Casualties of the gold rush

As hedge funds increasingly look to property investment, one real estate investment banker discusses five common mistakes—and how to avoid them. By Paul Fried

Finding office space and setting up trading floors used to be the limit of hedge funds' interest in real estate. This changed dramatically over the last five years as the funds saw real estate as a terrific vehicle for diversifying their portfolios and capitalizing on booming markets.

For hedge funds real estate is relatively safe, requiring miniscule resources compared to a traditional investment play. But many hedge funds are finding that even “cash flowing” real estate has unforeseen risks and costs they never expected. Real estate should be able to earn its keep in a fund's portfolio— and it has a better chance of doing this if practitioners can learn from the five most common mistakes these investors make when investing in real estate.

Focusing on cash flow instead of the asset
It has long been said that real estate is entirely different than any other asset. Some funds don't believe the adage. They should.

Experienced real estate investors are generally asset-focused. In contrast, hedge fund analysts focus on the cash flows and financial models. But cash flow modeling—which serves these investors so well in all their core acquisitions—fails to capture the asset's competitive position in a changing market.

Cash flow modeling doesn't account for unquantifiable factors, such as the approval process required for new construction or redevelopment projects—and the inevitable delays that dramatically impact costs. Traditional financial analysis also doesn't factor in the almost certain, yet unpredictable, hiccups that come with any real estate deal: A simple change in local government or zoning is a potential death knell for any project.

Funds also apply standard lease-up assumptions about office tenant retention costs and market average rents that fail to account for how a specific asset will perform in a post-bust climate. Funds are learning the hard way that many assets don't achieve the average. Less competitive properties suck wind if they have tired exteriors and interiors; dated technology and systems (such as air conditioning and small, slow elevators) ; or are “parking-challenged.” Add larger than anticipated rent concessions to compensate, and what was believed to be a “good buy” quickly becomes a loser.

Believing that the rent rolls never change
Applying standard lease analysis can lead to a false sense of security: The conclusion that the rent roll will not materially change since it's been thoroughly scrubbed, stressed and subjected to “market” assumptions. But real estate analysts know the truth: Rent rolls can-and do-change, no matter the history of a property or the quality of the tenant.

Recently we arranged capital for the acquisition of a vacant office tower in Austin. The tower previously had been fully occupied by government agencies. Certain issues were obvious: The interiors looked, well, like they'd been occupied by government agencies and the building also required extensive exterior improvements as part of a “branding” plan to reintroduce the property to brokers and tenants. This was the cornerstone, and really the key part of the business plan for this asset—an element that couldn't be discovered from rent roll analysis and wouldn't be properly budgeted for by using standard leasing and improvement assumptions.

Assuming all real estate risk is the same
One property sector that has attracted plenty of fund attention is land development—the process of acquiring raw land and obtaining “entitlements,” or the right to build on it. The strategy can offer high returns, especially when the developer has a good track record. But as every experienced real estate investor knows, when a developer promises to deliver the necessary zoning approvals, one can't count on them always coming through—even if the mayor is an investor.

In one recent scenario, a hedge fund made a $10 million investment in the development of a fully approved, master-planned community with single-family homes. The plan had been to sell the lots to different builders for development and sale to homebuyers. Weakening market conditions forced the developer to do the build-out and sales directly to the endusers. While the project was no less viable, the entire budget changed. More importantly, the project's timeline was greatly extended and, by taking on vertical construction and end-user sales, the developer would be taking on far greater risk than originally intended.

While risk is greatest in new development, each asset class has its own risk profile. The solution that we've found in many cases has stemmed from a “back-to-basics” approach, working with each fund to develop their particular “risk-and-reward” view and then tailor the structure accordingly.

For instance, in a recent residential condominium development, the hedge fund's overriding concern was construction cost overruns. Given the developer's financial capability, we advised the fund to consider giving up some of the upside potential for some downside risk protection—this lead to a structure in which the developer provided construction cost guarantees well above the norm. The fund received these enhancements plus a preferred—albeit lower—return and the developer received a greater share of the back-end profits.

Thinking the work is done when the deal closes
Some large hedge funds have created real estate investment divisions staffed with experienced professionals. These companies are the exception, not the rule.

