INTELLECTUAL PROPERTY: Public markets, drunken sailors

There is a fierce debate raging among real estate practitioners at the minute: are the public property markets a leading indicator as to what will happen in the private realm? In essence, will private ultimately mirror public?

There are many proponents of such an argument, not least among REIT professionals. The theory goes that REIT share prices tend to decline, trough and rebound around one to two years ahead of commercial property prices, and what we are currently seeing in the public markets is a leading indicator of what will ultimately take place in the private markets.

Zoe Hughes

The thesis is based on historical trends seen during the last major real estate crash in the late 1980s and early 1990s. According to economists at the National Association of Real Estate Investment Trusts (NAREIT), REITs peaked in late 1989, while commercial property prices topped out in late 1990. REITs reached a low at the end of 1990, but commercial property values didn't bottom until the first quarter of 1993. The same trend was then repeated at the start of the credit crunch, with REIT stock prices declining in early 2007, with private market values following in mid-2008.

For a significant proportion of private equity real estate fund managers, however, the public-private mirror theory fails to hold court. Investing privately based on public indicators is, as Liquid Realty Partners' founder and chief executive officer Scott Landress told a roomful of conference delegates last month, like “following a drunken sailor to the bathroom”.

The fundamental difference between the markets, warn naysayers, is the investors themselves. Comparing institutional investors committing tens of millions of dollars to a private seven-year, closed-ended fund with mom and pop investors buying a handful of shares in a REIT, with the ability to liquidate their stake at the touch of a button, is illogical. How can you attempt to make an apples-to-apples comparison when one investor is looking to the long-term and the other is focused very much on the here and now?

For true believers, though, there are some comforting and bullish conclusions to be drawn from recent public real estate market activities. Since the beginning of 2009, 51 US REITs have raised more than $16 billion in equity offerings – with most of the capital raised in April and May alone. During the whole of 2008, just $18 billion was raised by REITs. After witnessing declines of 17.8 percent and 37 percent in the FTSE NAREIT All REIT index in 2007 and 2008 respectively, the industry is beginning to see healthy gains, with the index rising by 26 percent since February.

It is too simplistic to state that private real estate markets will see a similar recovery soon. (The public property markets have fallen, peak to trough, by roughly 68 percent, while private real estate investors have been slow to mark down assets as aggressively.)

There is evidence, though, that the public markets do believe in the current government programmes meant to inject capital into the markets. If this trend makes its way to the private markets, a flood of LP capital may eventually be unleashed on troubled assets and spell a big uptick for those real estate funds who know how to buy them.

Last month, Starwood Capital floated a $500 million debt vehicle to target distressed commercial and residential real estate opportunities using financing from the US government rescue plans TALF and PPIP. According to regulatory filings, Starwood Property Trust – which will be registered as a REIT – will originate and acquire distressed debt instruments backed by commercial real estate, including whole mortgage loans, bridge loans, B notes, mezzanine loans and CMBS.

Part of the trust's strategy is to finance its deals with non-recourse borrowings from the Term Asset-Backed Securities Loan Facility (TALF) and to securitise senior tranches of its debt positions through TALF. It also plans to be an equity investor in one or more legacy loans from the Public-Private Investment Program (PPIP) scheme.

The IPO is expected to attract plenty of interest. But in looking to the public markets – and the growing appetite among retail investors to take advantage of current opportunities in the asset class – Starwood has overcome one difficultly being faced by all fund managers in private equity real estate: that of illiquid LPs.

The current real estate downturn may ultimately prove that the public real estate markets are like following a drunken sailor to the bathroom, but at least some private investors are determined to sell him a bottle of rum on the way.