LOOK AHEAD 2018: In alternative RE, terms favor operators, not capital

With more investors than ever in alternative property types, capital partners are taking on much of the risk previously assumed by operators – and losing control in the process, says Virtus Real Estate Capital chief executive Terrell Gates.

As more investors crowd American alternative real estate spaces, from student housing to medical office, operators are gaining an upper hand in terms negotiations, a trend that will only accelerate in 2018, predicts Virtus Real Estate Capital chief executive Terrell Gates.

The Austin-based executive has seen a sea change in the industry since 2002, when he founded Virtus to invest in a variety of niche property types. More entrants, from international sovereign wealth funds to domestic public pensions, are investing directly in the sectors, which has driven up transaction volume and valuations and changed the relationship between capital and operating partners.

“From 2002 to 2009, capital could get any term it wanted,” Gates says. “Now we’re on the other side of that. In this environment, operators, who don’t even necessarily have to be great, are perceived as incumbents in the space, even if they’re getting beta-like performance.”

He cited one large capital allocator that recently entered the student housing and senior living spaces that is taking on risks traditionally associated with the operator: pre-development, development and construction cost risk, rather than solely lease-up risk.

“The conclusion is we’re seeing big, supposedly smart funds and others come in and take on GP risk to get LP returns,” he says. “It’s fine to take on GP risk if you’re getting returns. Och-Ziff has done that for years…but they get paid for that. We’ve seen a balance of power shift.”

He also highlighted changing control provisions, with operators demanding joint control over exit and refinancing. “Imagine if you’re the LP and you’re putting in 85-90 percent of the capital but you’re beholden to the GP, who put in 10 percent of capital. That’s not a good balance of power.”

For established players, these new market participants’ terms create friction even for existing operating partner relationships. Gates recalled losing out on deals with groups that had worked with Virtus for years because newer entrants offered better terms for the operators. Virtus, however, could not underwrite the added risks that other groups are taking on.

“We’re far away from the pendulum swinging back toward capital,” Gates says.