Friday Letter Riding the rails

Earlier this week, Fortress Investment Group agreed to buy Florida East Coast Industries, a railroad company and real estate concern, for $3.5 billion (€2.7 billion). Yes, you read that correctly: a railroad company. 

At first glance, it may not seem the most logical acquisition for a private equity real estate firm, even for one with as diverse a business as Fortress. Yet from another perspective, not only does the deal make sense—Florida East Coast owns almost 9 million square feet of commercial property—it may also signal the future direction of the private equity real estate industry.

As most observers of the asset class recognize, it is extraordinarily difficult for the largest opportunity funds to generate their return thresholds by simply buying hard real estate assets, particularly in the US. Many of them are now moving up the risk-return spectrum to focus on property-rich operating companies: hotels, casinos and nursing homes, for example.

As “non-traditional” as those types of assets may be, however, a number of recent deals have highlighted just how far some fund managers are pushing the boundaries. In April, for example, Starwood Capital announced the acquisition of BR Guest, a high-end restaurant owner and operator, in a transaction valued at $150 million. One month earlier, a Colony Capital-led venture purchased a minority stake in Carrefour, the publicly traded European supermarket chain, worth approximately €4 billion.

These types of deals do not just represent a different point on the risk-return spectrum; they represent a different asset class altogether. This is straightforward private equity investing—or, in Colony’s case, straightforward hedge fund investing. The traditional concept of real estate valuation and execution plays a relatively minor role.

Of course, all of these firms have pursued esoteric property transactions in the past—Colony purchased the Paris Saint-Germain soccer team last year—but it’s rare to see these types of deals occur in such quick succession. Whether or not this represents a trend is too early to say. But it seems likely that these types of “non-traditional” transactions will occur with increasing frequency, both in the US and Western Europe.

The definition of private equity real estate has expanded considerably since the days of the Resolution Trust Corporation, when opportunity funds were primarily financiers taking advantage of an arbitrage in the US property markets. Since then, the asset class has evolved considerably—particularly in the past several years—but many of the largest firms remain, at heart, arbitrageurs and financial engineers. (Witness the enormous value created by Blackstone in the EOP sell-off.)

There’s nothing wrong with that. But it does create a dynamic whereby the world’s largest and most sophisticated private equity real estate firms will pursue ever more exotic investments, particularly in the current capital-rich and competitive environment.

These days, most industry practitioners keep repeating the same mantra: You can no longer count on cap rate compression or even intrinsic rental growth to generate returns; you have to work the asset. But that’s not necessarily true. Perhaps you can simply buy a different type of asset.