it.” The implication is obvious: here were sizeable – and typically unexploited – assets that tradition kept outside private equity's sphere of influence.

A few European private equity firms, though, were beginning to see that there was action to be had in real estate. Using the orthodox private equity structure of a blind pool, limited partner based fund, groups like Doughty Hanson (in 1999) and Carlyle (in 2001) set up dedicated European real estate funds with their own investment teams. But on the whole, ambivalence continued to characterise private equity's relationship with the sector.

Many real estate investment practitioners canvassed for this feature professed to have no idea why the sector should be viewed negatively by managers of private equity generalist funds, and several suggested the doubters should think again. At the value-add/opportunity end of the real estate investment spectrum (where assets are actively managed in an attempt to garner gross returns of around 20 – 25 percent per annum), there are certain features that any private equity investor would instantly recognise. Besides the aforementioned structuring of funds as English or Delaware limited partnerships, the funds deploy the same methods of compensating managers and also apply leverage to transactions in very similar ways.

Perhaps more significant than these basic shared traits is that real estate GPs' investment strategies increasingly appear to be mimicking those of their mainstream private equity cousins. Passive, yield-based investment strategies (of which more later) dominated European real estate investment ever since US investment banks began scouting opportunities in the office sector in the late 1980s. But recent years have seen the arrival of a new breed of investor far removed from the pioneers: they are hungry, proactive, and focused on transforming assets rather than on their potential for delivering stable (but low) yields.

Mainstream private equity investors sceptical of the merits of real estate investment may be surprised by how familiar some of the current real estate investment strategies practiced by the new breed of property investors are. Here are a few examples:

• Unlocking value: Opportunity funds like to sweat the assets they acquire. For instance, in December 2001, London-based real estate investor Patron Capital acquired Barcelona's Arts complex for €285 million from Sogo, a Japanese retailer that had entered bankruptcy. “Real estate investing is all about identifying and unlocking value,” says Keith Breslauer, the firm's managing director. In Patron's view, Arts had strong underlying assets comprising a hotel; an office building; a retail complex; a casino; vacant land; and an underground parking lot.

Undertaking a break-up strategy, Patron sold the office building to a German institution; 50 percent of the retail complex to its tenants; the parking lot to a private buyer; and the vacant land to a developer. Most recently, in early 2004, the hotel and casino were converted into a fund for Spanish high net worth retail investors, in which shareholders converted their existing stakes into a minority position. At the end of this process, Patron was left with a 3.6x return on equity multiple from the deal and an internal rate of return in excess of 700 percent, Breslauer says.

• Buy and build: In 2002 niche investment banks Shore Capital and Dawnay, Day launched the Puma Property Fund to invest in UK commercial property. The fund was a yield play designed to capitalise on low interest rates, and appears to have done so very successfully – delivering a 47.1 percent per annum return to investors in the year to April 5 2004. Now the fund is approximately 90 percent invested, with the remainder set aside for follow-on investments. Raising a follow-on vehicle with the same strategy increasingly lacks viability though, says Shore managing director Graham Shore, as interest rates creep up.

The two sponsors have now implemented a more operationally-focused long-term strategy through the establishment of Dawnay Shore Hotels (DSH), a new company targeting consolidation in the hotels sector. Following its £215 million acquisition of hotel chain Paramount Hotels from private equity firm Alchemy Partners in July, a statement said DSH would seek “further acquisitions of complementary hotels”. At the time of going to press, it was being linked with a possible bid of up to £200 million for Paramount rival Marston Hotels.

• Targeting high-growth sectors / identifying market niches: First-mover advantage in a sector with high growth potential is the holy grail of most private equity firms. Real estate is no different, and a number of investment hotspots are currently attracting the attention of investors. They include the German residential market, due to shareholder pressure on large companies to sell off non-core property portfolios, and logistics, resulting from the growth of the industry generally together with the increasing availability of cheap land in Central and Eastern Europe for the building of transport hubs.