Traditionally, hedge funds are lean machines. It's not unusual to find an investment platform run by three people with a five-person staff. Their experience has been that once a trade closes, the heavy lifting is over. Nothing in the non-distressed bond or public equity markets has prepared them for managing an active real estate investment.

Real estate investments require ongoing time, energy, focus and resources. The potential re-flagging of a hotel property mandates days or weeks of due diligence, paperwork and approvals. A straightforward investment in an office building can lead to hours spent approving leases—continuing for months after the acquisition is completed. New construction generally involves innumerable redesigns, revised budgets and contractor agreements. As a result there is an immeasurable cost associated with ongoing real estate asset management with which hedge fund executives can find themselves saddled.

We can't tell our funds that they're understaffed for an investment that they want to do, but we can zero in on the issues that will likely create drag on the fund—and ultimately the sponsor.

One of our recent hotel transactions involved a sponsor group which hadn't worked with institutional partners before and a fund which had never invested in this asset class. We spent considerable time working with the sponsor to get their systems in order, making sure they understood the “major decisions” and discussing likely scenarios, such as approval of large construction contracts, draw requests and changes to room rates, personnel and food and beverage services.


Global funds
N/A Alpha Real Capital London Europe/Asia diversified €400
Beacon Capital Strategic Partners V Beacon Capital Boston US/Europe diversified $3,000
Blackstone RE Partners VI The Blackstone Group New York Global diversified $8,000
Colony Investors VIII Colony Capital Los Angeles Global diversified $2,000
Contrarian Real Estate Fund Contrarian Capital Stamford (CT) US/Europe distressed $250
DLJ Real Estate Partner IV Credit Suisse New York Global diversified $2,000
GoldenTree In Site Partners Oppty Fund Golden Tree InSite Partners New York Global diversified $500
Lehman Brothers Real Estate Partners III Lehman Brothers New York Global diversified $3,000
Lone Star Fund VI Lone Star Funds Dallas Global diversified $6,000
Macquarie Global Property Fund III Macquarie Global Property Advisors Hong Kong Asia/Europe diversified $3,500
N/A Perella Weinberg Partners New York Global diversified N/A
Rockpoint Real Estate Fund III Rockpoint San Francisco Global diversified $2,000
Walton Street Real Estate Fund VI Walton Street Capital Chicago US/Europe diversified $2,500
WCP Real Estate Fund I Westport Capital Partners Westport (CT) Global diversified $500
Westbrook Real Estate Fund VII Westbrook Partners New York Global diversified $1,250
Global funds subtotal $35,036
North America funds
AEW Value Investors II AEW Boston US diversified $500
AG Realty Fund VI Angelo Gordon New York US diversified $500
Avenue Real Estate Fund Avenue Capital New York US distressed $300
Blackacre Institutional Partners Blackacre New York US distressed N/A
Black Creek Mexico Residential Fund Black Creek Group Denver Mexico diversified $500
Brascan Real Estate Opportunity Fund Brascan New York NA diversified $1,000
Broadway Real Estate Partners III Broadway Partners New York US office $1,000
Buchanan Fund V Buchanan Street Partners Newport Beach Global diversified $400
Canyon Johnson Urban Fund III Canyon Johnson Los Angeles US urban diversified $750
Capri Urban Investors Capri Capital Partners Chicago US urban diversified $1,200
Carlyle Realty Partners V The Carlyle Group Washington DC NA diversified $1,500
CASA Partners IV Henderson Global Investors Chicago US multi-family $300
Richard Ellis Richard Ellis Los Angeles US diversified $1,000
Ceres Realty Fund II BlakelyStern Investment Advisors New York US northeast diversified $100
CityView LA Urban Land Fund I American CityVista/Saybrook Capital San Antonio (TX)/Santa Monica (CA) California development $150
Clarion Development Ventures III ING Clarion Partners New York US development $350
CIM Urban Real Estate Fund III CIM Group Los Angeles California diversified $750
CREF IV Calare Properties Hudson (MA) US northeast diversified $30
