Scott Lanphere, founder of London-based private equity firm Aletheia Partners and a former director at Morgan Grenfell Private Equity, admits he has not yet thought up a name for his recently-announced first time real estate fund. But the fund's underlying investment strategy has long been cemented in his mind.
Says Lanphere, who earlier this year attempted to mount a bid for UK up-market retailer Selfridges: “We knew we'd be looking for deals that have long-term revenue. We knew we'd be looking for an asset base that can provide a stable cash flow in a defensible business niche. Real estate fits that profile to a tee.”
When you invest in an opportunistic fund, you're buying the skills of the manager
Many investors and fund managers agree. With appetite for unlisted real estate investment on the rise – especially among institutions in the UK and continental Europe – prospective investors are lining up to commit capital to private equity real estate offerings.
In some cases, investors and general partners are working together. After searching in vain for core investment funds that met his risk parameters, Chris Taylor, a director at Prudential Life Assurance Company, recently joined forces with Morgan Stanley to create a €1.5bn European Office Fund. “Most of the funds I saw being produced were a legacy of the 1990s bull market. Therefore, they were not relevant to the economic realities the property markets are facing today, which include downward pressure on rents, as well as occupational markets in disarray, particularly with offices.”
More assets come to market
This is the kind of environment that lends itself nicely to opportunistic real estate investment. The new fund, which closed earlier this year, recently acquired the headquarters of Italian liquor manufacturer Campari in Milan for €47m. With a 3 per cent vacancy rate in Milan, according to Taylor, this region is one of the few Western office markets where there is still relatively limited asset supply.
Other recent high profile property transactions in Northern Italy include a joint venture between Pirelli & C Real Estate and again Morgan Stanley, which together purchased the Fondiaria-SAI portfolio, which has property holdings in Milan, Florence, and Rome, among other locations. With a €1bn bid, Pirelli and Morgan Stanley beat competition from a number of US investors including The Blackstone Group.
Sweden is also seeing increased investment activity from opportunity funds, with more than SKr9bn (€977m) in deals involving international buyers this year. Goldman Sachs' Whitehall real estate investment funds made the biggest splash, when the firm purchased a portfolio of 31 office properties, for SKr5.2bn, from listed real estate manager Drott.
In the UK, the likely sale of East London's listed commercial real estate manager Canary Wharf Plc to a private equity buyer (both Goldman Sachs and Morgan Stanley Real Estate Funds are in the running), is certain to further boost the profile of property-focused opportunity funds in Europe. A number of other UK-based listed companies such as Chelsfield, Merivale Moore, Compco Holdings and Newport Holdings have already gone private, or are subject to offers.
Corporations in Europe and in the UK are becoming increasingly sophisticated about optimising their real estate portfolios
It is difficult to ascertain precisely how much capital has recently flown into private equity real estate vehicles especially outside of the US, as no definitive up-to-date research is currently available. (Ernst & Young's Real Estate, Hospitality and Construction Group, which publishes the leading survey on opportunity funds, says that in 2001, 23 such funds raised $17bn, against $11.5bn raised in 2000. At the time of this article going to print, a forthcoming updated version of the survey had not been made available yet.)
However, an interesting statistic providing a sense of the market opportunity presenting itself in Europe today is that, according to the research arm of Jones Lang LaSalle, a strategic consulting and global real estate and investment management provider, 67 per cent of the commercial real estate in Europe is still owner-occupied, while only 24 per cent of US commercial property is owned by its occupants. Because European corporations are likely to follow the US trend and sell off their property assets, opportunistic buyers of these assets are optimistic with regard to future transaction flow.
Edward LaPuma, chief acquisitions officer at New York-based real estate lender WP Carey & Co, which has an office in London, says his firm has seen an undeniable increase in European transaction activity driven by greater interest among corporate owners in disposing of property assets. “There is now a large contingent of European companies who see the benefit of sales-lease-back transactions. And in order to reach equilibrium, there has got to be increased capital flow as well.”
Paul Brewer, managing director and head of European private equity investments at Lehman Brothers in London, also believes that opportunity funds will benefit from the current change of the way in which businesses are managing the real estate they own: “Corporations in Europe and in the UK are becoming increasingly sophisticated about optimising their real estate portfolios. Businesses are taking the buildings off their balance sheets and are looking to lease property instead. They see this as a way to improve their capital efficiency. That's been a big boon for real estate opportunity funds like ours,” says Brewer, referring to Lehman's $1.6bn Global Real Estate Opportunity fund.