The retail sector is also buzzing, based partly on strong demand for out-of- town shopping centres due to tough planning restrictions in town and city centres. In March 2004, quoted UK property firm Pillar Property launched the Pillar Real Estate fund with a €600 million target to invest in retail parks in Eurozone countries. It has subsequently invested in three such parks on the outskirts of Madrid, Bologna and Lisbon.

Also keen on retail space is James Turner, who headed the UK arm of Australian developer Westfield and recently launched Balmain Asset Management, which is aiming to raise £400 million for investment in “under-managed” UK shopping centers. He will be hoping the words of William Benjamin, managing director of Apollo Real Estate Advisers in London, don't end up haunting him. “We have been very aggressive buyers of UK shopping centres,” says Benjamin. “But the prices are looking a little too high for us now.”

If it's true that shopping centres are getting a little overcrowded, why not jet off to a holiday home? In April, former Soros Real Estate partner Miltos Kambourides and ex-JP Morgan investment banker Pierre Charalambides launched Athens-based Dolphin Capital Partners to raise a €100 million fund (expected to close shortly) for investment in holiday and retirement home complexes catering for Northern Europeans seeking a place in the sun. “There was not a developed private equity real estate market to support these projects, and we saw a gap in the market to provide a dedicated source of financing,” says Kambourides.

What all these strategies demonstrate is a determination to go the extra mile in the hunt for value rather than simply relying on the tried and tested formulas of the past. But are investors buying that message? Data from Ernst & Young's most recent “Value Added and Opportunity Funds” survey suggests they are. The 64 GPs from around the world that responded to the survey raised $61.2 billion in the five-year period between 1998 and 2002, compared with $26.4 billion in the preceding five years. The report also found that more of these GPs were marketing value add vehicles in 2002 and 2003 than in 2001.

This increased allocation may be partly attributed to recognition that private equity-type returns can be achieved by real estate (private equity funds have struggled to get near their 30 percent IRR benchmark in recent years), but may also reflect more prosaic considerations. “Investors have been sobered by their experiences in the equity markets between 2000 and 2002, and realise that real estate is less volatile, while still offering growth and a current cash component,” says Benjamin at Apollo.

Either way, support is strong from investors on both sides of the Atlantic. Carlyle Group managing director Eric Sasson says a majority of investors in the firm's European Real Estate Fund, which closed on €430 million in January 2004, are based in Europe. By contrast, Keith Breslauer says he expects most backers in Patron's latest fund, which has a €303 million target and is scheduled to close in September 2004, to come from US sources.

Says Tony Horrell, chief executive of European capital markets at Jones Lang LaSalle, the real estate services and investment management firm: “Real estate remains an attractive investment [in 2004] in relation to other asset classes. While some capital will inevitably be drawn away if the recovery of equity markets gathers momentum, we believe that this could be offset by increased activity from institutions.”

But let's put the fanfares aside for a second and consider this: more than one source in the market confided to Private Equity International that much of the capital finding its way into real estate value add funds is coming not from wide-eyed optimistic investors confident they've discovered the next big thing, but rather from world-weary groups who've been let down a few times and are investing in opportunity funds despite, rather than because of, their experiences.

To shed light on this means going back to the roots of real estate investment in the US in the early 90s, when as a result of the savings and loan crisis a number of Wall Street investment banks were able to swoop on assets at rock bottom prices. Life was easy, and so was delivering the 25 percent-plus returns promised. Sources say when the US market began to get tougher in the late 90s, a number of the same banks promised similar returns from the emerging European real estate market.

“They found it much harder,” says one source. “The UK market was more complex and the rest of Europe less developed than they thought. They resorted to ever fancier financial engineering, but just couldn't pull it off.” The same source says investment banks now generally only market core-plus (targeting mid-teens returns) or even core vehicles (around ten percent) rather than value-add – leaving those seeking higher returns to take their money elsewhere.

Further disappointment may be in store for investors in yield-based funds, which invest primarily in the office sector. Yield investing involves capitalising on low interest rates by borrowing at a rate of interest less than the rental yield on the property acquired (the yield is worked out by dividing the annual rental income by the capital employed). Shore and Dawnay, Day's Puma Property Fund exploited this in a low interest rate environment, but anyone still pursuing the strategy faces reduced yields as borrowing costs creep up.