Crown Capital Opportunities Fund Crown Capital St. Louis US diversified $200
N/A Crescent Hotels and Resorts Fairfax (VA) US hospitality $350
Cronus Capital Fund I Cronus Capital New York US diversified $200
Colony Realty Partners II Colony Capital Los Angeles Global diversified $1,000
Concierge Apartment Fund Concierge Asset Managment Tiburon (CA) US multi-family $250
Cornerstone Apartment Ventures III Cornerstone Real Estate Advisors Hartford (CT) US residential $400
Crocker Partners IV Crocker Partners Boca Raton (FL) Global diversified $300
DRA Growth & Income VI DRA Advisors New York US diversified $1,250
Dunmore Capital Fund Dunmore Capital Sacramento (CA) California development $200
Embarcadero Capital Partners Fund II Embarcadero Capital San Francisco US office $400
Fidelity Real Estate Growth Fund III Fidelity Boston US diversified $750
Fremont Strategic Property Partners III Fremont Realty Capital San Francisco US diversified $750
Green Courte Real Estate Partners II Green Courte Partners Lake Forest (IL) US diversified $225
Guardian Realty Fund III Guardian Realty Investors Bethesda (MD) Mid-Atlantic diversified $500
Hampshire Partners Fund VII Hampshire Partners Morristown (NJ) US diversified $350
Hanover Real Estate Pertners III Hanover Financial Los Angeles Western US diversified $250
Hearthstone Path of Growth II Hearthstone Advisors San Rafael (CA) US development $500
Heitman Value Partners II Heitman Chicago Global diversified $800
Henderson Manager of Partners Fund Henderson Global Investors Chicago Global diversified $200
HG Capital VII HG Capital Menlo Park (CA) Western US diversified $65
House Investment RE Opportunities Fund IV House Investments Indianapolis US development $30
Hudson Real Estate Fund IV Hudson Realty Capital New York US diversified $300
Hunter Chase Real Estate Opportunity Fund Hunter Chase Irving (TX) US diversified $250
ING Lion Mexico Fund ING Clarion Partners New York Mexico diversified $500
Intercontinental Fund IV Intercontinental Boston Value-added US diversified $250
InvestLinc Real Estate Capital 3 Fund Investlinc Group Chicago US diversified $150
Invesco Real Estate Fund III Invesco Real Estate Dallas US diversified $500
Jamestown Coinvest IV Jamestown Properties Atlanta Southeast US diversified $500
JBC Opportunity Fund III John Buck Co. Chicago US diversified $300
JER Real Estate Partners IV JER Partners McLean (VA) US diversified $1,250
KBS Best Property Fund II KBS Realty Advisors Newport Beach (CA) US diversified $500
Kelly Capital Real Estate Special Situation Fund Kelly Capital San Diego US diversified $100
Kimpton Hospitality Partners II Kimpton Hotel San Francisco US hospitality $300
KMF Senior Housing Investors Fund KMF Senior Housing Investors Chicago US senior housing $250
LaSalle Canadian Income & Growth Fund II LaSalle Investment Management Chicago Canada diversified $350
LaSalle Medical Office Fund II LaSalle Investment Management Chicago US medical office $350
Lazard Freres Strategic Realty Investors III Lazard Freres & Co. New York US healthcare $500
LBA Realty Fund III LBA Realty Irvine (CA) US office/industrial N/A
Lexin AmTrust Real Estate Partners II Lexin Capital New York US residential $150
Los Angeles Development Partners Chadwick Saylor Los Angeles Southern California urban $150
Macfarlan Special Situations Fund Macfarlan Capital Partners Dallas US distress $300
MacFarlane Urban Realty Partners MacFarlane Partners San Francisco US urban diversified $1,000
N/A MayfieldGentry Realty Detroit US urban diversified $150
Market Street Capital DivcoWest San Francisco US office $650
Miller Global Fund V Miller Global Properties Denver US diversified $400
N3 Opportunity Fund I N3 Realty Advisors Forth Worth (TX) US diversified/retail development $50
Urban Strategy America Fund New Boston Fund Boston US urban redevelopment $200
O'Conner North American Property Partners O'Conner Capital Partners New York North American diversified $750
Palisades Distressed/Value-Added Fund Palisades Financial Englewood Cliffs (NJ) US diversified $200
Genesis Workforce Housing Fund Phoenix Realty New York Los Angeles residential $175
Metropolitan Workforce Housing Fund Phoenix Reality New York US residential $250
Praedium Fund VII Praedium Group New York US diversified $700


