FEATURE: Second half events auger 2011 trends

Many of the trends in private equity real estate for 2011 are likely to have had their genesis in the latter half of 2010. Whether it is the continuation of a trend that already emerged last year or reaction to an event or development that occurred in 2010, much of what transpires this year with regard to LPs, GPs, regulation and the lending environment will takes its cues from 2010.

LPs to play less safe
Some of the bigger trends to emerge among LPs in 2010 included greater use of co-investment models and club deals, as opposed to investing through commingled funds; a renewed focus on core assets in top-tier markets; and the desire to invest alongside local real estate operators, as opposed to global allocators. Most of these trends were the result of LPs’ desires to re-take control of their investments and play it safe in the wake of the financial crisis.

Market players, however, believe these trends will be short-lived as investors’ appetite for risk grows and more over-leveraged properties come to market. Jacques Gordon, global strategist at LaSalle Investment Management, said LPs that focused solely on core will begin loosening up as last year’s intense focus on core has created its own risks. Howard Roth, global and Americas real estate head at Ernst & Young, added: “The problem is that core is back to 5 percent cap rates, but pensions need better returns from real estate to meet actuarial obligations in the future.”

In the US and Europe, the largest and most liquid markets benefitted the most from capital flows in 2010, and that trend is expected to continue this year. But some of these flows will start to shift to secondary markets later in 2011, as investors search for yield and relative value. In addition, Gordon believes the long-awaited disgorgement of distressed debt will start to pick up steam in 2011 as regulations on both sides of the Atlantic force banks to change their policies.

In Asia, there are fewer domestic LPs, with the exception of Australia, so much of the activity has centered on sovereign wealth funds like China Investment Corporation, National Pension Service of Korea and Australia’s Future Fund. According to Simon Treacy, group chief executive officer at MGPA, another reason is the fact that many sovereign funds are underweight to real estate and looking to build up their allocation. However, he added that, like other large LPs around the globe, many of them are taking a more direct approach to their investments or investing through club deals.

GPs to adapt or perish
Much like the LPs they service, GPs also were reactionary. But not only were they reacting to the financial crisis, they also were reacting to strategic changes made by LPs. Some of the bigger trends to emerge among GPs in 2010 included offering smaller, more targeted funds in the wake of a difficult fundraising market; lowering return expectations for new offerings as well as existing investments; and looking to consolidate with like-minded GPs if staying in the game or devising an exit otherwise.

Indeed, 2010 saw the beginnings of a shakeout among investment managers and private equity firms. Big players, like Citi Property Investors, Lehman Brothers and Bank of America Merrill Lynch, exited the business through sales and closures, while new players like Peakside Capital and Silverpeak Real Estate Partners were formed through management-led buyouts. And, of course, there was straightforward consolidation, not the least of which was CBRE Investors’ acquisition of most of ING Real Estate Investment Management.

Barring those strategies, GPs looking to tough it out will need to diversify their platform. “Those that stay will need to broaden and diversify their business with complementary products, such as coming down the risk spectrum to core-plus, offering separate accounts and structuring club deals,” said MGPA’s Treacy.

And good news for those GPs treading water due to legacy issues: Gordon believes the restructuring and resolution of vintage year 2005 to 2007 funds will pick up in volume this year. GPs are working with existing LPs and new sources in exchange for preferred and senior returns, he noted, explaining that this strategy is more about keeping afloat until the recovery hits the funds’ investments. “It currently is the only alternative to turning off the lights,” he added.

That said, hiring in the private equity real estate industry is expected to be stronger than last year. This will be the result of a number of trends, including the need to address the changing skill sets currently required by the market and renewed fundraising efforts around the globe as capital returns to the market, according to Bill Ferguson, co-chief executive officer of FPL Advisory Group, a Chicago-based executive search and compensation firm focused on the real estate industry.

Indeed, last year’s dramatic shift to core assets and ratcheting down of risk caught many firms unprepared, said Michael Herzberg, co-chief executive officer of FPL Advisory, adding that those firms now are bringing in the expertise in order to offer the service. In addition, aspiring global firms will continue their push by building out their platforms, Ferguson noted.

Taking all this into consideration, cash compensation will remain relatively flat in the industry, Herzberg said, but a larger bonus pool will create the sense that compensation is on its way back up.

