Euro survivors

On 5 February, PERE invited four real estate pros to the landmark “Gherkin” tower in Central London to swap notes on the industry. Robin Marriott discovered what happens when two bankers, a fund manager and a limited partner who have witnessed enormous turmoil meet head-on.  
One crisp Friday morning in February, PERE shared Deutsche Pfandbriefbank’s London office suite high up in 30 St Mary Axe – popularly known as the Gherkin – to debate real estate in Europe. In a way, it felt a bit like a gathering of war horses.  
Without exception, our guests and their respective organisations have been through transformational events.
Take Harin Thaker, for example. The chief executive officer of real estate international at Deutsche Pfandbriefbank has been with the German banking group for over 18 years. None of those years can have been as dramatic as the last two, though. In that time, the Munich-based group replaced its chief executive, received billions of state aid, was nationalised, changed its name from Hypo Real Estate to Deutsche Pfandbriefbank, reduced overseas branches and underwent a fundamental restructuring. One of the next steps in Deutsche Pfandbriefbank’s recovery is to create a “bad bank” housing up to €210 billion of assets.That structure should cut Thaker some slack as he looks to steer the bank back to its core business

The war of talent between public and the private sector – that’s going to be the next challenge

Harin Thaker, Deutsche Pfandbriefbank

of arranging and underwriting real estate loans again. Then again, repositioning the bank to invest and refinance loans so soon can’t mask the challenge of retaining talent in a banking sector that resembles a highly-regulated utility. “The war of talent between public and the private sector – that’s going to be the next challenge,” says Thaker.

Edmund Craston, for his part, lost his job as head of real estate investment banking, EMEA, at Lehman Brothers when the bank collapsed into bankruptcy in September 2008. Now, after 22 years as a banker, Craston is partner and managing director of one of the most-talked about pan-European property fund managers around: Rockspring Property Investment Managers. Rockspring is one of those “firms of the moment”, often spoken about by peers, not least owing to the notable achievement last year of winning a mandate to advise the National Pension Service of Korea on investing in Central London property.

Our other participant, Brendan Jarvis, is a survivor too. Though the CMBS market in which his bank became involved has since crumbled, Jarvis remains at Barclays Capital, a bank he joined nearly 38 years ago. The difference today is that Jarvis has been elevated to head of Barclays Capital’s Real Estate Group, which has moved back into more traditional fee-based real estate investment banking.

With two bankers and one fund manager sitting round our table, it would be amiss not to hear the voice of an LP. Dublin-based Brendan O’Regan is responsible for Ireland’s National Pension Reserve Fund (NPRF) property portfolio, which began investing in unlisted property funds from 2004. Coming from Ireland, where the banking system has big issues of its own to tame, O’Regan has a ringside seat in a country tasked with working out colossal systemic challenges. At the same time, as a sophisticated investor his comments on the future of the property fund industry are pertinent.

Combined with Thaker’s, Craston’s and Jarvis’ thoughts, the annual PERE European roundtable promises to be a dynamic hour and a half discussion.

Craston, for example, is concerned about where and how to invest and argues that bank deleveraging is the single most important issue in real estate. He questions our two bankers on whether banks are anywhere near deleveraging their balance sheets.

Thaker is concerned about “the war on talent” and how banks are best able to retain staff at a time when banks look increasingly like regulated utilities. “How fast and how soon can the banks be fixed?” he wonders, pressing home the point that banks need time and a benign economy to facilitate their own recovery. He argues that banks can’t take big losses immediately by writing down huge loan books. Instead, banks need

The good point that is emerging is there does seem to be life in the debt capital markets

Brendan Jarvis, Barclays Capital

a stable economy to try to recover value from assets as best they can. On the plus side, he sees opportunity in restructuring and refinancing loans made between 2004 and 2006.

Barclays Capital’s Jarvis worries about potential acceleration of bank foreclosures and, like Thaker, whether the benign economic environment can continue with interest rates and inflation held in check. But at the same time he finds grounds for some cautious optimism, such as the appetite for real estate in the debt capital markets. “The good point that is emerging is there does seem to be life in the debt capital markets,” he says. “Investors want new property and new exposure.”
Relying on relationships


But first, we start by going to the heart of what this magazine concentrates on: the relationship between fund managers and their investors.

