Days of real estate capital allocation ‘are gone’

The traditional business model of fund managers acting as capital allocators for real estate opportunities globally is evolving, with many GPs being forced to revamp their structures and amend their fees to ensure investors no longer pay “double promotes”.

Robert Stern, founder of Castle Hill Investors and a former real estate executive at Perry Capital and Cerberus Capital Management, told PERE the business model that much of the industry was “accustomed to operating under doesn’t work universally anymore”.

I think we have to be more open to sharing the promote with our operating partners and vice-versa. We have to re-think the value proposition. Robert Stern, founder of Castle Hill Investors

As LPs call for greater movement on management and fund-related fees, Stern said the days of investors paying double promotes – one to the GP to allocate capital and one to the operating partner to deal with the real estate asset – are no longer achievable for many fund managers, for the foreseeable future.

“I think we have to be more open to sharing the promote with our operating partners and vice-versa. We have to re-think the value proposition. Investors are not eager to give fund managers full discretion, and they certainly don’t want the same fee stream as previously,” Stern said. “LPs want to team up with a great manager or operator, but they don’t necessarily want to pay twice for that.”

Stern left Perry Capital six years after co-founding its real estate business in 2002, intending to set up his own fund just. He previously worked at Cerberus Capital Management between 1998 and 2002. In leaving Perry just before Lehman Brothers filed for bankruptcy in 2008, Stern hit what has become a difficult fundraising environment for all private equity real estate firms. Stern is now investing friends and family capital with multifamily and hospitality operating partners in the US.

Castle Hill recently closed on a 625-unit low-income multifamily deal within the Beltways in Houston in partnership with a local operator. The property, purchased from a local bank, was in need of a workout having had a variety of liens placed on the asset following previous bad management, and having suffered from deferred maintenance and occupancy of just 65 percent. The two firms are repositioning the asset, and helping it qualify for government-sponsored enterprise (GSE) financing.

Investors are generally not willing to pay you significant fees while you sit around for a year and a half searching for stuff to buy.

As part of the deal, Stern said he was sharing the promote and fees with the operator, with both sides bringing different skills to the table. Stern said he was, in effect, “part operator and part capital allocator” adding the structure “capitalises on the desire by many LPs to disintermediate the pure capital allocator, while facilitating the access to capital for the operator and the access to investment opportunities for the capital”.

He also added that the days of GPs being able to collect large management fees on committed but uninvested capital were also likely at an end. “Investors are more suspicious and cautious about the future now. As a result all aspects of our business are being scrutinised and reviewed. Investors are generally not willing to pay you significant fees while you sit around for a year and a half searching for stuff to buy,” he said, predicting that an increasing number of investors will look to deploy equity on a “deal-by-deal basis”.

Stern’s one-man operation will invest in deals in the $5 million to $10 million range, in conjunction with operating partners which have close relationships with local and regional banks.

He said smaller financial institutions were “struggling mightily” with the toxic real estate loans on their books, but didn’t have the ability to “earn their way to health” as the larger banks currently were. In situations “where properties are not cash flowing or not fully operational, many banks cannot simply allow existing borrowers to remain in control of the collateral and must take action”, he said.

As with structuring deals with developers, Stern predicted the private equity real estate industry would need to be “creative and amenable” to  sharing the upside profits with banks too. In “stress testing” the traditional opportunity real estate fund model, Stern added: “There has to be tangible and aligned value for everyone in the chain today.”