The great regulatory hurdle
On the regulatory front, 2010 saw an unprecedented level of initiatives begin to take shape as governments around the globe sought to reduce risks in the financial system. In Europe, the Alternative Investment Fund Managers (AIFM) directive and the Solvency II legislation are likely to have Europe-wide implications for all asset classes, including property. Meanwhile, in the US, the Dodd-Frank Act and the Volcker Rule are expected to have a similar impact.

Gordon sees private equity real estate facing “a 1-2-3 punch.” The first is broad financial regulation, including the Dodd-Frank Act in the US and European Market Infrastructure Regulation in Europe. The second is insurance regulation, specifically Solvency II, which is scheduled to hit this year. And the third is global banking regulation, courtesy of Basel III. All three have tremendous implications for investors starting this year, so GPs and LPs need to be planning for these, he said.

Stephen Tomlinson, senior partner in the real estate practice group of Kirkland & Ellis, believes Basel III and its capital reserve requirements will have a more powerful effect than the Volcker Rule, creating greater pressure to exit the business through a sale or by winding down. “This plays into the consolidation trend on the GP side,” he added.

The proposed Solvency II legislation, a review of the capital adequacy requirements for insurance companies in the European Union, could result in these investors reducing allocations to real estate. As it stands, the guidelines would require them to reserve 39 percent for real estate. This could prompt a retreat from the sector and a release of stock into the market, or conversely an increased appetite to move up the risk curve to justify the risk capital.

Philip Cropper, head of real estate finance at Richard Ellis, is one of those who believe Solvency II would actually make real estate a more attractive place to put capital. Provisions within the rule would make insurers more likely to provide debt funding and fill the gap left by banks, he explained.

In the US, the Dodd-Frank Act restricts banks’ investment in equity and hedge funds, while the Volcker Rule will prevent banks and large financial organisations from making equity investments in commercial real estate, limiting them to providing debt financing. As a result, many large banks that have real estate investment arms either have or are thinking about selling off the business, Roth said.

Other regulatory issues include European derivatives legislation, which would require those using swaps to hedge interest rates on their debt to mark to market daily and hold capital against those positions, and changes to accountancy standards. “If you are a tenant and take a lease on a property on your balance sheet, you will need to recognise the long-term liability obligations of that lease,” Cropper said, adding that the change would put pressure on shorter leases. In addition, the benefits of sale-leasebacks would diminish under the new rules.

A bit more liquidity
Although the financing markets have been tough for investors in commercial real estate since the credit crunch, debt availability is likely to improve in 2011. Still, it may be one step forward and two steps back, as Basel III and Solvency II could limit the availability of funding from several usual sources. At the least, it may take longer for normalised lending activity to return.

One encouraging sign for the market, though, is the return of CMBS. John D’Amico, chief executive officer of the CRE Finance Council, noted that roughly $8 billion was issued in the US in 2010, including $2.7 billion in the last three months. About a dozen banks are active again and insurance companies are likely to soon join in, he added. But new issues will be different than those of the past, Roth said, noting that structures will be simpler with less tranches and the underlying loans will have lower loan-to-value and higher debt-service-coverage ratios.

Although the CMBS market is expected to grow to $40 billion this year and $100 billion in 2012, that volume still only represents 14 percent of the need, D’Amico said, noting that roughly $1 trillion in real estate debt is set to mature over the next two years. “Private capital will need to fill this gap,” he added. Luckily, life insurance companies and mortgage REITs also are expected to be more active sources of capital over the next two years.

In Europe, however, there was no CMBS activity in 2010. Banks there want to see the securitisation market recover, but they will need to retain stakes in the loan pools they originate. “The European market was frozen in 2010, except for covered bonds, but it is likely will see some deals come through this year,” Cropper said.

With regard to lending in Asia, Treacy said the region has ample liquidity except for Japan, and even that market is starting to come back in Tokyo, albeit at lower levels. Basel III, however, will create a big question mark on the willingness of banks to lend, he noted.

However, according to D’Amico, the biggest concern with financing is the equity gap created by decreased property values and lower loan-to-value ratios. The question becomes who will cover this gap. Because a further reduction in prices does not seem likely, the gap is most likely to be addressed by either new players or new money entering the market, he said.

Overall, D’Amico has a positive outlook for 2011 and beyond. “The market has seen the worst, and we look forward to a turnaround,” he said. In summary, he predicted three main trends for 2011: “the certainty of regulation, the resurgence of securitisation and the closing of the equity gap.”