PLA Industrial Fund II Prudential Real Estate Investors Parsippany (NJ) Mexico industrial $140
PLA Residential Fund II Prudential Real Estate Investors Parsippany (NJ) Mexico residential $400
Prudential Senior Housing Partners III Prudential Real Estate Investors Parsippany (NJ) US senior housing $300
RCG Longview Equity Fund Ramius Capital Group New York US diversified $300
Sarofim Multifamily Fund I Sarofim Realty Advisors Dallas US residential $150
Savanna Real Estate Fund I Savanna Partners New York East Cost diversified $400
Sentinel Realty Partners VII Sentinel Real Estate Corporation New York US diversified $200
Somera Realty Value Fund II Somera Capital Santa Barbara (CA) US diversified $300
Square Mile Fund I Square Mile Capital Management Greenwich (CT) US distressed $300
Stillwater Real Estate Partners Fund Stillwater Capital New York US residential $50
Stockbridge Real Estate Fund III Stockbridge Capital Partners San Mateo (CA) US diversified $3,000
Strategic Office Fund I NNN Realty Advisors Santa Ana (CA) US net-leased office/retail $250
Stratford Lane Fund III The Stratford Company Tacoma (WA) US land $300
TA Associates Realty Fund VIII TA Associates Boston US diversified $900
Tishman Speyer Real Estate Venture VII Tishman Speyer New York US diversified $2,000
Thor Urban Retail Fund II Thor Equities New York US retail $500
Urdang Value Enhancement Fund VI Urdang Capital Mgmt. Plymouth Meeting (PA) US diversified $450
Williams Opportunity Fund Williams Realty Advisors Atlanta US diversified $120
North America funds subtotal $42,085
Europe funds
N/A AIB Capital Markets Dublin Poland diversified €100 – €150
Arminius Real Estate Opportunity Fund Arminius Advisors Frankfurt Germany distressed €300
Capmark UK Realty Partners Fund Capmark Financial Horsham (PA) UK diversified €250
Carlyle Europe Real Estate Partners III The Carlyle Group Washington DC European diversified $1,500
N/A Catalyst Capital London Europe diversified €500
CBRE Strategic Partners Europe Fund CB Richards Ellis Investors Los Angeles Europe diversified €600
CBRE Strategic Partners UK Fund CB Richards Ellis Investors Los Angeles UK diversified £300
Colony Europe II Colony Capital Los Angeles Europe diversified €500
Corestate German Residential Corestate Capital Frankfurt Germany residential €4,000
Elgin Capital Fund Elgin Capital Dublin Berlin residential €60
EPI Baltic I EVLI Bank Helsinki Baltic states diversified €100 – €150
European Continental RE Fund Clearbrook Capital Partners London Europe diversified £1,000
Global Property Fund Global Finance Athens Balkan development $150
Heitman European Property Partners IV Heitman Chicago Europe diversified €500
Hines European Development Fund Hines Houston Europe development $430
Italian Opportunities II Cordea Savills London Italy diversified €300
LaSalle UK Venture Funds LaSalle Investment Managment Chicago UK diversified €2,200
MIL Equity Partners EquityInvest Boston Central/Eastern Europe diversified $100
Moor Park Real Estate Fund Moor Park Capital London Europe diversified €1,200
Central European Industrial Fund Morley Fund Mgmt/Teesland loG London Central/Eastern Europe industrial €160
NIAM Nordic Investment Fund IV Newsec Incentive Asset Mgmt. Stockholm Nordic region diversified N/A
Europe funds subtotal $19,959
Asia/RoW funds
