FEATURE: Capital Splurge

The anticipated flood of distressed sellers has failed to materialise in the US and UK, creating instead a pool of distressed buyers all trying to deploy the capital burning a whole in their pockets. PERE magazine May issue 2010

It was supposed to be a generational opportunity – an era that offered a once-in-a-lifetime buying spree.

With more than $225 billion of property in default, bankruptcy, foreclosure or having been taken back by banks; with US CMBS delinquencies rapidly charging past their current 7.8 percent position; with prices in the US and UK still down at least 25 percent from their peaks – and down up to 50 percent peak to trough – and with banks being nationalised and propped up by governments the world over, real estate was expected to deliver a feast of investment opportunities, large and small.

In the immediate aftermath of the credit crunch, and for a significant part of 2009, predictions of a wave – even tsunami – of deals hitting global property markets abounded. The reality – especially in the US and UK – has proved to be quite different though.

Today, private equity real estate professionals are struggling to deploy their equity. Global transactions are still 70 percent off their peak of 2007 and cap rates and yields for certain deals in key US and UK markets are compressing to levels not seen since the very height of the property bubble.

It has actually been shocking how much the market mindset has changed lately.

A fund manager

Rather than the RTC 2.0, as many had hoped, there is shock at the aggressive rally in pricing that has taken place in the US and UK in the past six months. That relief rally, as one professional dubs it, comes despite the fact real estate fundamentals are still deteriorating, and with industry experts predicting more pain ahead.

“It has actually been shocking how much the market mindset has changed lately,” one fund manager, who operates in both the US and UK, tells PERE. It’s a sentiment that is being shared widely in private equity real estate circles. At last month’s spring Urban Land Institute conference in Boston, numerous panels and debates centred on the growing disconnect between sales prices and fundamentals, with one US real estate lender saying prices had moved up “shockingly” fast in the past few months.

Dan Fasulo, managing director of real estate data provider Real Capital Analytics, says the fact that private equity real estate players – along with REITs, open-ended funds and sovereign wealth funds – are struggling to spend their capital in the first quarter of 2010 is “remarkable. If you had told me back in 2009 that in early 2010 everyone would have trouble allocating capital, I would have laughed at you”.


The bottleneck is largely due to the fact banks in the US and UK are in no hurry to offload troubled mortgages, unlike the last major real estate recessions. Boosted by massive government stimulus packages, financial institutions are earning their way back to health, allowing them to deal with their legacy loans one modification, one restructuring and one foreclosure at a time. These same institutions, along with their governments, remember only too clearly who made all the money the last time round, and it’s an experience neither are willing to repeat.

Without the catalyst of the banks to force assets to market, therefore, deal flow remains weak. However the wall of capital currently stalking the sidelines of the world’s major property markets is immense. Anecdotal evidence gathered by PERE places the figure anywhere between $150 billion and $200 billion, including $45 billion of private real estate equity. With modest leverage, this could equate to between $250 billion and $350 billion of firepower.

This surge of capital is made up of institutional investors, such as pensions and sovereign wealth funds, as well as private equity funds, real estate investment trusts, open-ended funds, high-net-worths and other less-traditional real estate investors eyeing the asset class in the hope of generating attractive returns in a low-interest rate world.


With so much capital chasing so few deals in several US cities and London, there are now fears of the emergence of pricing bubbles.

Last month, one of three core properties in New York being eagerly watched by the US real estate industry as an indicator of pricing sold for a cap rate of 4.8 percent. Marketed by Richard Ellis, Hines sold the 36-storey office tower 600 Lexington Avenue for $193 million, or roughly $636-per-square-foot, to REIT SL Green. Hines originally bought the property on behalf of its US Core Office Fund for $91.6 million in 2004 at a cap rate of 7.2 percent, according to RCA.

“There were a lot of people who wanted to buy core real estate last year and thought they were going to buy Washington DC and New York for an 8 cap,” says Charlie Baughn, executive vice president and chief executive officer of Hines Capital Markets Group, explaining much of the equity circling the US and UK for deals is opportunistic and foreign capital. “That’s not going to happen and they need to adjust their sights.”

Baughn, who was not involved in the 600 Lexington deal, says markets for core real estate have changed dramatically in the past few months, adding: “When markets go down as fast as they did in this cycle then perhaps in hindsight we should have anticipated the recovery to be stronger than expected.”

Anecdotal evidence gathered by PERE places the figure anywhere between $150 billion and $200 billion, including $45 billion of private real estate equity.