Reasons to invest
Private equity real estate investment has proliferated in the United States since the early nineties, in part as a knock-on effect of the US Savings & Loan debacle, which prompted a number of Wall Street firms to get involved in bidding on the massive amounts of problematic real estate assets that emerged from the S&L crisis. Investors recognised that opportunistic investment in these assets could generate significant returns. The field quickly grew into a separate asset class, and soon came onto the radar of non-US investors as a viable alternative investment opportunity as well.
Part of what attracts the buyside to opportunity funds is the private equity style control element that these funds exercise when managing their investments. Tom Grainger, executive director of alternative investments at Morgan Stanley, in West Conshohocken,
Pennsylvania, explains: “When you invest in an opportunistic fund, you're buying the skills of the manager. You're buying his ability to source assets, and his ability to make changes in a property in order to generate return, and you're also buying the ability to swiftly exit the investment.”
Grainger, who has invested in several opportunistic real estate private equity funds, says there is now significant momentum among European investors looking to invest in opportunity funds. He says: “There's now more of a portfolio approach to investing. Europeans are making up for lost time in investing in real estate opportunity funds, and there's been an explosion of these funds in Europe because of this.”
REITs to the fore
Other market participants say investors' current enthusiasm for private equity real estate investing in Europe is also to do with a growing recognition of the tax benefits offered by structures such as real estate investment trusts (REITs). REITs have long been fixtures in the US, where they provided a blue-print structure that proved conducive to the private equity real estate investment market. Now REIT structures are emerging in other parts of the world as well.
“There is a growing acceptance of the REIT in countries like Belgium, Italy, Holland and France”, notes Charles Graham, whose London-based Europa Capital Partners is currently investing a pan-European opportunity fund.
Graham points to the fundamental difference in real estate investment habits between investors in the US, where people own real estate through limited partnerships and direct investments, versus those in the UK and continental Europe, where quoted property company investment has traditionally been the norm. “Europeans are starting to realise that you can invest more efficiently through a REIT than by buying shares in a property company,” he says, adding that as REITs further develop in Europe, they will continue to weaken the appeal of quoted real estate companies to UK and European investors.
Most large institutional investors can comfortably maintain a portfolio with both the publicly-listed property managers and private equity investments
Performance is another reason why investors are warming to the opportunistic model. Erwin Stouthamer, a director of Holland-based MN Services, an independent management firm that acts on behalf of several Dutch pension funds, private equity real estate funds offer several enticements. For one thing, they provide a way to directly participate in the upside of an investment. “Also, your universe is bigger”, he notes, adding that “it would be bad judgment to exclude this deal source, and to forego the good opportunities there are for attractive risk/return profiles.”
Like Graham, Stouthamer says his migration towards private equity real estate investment techniques is in part driven by his experience in dealing with REITs. Over the last five years, Stouthamer has committed over $1bn to 23 different non-listed investments, including funds, joint ventures, co-investments, and private equity investments.
According to Bill Benjamin, managing director of Apollo Real Estate Advisors, many of his European investors say they appreciate the high level of discretion that is built into the opportunity model.
However, while pointing out that European investors have an appetite for targeted, geographically-specific investment vehicles, he is less certain that the growing success of opportunity funds is necessarily going to be detrimental to the more conventional listed property managers: “Most large institutional investors can comfortably maintain a portfolio with both the publicly-listed companies and private investments. The two aren't mutually exclusive.”
Diversification, outperformance, tax efficiency
Benjamin notes that for a while raising capital for opportunistic real estate investment had not been easy, but he also notes that demand has since recovered. “When the economy began suffering in 2000 and 2001, it became more challenging to raise money through opportunistic funds, although interest has been renewing since then. And I think that if interest rates rise a bit, commercial mortgage-backed securities may see trouble, and there may be an opportunity to buy those at a discount. That's the immediate opportunity, but in the long term, if there is a general economic recovery, real estate should benefit as well.”
Peter Pereira Gray is a private equity investor who runs the runs property investment operation at the Welcome Trust in London. For him, the fundamental attraction to investing in private equity real estate funds is the ability to generate high risk-adjusted returns at a portfolio level. He says: “If you have diversified positions in real estate, you can add alpha by adding private equity real estate to your overall portfolio. That, on a risk-adjusted basis, should give you enhanced returns. In my view, the required return should be higher then your required return if you invested in real estate directly.”
