GPs need to underwrite unlevered returns

Opportunistic real estate fund managers have to look at potential deals assuming they will not be able to secure leverage in the near future – and still achieve returns in excess of 15 percent.

GPs speaking at the annual IMN US Real Estate Opportunity and Private Fund Investing Forum in New York today said the collapse of the capital markets had fundamentally changed their outlook to underwriting deals.

Westbrook Partners' managing director Sush Torgalkar said the New York-based private equity real estate firm would only price a deal based on unlevered returns. “There is a huge pipeline [of deals we are looking at] but we are not assuing any financing comes in. There is a hope it will, but we are not assuming. If we have to add leverage into our underwriting, we are not going to do it.”

He was joined by Angelo Gordon managing director Keith Barket who said all deals had to be underwritten with “either no or very low leverage”. But he added: “From a risk-reward standpoint, it's fanatastic … You want to be an owner when the leverage comes back.”

The capital markets have shrunk significantly in the wake of the credit crisis, with many lenders able to deploy capital focused solely on existing relationships. For GPs able to find new sources of debt, the cost of capital has increased with banks and financial institutions demanding tougher terms such as recourse, lower loan-to-values and higher debt yields. Many will not consider loans of more than $50 million. 

Och Ziff Real Estate president Steven Orbuch said opportunistic fund managers should therefore look to discounted cash flows for underwriting assumptions, stressing the need to assume unlevered returns. He said if opportunistic managers were looking for 20 percent-plus returns on a levered basis then “unlevered returns have to be at least 15 percent for us to get even remotely excited about.”

He warned the days of looking at 7 percent to 8 percent unlevered IRRs and turning them into 20 percent returns with leverage were gone. He estimated that, over time, unlevered returns would achieve between 12 percent to 14 percent.