AG Asia Realty Fund Angelo Gordon New York Asia diversified $300
Anand Rathi Realty Fund Anand Rathi Mumbai India diversified $115
Appian Indian Real Estate Portfolio Appian N/A India diversified $150
Horizon Realty Fund Capitaland/Pantaloon Retail Singapore/Mumbai India retail $350
N/A The Carlyle Group Washington DC Latin America diversified $400-$600
Carlyle Santa Fey Real Estate Fund The Carlyle Group Washington DC India diversified $300
Colony Asia Investors II Colony Capital Los Angeles Asia diversified $400
DHFL Venture Capital Fund II Dewan Housing Finance Mumbai India residential $200
N/A EAV Realty New York China diversified $100-$500
Fortune Capital Holdings PFH Investment Advisory Mumbai India hospitality $200
Forum Asian Realty Income Fund III Forum Partners Beijing Asia diversified N/A
N/A Greenwich Group International New York India development $1,000
HDFC Real Estate Venture Fund II HDFC Mumbai India hospitality $750
India Real Estate Opportunities Fund II IREO New York India development $400
N/A New City Capital Tokyo Asia diversified $1,000
LaSalle Asia Opportunity Fund III Lasalle Investment Managment Chicago Asia diversified $1,000
LaSalle Japan Logistics Fund II Lasalle Investment Managment Chicago Asia logistics $400
Kotak Realty Fund II Kotak Realty Fund Mumbai India diversified $350
Kshitij Venture Capital Fund Pantaloon Retail/Dalmia Group Mumbai India retail $60
Prosperitas Real Estate Partners I Prosperitas Capital Sao Paolo Brazil diversified $330
Red Fort Real Estate India Fund I Red Fort New Delhi India diversified $300
Tano India Real Estate Fund Tano Capital San Mateo (CA) India diversified $100-$500
Tishman Speyer Brazil Fund Tishman Speyer New York Brazil diversified $500
Tishman Speyer India Fund Tishman Speyer/ICICI New York India diversified $600
Tishman Speyer GSC China Fund Tishman Speyer/GSC New York China diversified $500
N/A Trikona Capital Grand Cayman India development $300
Walton Street Mexico Fund I Walton Street Capital Chicago Latin America diversified N/A
N/A West University Capital Houston India diversified $300
Asia/Row funds subtotal $13,875
Fund of funds
4IP European Real Estate Fund of Funds Sal. Oppenheim Zurich Europe fund of funds €300
American Value Partners Fund I American Value Partners Los Angeles US fund of funds $400
Composition Capital Americas Composition Capital Partners Amsterdam Americas diversified $300
Composition Capital Asia II Composition Capital Partners Amsterdam Asia diversified $400
Composition Capital Europe II Composition Capital Partners Amsterdam Europe diversified €350
Continental European Fund II Schroder Property Investment London Europe fund of funds €250
Fiduciary International Real Estate Fund 2 Franklin Templeton/Fiduciary San Mateo (CA) Global fund of funds $300
Goldman Sachs Real Estate Partners Goldman Sachs New York Global fund of funds $1,000
Madison Harbor Private Real Estate Partners Madison Harbor Capital New York Global fund of funds $400
Metropolitan Real Estate Partners V Metropolitan Real Estate New York US fund of funds $250
Metropolitan Real Estate Partners Int'l II Metropolitan Real Estate New York Europe fund of funds $200
Newlin Realty Partners Newlin Capital Partners Princeton (NJ) Global fund of funds $130
Fund of funds subtotal $4,251
TOTAL $115,206


