Friday Letter A man looks into the abyss…

Opportunistic real estate funds have reported -50% returns in the past year. But do GP-submitted fund valuations faced up to the full reality of collapsed property prices? Zoe Hughes  

At first glance, the latest performance figures from NCREIF and The Townsend Group offer a slight glimmer of hope for opportunistic and value-added fund performance.

Despite reporting returns of -50.3 percent and -34.4 percent for opportunistic and closed-ended value-added vehicles, respectively, in the 12 months to the end of June, the pace of the decline has actually eased since the end of 2008.

According to the indices produced by the National Council of Real Estate Investment Fiduciaries and Townsend, quarterly returns have improved from their lows of -26.2 percent in the fourth quarter of 2008 – to -14.5 percent in the first quarter of 2009 and -11.3 percent in the second quarter.

A good sign, surely, that the worst is behind the industry and that GPs have taken the necessary write-downs? Yes, but possibly not.

PERE has spoken to numerous market professionals about the scale of the write-downs, and one question repeatedly emerges its head: have they been enough?

Indeed, several US-based fund managers, conducting fund-level due diligence as part of potential preferred equity investments, note that some general partners need to become more realistic over their own internal valuations.

The evidence is anecdotal, and certainly not quantifiable. It relies primarily on the fact that the US public real estate markets have seen peak-to-trough declines of up to 75 percent, and what happens in the public REIT market tends to be reflected in the private market further down the road.

It also depends on how leverage is assessed when calculating property returns. As Cohen & Steers’ funds of funds chief investment officer Stephen Coyle said in an investor letter in July, a 19 percent decline in unleveraged real estate values would lead to a 35 percent value decline for a 50 percent LTV, and a 52 percent decline in value for a 75 percent LTV. He expected unlevered property values globally to decline peak-to-trough by between 40 to 50 percent – and by up to 60 percent.

Boom and busts of old have shown only too well the need (and the benefits) of taking the hits quickly and early, rather than dribbling the bad news out from quarter to quarter.

Therefore when limited partners ask fund sponsors ‘Are we there yet?’, blunt honesty is the best policy, as well as having an air-sickness bag nearby.