For this, we turn to NPRF’s Brendan O’Regan. In some senses the NPRF is akin to the perfect investor. It is a long-term investor, in the early stages of building a globally diverse portfolio of unlisted real estate fund investments. It does not have any pressure to draw down funds until 2025 at the earliest.
NPRF largely stopped making commitments to funds from mid-2007, primarily because of the lack of value in the market and economic uncertainty.

For O’Regan, GP stability is one of the greatest issues when considering the GP-LP nexus. Refreshingly (considering the angst emanating from many limited partners) he adds that the NPRF is not in the “blame game” and doesn’t think other investors should be either.

“If managers have adhered to the fund strategy that was articulated at the time investors entered the fund, and deployed the capital in line with this strategy, then LPs should not rush to blame GPs if that fund has not performed well,” he says. Only in cases where the GP has deviated from the strategy should the finger be pointed at them. O’Regan is not critical of a manager that had a strategy that “didn’t work out”. What matters now is how managers behave next.

He cites an example of good management. One fund, concerned about the possibility of breaching a loan-to-value covenant, set out to raise equity to inject in a deal if it became needed. In fact, the valuation did not depreciate as much as initially anticipated, and the committed capital was not required. “We were very happy with the management of this issue. It was preemptive and reflected very well on the manager’s understanding of the potential downside risks,” says O’Regan.

Thaker’s experience of how property funds have behaved is mixed. The mature ones, he says, tend to come forward to inject more money. But it is a “very hard struggle.” The issue he raises is that a fund may not wish to throw more money at a problem issue when there are new, fast-emerging, opportunities to be had. They really have a difficult choice deliberating over whether to postpone or defer issues knowing that the banks do not want to become property companies.

If managers have adhered to the fund strategy that was articulated at the time investors entered the fund, and deployed the capital in line with this strategy, then LPs should not rush to blame GPs if that fund has not performed well

Brendan O'Regan, senior portfolio manager, Ireland’s National Pension Reserve Fund (NPRF)

Sources of capital, such as other private equity firms, are knocking on the door suggesting they could take over asset management functions. “But to get three or four parties together is a nightmare,” he says. It is a long protracted process that can take up to a year. That said, lenders will remember the GPs who acted “honourably” and “reasonably” in difficult times.
Fee discussions
Another topical issue O’Regan identifies in the GP-LP relationship is alterations to fee models. He notes many fund managers have voluntarily adjusted fees to reflect existing assets under management and conditions. Those that haven’t done so voluntarily have been “encouraged”. By and large, he says most funds have been responsible about fees.

Craston is against saying the industry’s challenges can be met simply by a round of fee cuts. “Brendan said as an investor they were not in the blame game – I’m heartened to hear that – but he also says investors will look to those managers that have shown the “right” behaviour. Yes, there will be discrimination in paying the right fees, but I’m not convinced that is the key issue or that there will be a dramatic reduction.”

He adds: “If you cut fees too much you may not get the level of attention that you need – and the last couple of years have proved that inattentive management is a problem. That isn’t to say there won’t be a downward pressure on fees, but there is a danger in getting caught up in the fee debate when it should really be about the quality and stability of the manager. That in turn leads you to this: a lot of managers will disappear. They will not be able to raise the next fund.”

As so often in our discussion, Barclays Capital’s Brendan Jarvis introduces a salient point – some fund managers have so little equity left, why should they bother continuing to properly manage the assets within their vehicles.

It strikes a chord with O’Regan and Thaker. Rockspring’s Craston also picks up on the point, suggesting a lot of discussions are taking place about fund structures, the GP-LP relationship and specific issues, such as GP and LP risk. “If you have a manager completely demotivated then that is a risk,” Craston says. “Equally there is LP risk if a drawdown is coming or a fund needs to be recapitalised and some of fellow investors haven’t got the money. That can destabilise the fund.”

Strikingly, O’Regan says so far the European market has not yet seen fund managers decamp from weak GPs. When that begins to happen, it will be a “real leading indicator sign of a recovery” in the wider markets.

Many good people in vintage funds which do not stand a chance of earning a promote will jump ship for a new fund without legacy issues.

NPRF's O'Regan

“We are concerned about the stability of our managers and their ability to retain key team members during this period – this concern will be exacerbated once a recovery takes shape and a sustainable fundraising environment resumes,” he says. “Many good people in vintage funds which do not stand a chance of earning a promote will jump ship for a new fund without legacy issues.”