The cap rate attained for 600 Lexington Avenue though may well be beaten by the upcoming sale of 125 Park Avenue. The office block, acquired by Shorenstein Properties in 2004 for $225 million or $373-per-square-foot, is being marketed by Richard Ellis. With many of its rents below market levels and the potential to almost double the rent roll over the next five years, according to one New York broker PERE spoke with, the Park Avenue property could fetch a sales price of between $700-per-square-foot and $800-per-square-foot.

However it’s not just core markets and assets that are being affected. According to one US fund manager, who asked not to be named, up to 30 bids were received for a portfolio of almost empty properties in Orange County, California, where the local market had vacancy rates of up to 30 percent and where rents were still declining. “For the best quality assets you are getting aggressive pricing, but there is even cash for trash and prices have been pretty hefty,” the GP says.

Capital values

In London, the same bullishness is also being seen. RCA’s Fasulo notes that cap rates in London have come down 150 basis points in the past six months. Meanwhile Jeremy Newsum, chairman of the Urban Land Institute and executive trustee of Grosvenor Trusts, part of the Duke of Westminster’s London-based property investment firm, told the Boston ULI conference recent price gains in the City and West End were “worrying” because “there was no underlying reason for it”.

Indeed, even Brookfield Asset Management’s publicly-held commercial real estate arm, Brookfield Properties, is taking an optimistic bet on the central London office market. Last month, the firm became one of the first companies to jump back into the development arena when it acquired a 50 percent interest in the speculative 100 Bishopsgate scheme for £43 million in cash. Construction is set to begin in late 2011, early 2012.


With real estate fundamentals in the US and UK still considered fragile, such pricing has prompted many on both sides of the pond to wonder whether there is too much exuberance.

“People are getting ahead of their skis,” one US fund manager notes. “That’s not to say some great buys aren’t being made, there are, but I do fear there’s too much optimism given fundamentals.”

As such this wall of capital is leaving many frustrated at the inability to execute deals. Having raised $45 billion since the start of 2009, US REITs have already paid down substantial portions of their debt load – and are now desperately searching for deals. At the end of March, Vornado Realty Trust chairman Steven Roth cited an analyst in his annual letter to investors saying: “The anticipated avalanche of distressed sellers has yet to materialise, thereby creating a class of distressed buyers.”

The same is true for opportunity fund managers as well. Despite having an estimated $45 billion to play with, many GPs are now racing against the proverbial closed-ended vehicle clock, with investment period deadlines drawing near and fund managers needing to deploy their capital or face having to return the capital to investors.

In response, according to John Perkins, Richard Ellis’ senior managing director and head of investment banking for Americas, “high-octane opportunistic capital needs to be creative in sourcing transactions, and one of those means is through recapitalisations”.

What we are seeing is very good, solid cash flows, but properties that have been under-managed and have run out of money.

Lee Neibart, global chief executive officer of AREA Property Partners

With roughly half of the €970 billion of outstanding commercial real estate debt in Europe due by the end of 2012, and an estimated $2 trillion of property loans, including $700 million of CMBS, set to mature in the US by 2013, recapitalisations, rescue financing, preferred equity infusions, and mezzanine equity have become a prime strategy of opportunity real estate professionals. “There may be a wall of capital,” says Perkins, “but even that might not be enough to fill the void that’s coming, though recent improvements in the property sales market and the re-emergence of the financing markets here in the US will likely help in mitigating some of the problem.”

Lee Neibart, global chief executive officer of AREA Property Partners, adds – in terms of recapitalisations deals – the deals the New York-based firm has seen to date are compelling. “What we are seeing is very good, solid cash flows, but properties that have been under-managed and have run out of money.”

However, trying to gain access to the equity through the capital stack isn’t just the forte of private equity real estate fund managers. Some REITs, which have traditionally focused on equity investments, are also trying to focus on debt deals. One New York-based REIT PERE spoke with said it had just closed a mezzanine construction loan secured against a number of other assets owned by the developer, despite never having entered the mezzanine space before. SL Green is also in the process of trying to foreclose on Harry Macklowe’s 510 Madison Avenue tower after buying the senior mortgage and mezzanine loans on the property. That strategy was thrown into doubt last month though, when a New York state Supreme Court supported an injunction issued by Macklowe, ruling there should be a trial to determine ownership.

With deal flow expected to increase only steadily throughout 2010 in both the US and UK, private and public real estate investors may continue to find themselves chasing the same few compelling deals.

Instead, the industry is readying itself for an expected wave of opportunities from 2011 and 2012 as trillions of dollars of debt in the US and Europe looks for refinancing options. That is, of course, provided that next opportunity arrives as well.