In reality, neither general nor limited partners would be likely simply to sit back and watch their returns diminish. Instead, more active management of the assets may be attempted through such methods as increasing rents or refurbishing and/or expanding the property.

In June, The Carlyle Group showed office ownership could be lucrative when posting a 36 percent internal rate of return from the sale of five office buildings in Paris and one in Milan to various unnamed real estate funds. In a statement, Carlyle said it had “renovated and refurbished the buildings to improve their quality” following their acquisition in March 2003.

But despite individual successes, the general weakening in popularity of office investment may give limited partners pause for thought, because it is still easily the largest sector in terms of capital invested. According to Jones Lang LaSalle, it received 44 percent of all European real estate investment in 2003, despite this figure representing a second successive year of decline.

Another taxing issue for would-be investors in the asset class is the difficulty of attaining sufficient diversification. Many of the GPs approached for this feature claimed to have effective pan-European networks, enabling access to high quality proprietary deal flow around the continent. But is this reality or spin? There is no doubt that having well connected locals is extremely useful.

For example, witness the role of Xavier Faus in the acquisition of the Arts complex by Patron referred to earlier. Faus was well plugged into the Barcelona real estate market, having run his own M&A and real estate advisory boutique since 1997. He not only advised Patron on the Arts project but also invested in it and became its chairman. Having helped deliver a sexy return, the contribution of Faus was acknowledged through his subsequent appointment as a Patron partner and head of the firm's new Spanish office.

But such mutually beneficial relationships don't fall from trees and, without them, investing on a pan-European basis is a tough task. The ‘Emerging Trends in Real Estate Europe 2004“ survey compiled earlier in the year by the Washington DC-based Urban Land Institute and PricewaterhouseCoopers, noted: “The real estate industry's full potential is tempered by continued barriers to pan-European investment such as vastly different tax and legal structures, business infrastructures, leasing conventions, operating standards and business cultures and varying languages.”

And if it's this tough for Europeans, surely US GPs are seriously deterred from chancing their arm? Well, no. Not if you can simply cherry pick the best available locals. In 1998 Harbert Management Corporation, the Alabama-based alternative asset manager, recruited real estate veteran Doug Kirkman from investment adviser Security Capital Group to spearhead its push into Europe, having grown tired of parachuting in senior management on an opportunistic basis. Scott O'Donnell, the former European real estate head at Credit Suisse First Boston in London, subsequently joined him.

Having built up a five-strong London team, Harbert has made ten investments from its debut $105 million fund, including a 22 percent stake in a joint venture that acquired London's upmarket Cadogan Hotel, and is, according to a source, considering launching a second fund “in the near future”.

O'Donnell explains the attractions of Europe for North American investors: “There can be frustrations due to the number of protected buildings, planning restrictions and the amount of bureaucracy you encounter. However, all these things serve as barriers to entry, and coupled with certain social protections that exist in Europe but not in the States, also protect you from oversupply, which has tended to have a more profound effect on the major US markets.”

Other firms will undoubtedly take that message on board, particularly in light of increased liquidity promised by the growth of the real estate investment trust (REIT). The REIT, a tax efficient vehicle for property investors, is a staple of the US real estate market and has already been introduced to a number of European countries such as France and Belgium. Its implementation is being considered in various other countries including the UK, though market practitioners point out that some of the European REITs seen so far are effectively a watered down version of the US model, meaning their impact is more limited.

Whether that's a fair assessment or not, there are plenty of other reasons why European real estate general partners can look to the future with confidence – not least because, in comparison with certain other asset classes, theirs is looked upon favourably by institutional investors. In light of this, expect more first-time investment teams to try their hand, as well as spinouts of teams from larger groups in order to exploit perceived niche opportunities. And if viewing the activities of opportunity funds leads Europe's mainstream private equity firms to feel they are looking in a mirror, is it fanciful to imagine others following the likes of Carlyle and Doughty Hanson into the dedicated real estate arena?