Bricks and mortar

The future looks challenging for private equity real estate funds. Lynn Strongin Dodds reviews the outlook and highlights some of the brighter spots

T his year is going to be difficult for private equity real estate funds. The fallout from the credit crunch is deepening as banks pull their lending strings even tighter. There are pockets of opportunity, particularly in Asia and eastern Europe, but gaining financial backing and investor support is likely to prove more challenging.

“Last year was a strong year for traditional and private equity real estate fundraising but there is now a huge amount of cash piling up,” says Matt Maltz, tax partner and head of Ernst & Young’s real estate funds practice. “Private equity firms can no longer borrow at the same levels and, as a result, they will struggle to produce the 20%-plus returns that investors had come to expect. General partners will have to explain that performance will be less although it will still be possible to produce relatively healthy returns of 15%-plus.”

News from the US points to a long, hard road ahead. Industry participants are divided as to whether the world’s largest economy is in recession, but weak unemployment figures, consumer spending and renewed concerns about the health of global credit markets is making investors in every asset class nervous.

The result is that real estate transactions in the US and Europe have stalled and a recent report by data provider Private Equity Intelligence Real Estate reveals that there has been a slowdown in completed fund raisings so far this year. As of February 2008, there were 12 private equity real estate funds reaching a final close worth a total of $6.3bn (€3.9bn) compared with 20 final closings a year ago valued at $11.2bn.

The final fundraising numbers for 2007 are still being tallied, but it is likely that they will come close, or even exceed, 2006’s record $85bn. Preqin Real Estate figures show that 126 private equity real estate funds held final closings, raising $79bn. The US remained the most popular destination with 60 funds garnering $36.5bn. Next came Asia and the rest of the world, usurping Europe’s second place. These countries, especially India and China, attracted 37 funds with $21.6bn in their coffers, which was slightly higher than the 37 funds that raised $20.6bn for European-focused funds.

As to be expected, the first half of 2007 was the most buoyant with 73 funds collecting $44.2bn. Activity dropped sharply in the second half to 53 funds raising $34.5bn due to fears over the subprime crisis. While few industry participants are willing to predict the outlook for 2008, it is certain is that private equity real estate remains popular with investors, according to Ignatius Fogarty, head of real estate research for Preqin.

Fogarty notes that a recent Preqin survey of key institutional private equity real estate investors in its database of 800, found that about 54% intended to maintain their current exposure to private equity real estate, while around 46% said they were seeking to increase their holdings.

“Despite the credit crunch, we found that no-one was planning to cut their allocations,” Fogarty says. “However, many investors are cautious about current market conditions, which means that managers currently raising new vehicles will have to emphasise how they intend to deal with credit conditions.”

Private equity investment in real estate gathered a frenetic pace over the past three years due the availability of cheap debt, spiralling prices and investors’ demand for octane-fuelled performance. Although private equity activity contributed to the gravity-defying price rises, it had plenty of help.

Ubbe Strihagen, director at Aberdeen Property Investors, believes private equity has been positive for the industry. “Private equity firms’ interest in real estate has led to the overall professionalism and development of real estate as an asset class. Also, they helped make it a more international asset class and made investors look beyond their own domestic markets.”

There is some blurring between mainstream and private equity funds in opportunistic deals, but the private equity typically opts for the much riskier and leveraged investments. Private equity also tends to operate on a shorter time frame than the traditional 10-year core or core-plus funds.

General partners specialise in opportunistic or value-added close-end funds that offer the promise of higher returns in exchange for added risk. The investments cover commercial real estate, residential, leisure, distribution and warehouses. Depending on the size of the fund, transactions have included direct equity investments, debt investments secured by real estate and joint ventures with local developers.

There are also cultural nuances within different jurisdictions. In the US, the privatisation of REITs has become extremely popular with large groups like Blackstone Real Estate Group. The firm, which is currently trying to raise $10bn with its sixth fund, made the news with one of the largest transactions last year - the $39bn takeover of Equity Office Properties. The deal hinged on the rapid sell-off of most of the real estate to limit interest payments on the debt.

In the UK, private equity investors often targeted companies that had undervalued real estate assets and would then adopt some sort of leaseback or so-called op-co/prop-co structure, where the operating company is split from the real estate holdings. Unlocking the potential of vast property holdings was one of the main drivers behind KKR’s €15.5bn purchase of Alliance-Boots, the last major private equity deal to hit the market. It also featured prominently in the failed attempts of a CVC Capital Partners-led consortium and then Qatar Investment-backed investment group Delta Two for property-endowed supermarket giant Sainsbury.

Private equity investors in Germany have focused more on residential, from state pension administrators and other quasi-public entities. In 2006, London-based Terra Firma orchestrated one of the largest private equity deals in Europe, paying €6.1bn for 138,000 units sold by German utility company E.ON.

It is difficult to predict what type of deals will flow through the market this year. “Real estate deal volume has significantly shrunk in the US to almost negligible levels”, says Asieh Mansour, chief economist and strategist at RREEF. “There is a significant amount of capital on the sidelines. The only activity we are seeing is in the small- to mid-market area, with bite-sized deals of less than $100m being done.”

The same applies to the UK, which was one of Europe’s hottest markets. The lack of available leverage is a major contributing factor. A recent report from RREEF found that since October, lenders have pulled back from the commercial real estate sector, with about 50% indicating that they were tightening underwriting standards. In fact, investors’ access to debt has reached levels not seen since the recession in 2001/2002.

The days of 90% loan-to-value (LTVs) - the ratio between the size of a mortgage and the mortgage lender’s valuation of the property - are long gone. Today, the ratios have been whittled down to 65-75% and banks are demanding a higher income-to-loan ratio. They are no longer willing to shoulder the debt burden alone.

Jonathan Dracos, co-head of Investcorp’s real estate group, says: “Lending institutions may be willing to go to $75-100m, but they are looking to syndicate anything bigger than that. The other major problem is a mismatch between the expectations of buyers and sellers. Sellers are still expecting to get the same prices they were getting early last year. We are actively meeting with capital sources, looking to buy properties and are winning a handful of transactions, but there needs to be more commonality on pricing.”

This standstill is predicted to last for the rest of the year because vendors are not putting their properties onto the market, according to Emma Bucknall, real estate partner of law firm Paul Hastings. “Investors had expected that there would be more distressed sales following last August’s events in the sub-prime markets, but so far with rents holding up and with debt still being serviced we have seen few forced sales in the UK.”

This could change says John Forbes, UK real estate leader at PriceWaterhouseCoopers. “Some of the problems that the open-ended funds are experiencing may create opportunities for private equity firms and other opportunistic investors because the open-ended funds are already starting to sell assets at a discounted price to pay for the redemptions.”

Private equity houses are also looking at opportunities in BRIC, as well as Turkey. Last November, Pacific Alliance raised two funds worth $400m and listed on London’s Alternative Investment Market, to take advantage of opportunities in greater China.

“The credit crunch has generally not impacted China,” says Pat Boot, managing partner, Pacific Alliance China Lan. “But attempts by the government to cool the economy and restrict lending to the property sector is providing opportunities for foreign investors as local developers need new funding sources.