Friday Letter Lessons for hedge funds

Hedge funds that have been seeking quick wins in real estate are getting burned by the credit crunch.  

In the west end of London earlier this month, a pioneering hedge fund manager, Permal Capital, set a record. It agreed to pay £135 (€199; $270) per square foot for two floors at 12 St. James’s Place, near the Ritz Hotel and the Queen’s residence, Buckingham Palace.

No one batted an eyelid or suggested the US firm was paying too much. Rents at that level, after all, are a mere drop in the ocean compared to the hundreds of millions that successful hedge fund managers earn. Indeed, Permal is not alone in paying top dollar in order to operate from an exclusive address. Some 40 percent of lettings in the most expensive locales of London’s Mayfair and St. James’s neighborhoods have been to hedge funds, or other types of super-rich money manager.

But office space aside, hedge funds and related alternative asset managers are suddenly also in the spotlight over their real estate strategy.

As a result of the credit crunch, those that invested in potentially toxic asset-backed securities are already being swallowed up by rivals or holding emergency talks with their banks. This week, London-based hedge fund Cairn Capital was locked in talks with Barclays Capital to keep afloat a $1.8 billion investment vehicle investing in prime and subprime US residential mortgage-backed securities, according to Dow Jones.

The liquidity crisis has served not just to highlight the riskier strategies hedge funds have pursued, but a fundamental difference in approach to real estate investing compared to specialized property investors. In focusing on cash flows and financial models when buying real estate with debt or equity, hedge funds stand accused of ignoring the risks of unquantifiable factors.

By buying direct property, for example, their modus operandi is often to ignore variable factors such as the vagaries of the approval process for a development, or the possibility of rent concessions.

Assuming that rent rolls are stable can be another mistake. Experienced investors know that rents can change no matter how good an asset or quality of tenant.

Yet another trap is for hedge funds to assume they can transfer their typically lean-and-mean approach to investing in real estate when property can be an extremely management intensive business.

Finally, a hedge fund’s short-term interests are often misaligned with a property owner/operator, who might want to hold an asset and use its cash flow to help finance additional acquisitions.

However, even with the collapse of the subprime mortgage business and setbacks in CMBS and CDO markets, hedge fund (and private equity) dollars will continue to chase real estate deals as long as they continue to provide outsized returns—especially if distressed assets are up for sale.

Paul Fried, a principal at AFC Realty Capital in New York, says that although hedge funds aren’t going away from real estate, they will have to change their ways in the asset class going forward. “They just need to incorporate the wisdom of real estate investment experience into their due diligence,” he says.

Easier said than done, perhaps, but it’s valuable advice nonetheless. Those hedge funds that come out of the crisis in one piece will do well to take it on board.

See September’s issue of Private Equity Real Estate magazine for a full run down on the impact of the credit crunch on real estate investors.