According to Sanford Presant, national director of Real Estate Tax Strategies and Opportunity Fund Services at Ernst & Young, investors should expect returns from opportunistic real estate investments to average somewhere between 16 to 20 per cent.
Investors and managers are also keen to incorporate property investments into their private equity allocations because they offer the much-coveted prospect of low volatility. Lehman Brothers' Brewer says: “Real estate assets are hard assets, and although there will always be cycles, at the end of the day you still own the building. It's been a risk-averse time in the last two years, which hurts private equity a little bit, but it helps the underlying real estate investment, so on balance, private equity real estate funds are looking attractive.”
Timothy Spangler, a London-based partner at law firm Berwin Leighton Paisner, says the intrinsic diversification element of fund investing is another selling point when it comes to private equity real estate. Says Spangler: “If you are a midsize institution and you have £100m to allocate to [direct] property investments, that could be only a couple of buildings. Alternatively, you can invest £10m in 10 different private equity real estate funds.”
Spangler also points to the virtue of sector differentiation inherent in property investments, be it commercial, residential or leisure. “You want exposure to all these things, and third party managers have expertise that investors don't have. You want someone to advise you on them, but if you don't have the money to get them to meet with you on a one-on-one basis, a fund is a good way to go,” says Spangler.
There is a growing acceptance of the REIT in countries like Belgium, Italy, Holland and France
For many investors, another critical criterion influencing their investment decisions is tax-efficiency. Mark Tagliaferri, a former private equity executive at Terra Firma Capital Partners in London and chairman of UK newcomer Active Asset Investment Management, which recently completed the $150m acquisition of a combined office and retail building in the City of London, explains that when investors purchase listed property companies in the UK, when gains are realised, a company is taxed at the corporate level before investors are taxed on their dividends. “But in our structures, the entity prepares its tax return, and each individual gets their share of the gain or loss each year. With most real estate investments, you have losses in the early years, which can be used to offset gains.”
There is also a psychological aspect of real estate that contributes to its popularity, according to Spangler. “People understand real estate. They own real estate. They own their homes. They invest in other people's homes. They speculate in real estate. It is logical for them to take it to the next level and invest in private equity real estate funds.”
European institutions are not the only entities that are jumping on the private equity real estate bandwagon. High-net-worth individuals and other sophisticated investors -though on a comparatively smaller scale – are also beginning to climb on board.
Jonathan Short, chief executive of London-based Pricoa Property Private Equity, which specialises in investing in the management companies of privately owned property managers, has noticed a shift in his client base. He notes that when raising capital in 2000 and 2001, he typically spoke with real estate specialists at large global institutional investors. Today, he views high-net-worth individuals, funds of funds, and family office aggregators as equally viable prospects.
“Three years ago, those investors were much more interested in leveraged buyout vehicles and telecom funds, because real estate returns weren't as sexy,” Short notes. “Today it is different. There has been a bit of a sea change in terms of investors' appetite for the product.”
So many funds
Given the increase in private equity real estate vehicles to have come to market, and given the fact that a number of mainstream private equity firms such as Doughty Hanson, Blackstone and Carlyle already operate real estate funds as part of their offerings, investors say they have had to do more due diligence in order to identify the managers that are most capable of executing the strategy.
“The fundamental consideration is prospective returns,” notes Pereira Gray. “Are they attractive compared with the risk of the vehicle that [investors] are taking on? We consider this heavily, but we also look at the management's confidence. Do they have the infrastructure in place to run the strategy? Is the strategy cohesive? Do we believe it? As a professional investor, I can't just buy into an idea without the knowledge that the idea can be professionally implemented.”
Tom Grainger says he looks for local partners, and is a firm believer in alignment between himself and the GPs. He also takes a close look at fees, costs, and terms and conditions.
The opportunity fund community is confident that with the right choice of manager, investors can look forward to an interesting period going forward, particularly in geographies where the property sector is going through a difficult time right now.
The UK is a good example. “I think London is experiencing a lull,” says Mark Tagliaferri. “And in this climate, real estate investing makes sense, as long as you think real estate will recover, and that demand will catch up with supply over the next few years.”
Spangler at Berwin Leighton Paisner agrees: “The closed IPO market has made leveraged buyouts not as attractive as in the past. Real estate private equity funds are more attractive to investors than ever.”
It is a message that institutions seem to be hearing loud and clear at present. Europe's still emerging opportunistic real estate investment industry looks set for a healthy spat of growth over the coming years.