Global funds
Baynorth Realty Fund VII Baynorth Capital Boston US/ Europe diversifiied Final $400 $473 Mar-07
Beacon Capital Strategic Partners V Beacon Capital Partners Boston US/Europe diversified First $3,000 $1,200 Feb-07
Macquarie Global Property Fund III Macquarie Global Property Advisors Hong Kong Asia/Europe diversified First $3,500 $800 Jun-07
Morgan Stanley Real Estate Fund VI Int'l Morgan Stanley New York Non-US diversified Final $8,000 $8,000 Jun-07
Redwood Grove International Grove International Partners London Europe/Japan diversified Final $1,500 $2,000 Jun-07
Whitehall Street Global Real Estate 2007 Goldman Sachs New York Global diversified Final N/A $4,100 Jun-07
Global funds subtotal $16,573
North America funds
Acadia Strategic Opportunity Fund III Acadia Realty Trust White Plains (NY) US retail First $500 $450 May-07
Avanti Strategic Land Investors V Avanti Investment Advisors Winter Park (FL) US land Final N/A $200 Feb-07
Birchmont Capital Partners I Birchmont Capital Partners Los Angeles North America diversified Final N/A $200 Feb-07
Equastone Value Fund II Equastone San Diego US office FInal N/A $172 May-07
Harrison Street Real Estate Partners I Harrison Street Chicago North America diversified Final $150 $210 May-07
Hines US Office Fund Hines Houston US office Final $650 $828 Aug-07
IMT Capital Fund IMT Capital Los Angeles US residential Final N/A $350 Aug-07
Madison Marquette Retail Enht. Fund Madison Marquette Washington DC North America retail Final $350 $487 May-07
Noble Hospitality Fund Noble Investment Group Atlanta US hospitality Final N/A $310 Mar-07
Shamrock-Hostmark Hotel Fund Shamrock Capital Los Angeles US hospitality Final N/A $100 May-07
Shorenstein Realty Investors IX Shorenstein Properties San Francisco US diversified Final N/A $1,300 May-07
Rockwood Capital Real Estate Fund VII Rockwood Capital San Francisco US diversified Final N/A $1,100 Jan-07
Sterling American Property V Sterling Equities New York US diversified Final $400 $610 Jan-07
Place/Blue Vista Student Housing Fund Place Properties/Blue Vista Capital Atlanta/Chicago US student housing Second $200 $280 Apr-07
North America funds subtotal $7,447
Europe funds
CapMan Real Estate Fund II CapMan Stockholm Finland diversified Final $150 $150 Apr-07
Europa Emerging Europe Fund Europa Capital London Eastern Europe diversified First $200 $100 Mar-07
Harbert Real Estate II Harbert Managment Birmingham (AL) Europe diversified Final N/A $305 May-07
ING Real Estate Iberian Value Added Fund ING Real Estate Amsterdam Spain/Portugal diversified Final $250 $300 Jun-07
JER Real Estate Partners Europe 3 JER Partners McLean (VA) Europe diversified Final $300 $809 Jun-07
Marbleton Property Fund JER Partners/Alfa Capital McLean (VA)/Moscow Russia/Ukraine diversified Final $200 $321 Jun-07
Patron Fund III Patron Capital London Europe diversified Final $500 $895 Mar-07
Tishman Speyer European RE Venture VI Tishman Speyer New York Europe office Final $500 $1,350 Jun-07
Europe funds subtotal $4,895
Asia/RoW funds
CPI Capital Partners Asia Pacific Citigroup Property Investors New York Asia diversified Final N/A $1,290 Feb-07
Triseas Korea Property Fund Doran Capital Partners Seoul Korea diversified First $250 $135 Mar-07
N/A KK Davinci Advisors Tokyo Asia diversified Final N/A $2,800 Feb-07
SUN-Apollo India Real Estate Fund SUN Group/Apollo Real Estate Mumbai/New York India diversified Final $500 $630 Jan-07
Asia/Row funds subtotal $4,855
Fund of funds
Aberdeen Indirect Property Partners Asia Aberdeen Property Investors Stockholm Asia fund of funds Second $600 $435 Apr-07
Continental European Fund I Schroder Property Investment London Europe fund of funds Final $250 $253 Jul-07
Franklin Temp. European Fund of Funds Franklin Templeton/ Fiduciary San Mateo (CA) Europe fund of funds Final N/A $273 Feb-07
LaSalle Investment Company II LaSalle Investment Managment Chicago Global fund of funds Final $1,000 $1,000 Mar-07
Fund of funds subtotal $2,047
TOTAL $36,022

The big boysFunds in market with targets of $2bn or more

Beacon Capital Partners US/Europe diversified $3,000
The Blackstone Group Global diversified $8,000
Colony Capital Asia diversified $2,000
Credit Suisse Global diversified $2,000
Lehman Brothers Global diversified $3,000
Lone Star Funds Global diversified $6,000
Macquarie Global Property Advisors Asia/Europe diversified $3,500
Rockpoint Global diversified $2,000
Walton Street Capital US/Europe diversified $2,500
Stockbridge Capital Partners US diversified $3,000
Tishman Speyer US diversified $2,000
Corestate Capital German residential €4,000
LaSalle Investment Management UK diversified $2,200