The failure of GPs to earn carry will simply compound problems for the fund. If the fund forecasts a return of 75 percent of investors’ equity, and staff start leaving, the firm loses the depth of resources, and that 75 percent return of equity could easily reduce to 50 percent. Both sponsors and LPs need to grapple with this problem and decide the value and cost attached to maintaining a stable platform.
Deleveraging the banks
As O’Regan mentions there are “signs of recovery”, a new topic of debate is triggered. And it is a topic heavily intertwined with the banks.

In many people’s minds, the hottest issue facing the global property industry today is how banks are going to delever. This one issue alone led to an interesting exchange between Thaker, Jarvis and Craston, the latter wanting to know how the banks were dealing with their problems.

First of all, it is clear banks have had to adapt. Brendan Jarvis, whose bank used to be a significant player in the CMBS market prior to the crash, explains how Barclays Capital has a business model more akin to the new era. “It used to be about debt, debt, debt, but we are now more into real estate investment banking.”
It is concentrating on four key areas, the debt capital market, the equity market, providing mergers and acquisitions services and risk management services. “This is timely because the cost of debt on a bank’s balance sheet has increased quite rapidly, so now we are targeting companies and areas that will give us reach across the product set. So we have moved from being a debt house building up commercial mortgages, warehousing them and securitising them, to occupying a more traditional business.”

To an extent that business depends on recovery, which is tentative at best. In terms of macro economics, Europe is “bumping along the bottom” says Jarvis, and he is also bothered about banks accelerating loan foreclosures. 

Nor does he have a solution to the “extend and pretend” stance that banks have adopted of extending debt maturities for performing loans, even if valuations have declined dramatically. Extend and pretend, Jarvis says, also applies to CMBS, as well as more plain vanilla loans. Refinancing, of course, is a huge issue that will suck out much of the liquidity starting to emerge in the capital markets, according to Jarvis.
Light at the end of the tunnel
Jarvis does though see the debt capital markets as a source of cautious optimism. There is optimism, he says, because there is life in it. “Investors want new property and new exposure, and we have seen that ourselves. In the next couple of weeks a round of results will come out in Europe from corporates, and I personally think that will stimulate some activity in the debt capital markets. You will see more activity and more liquidity than you thought was there.”

More specifically, Barclays Capital is seeing a lot of activity among owners of property wanting to monetise the prime properties they own through sale-leaseback transactions. Jarvis adds that M&A activity is another sign to be optimistic, not least because Barclays Capital is processing a slew of real estate-related IPOs.

Investors want new property and new exposure, and we have seen that ourselves. In the next couple of weeks a round of results will come out in Europe from corporates, and I personally think that will stimulate some activity in the debt capital markets. You will see more activity and more liquidity than you thought was there”

Barclays Capital's Jarvis

Germany is one example of a country where activity is stepping up a gear having altered its rules on REITs to allow holders of German residential property to transform themselves into more tax efficient structures.

Jarvis concludes that while there is no distribution market available, institutions, such as Barclays Capital, are at least lending and originating mortgages. Institutions may be lending in smaller lot sizes or in club deals, with most banks only wanting to originate downwards of £100 million (€114.7 million; $157.8 million), but for Jarvis that tiny spark of activity will help generate a small flame at the right values, helping keep some sense of stability in European property markets.

“Stability” is latched onto by the others, not least because a benign environment has implications for styles of property investing. Craston jokes that he wants to believe the last economist he heard, who predicted short term interest rates would need to stay low for a long time, inflation was inconceivable for a long time, and even long-term interest rates couldn’t really go up either. “It was very heartening, whether I believe him or not.”

Benign inflation would certainly help Thaker and his business owing to the bank’s preference to let time work out legacy issues.
Benign benefits
For sure, there are alarming signs still for our participants, such as the predicament of Greece and Spain, with its high unemployment. O’Regan, for example, is fairly bearish on the pace of the economic recovery over the next 12 months and argues that the real economy is where money supply needs to be. “We all agree that real estate markets are reliant upon sound economic fundamentals and that its recovery will lag the wider economic recovery,” O’Regan says. With all European economies struggling to gain and maintain a recovery, one should be very cautious about heralding the nadir of the market. O’Regan is aware of the challenges of refinancing maturing debt, particularly if interest rates rise, and the difficulties involved in dealing with problematic CMBS deals.

For Deutsche Pfandbriefbank there are some positives. The German covered bond market picked up in mid-2009 making it easier for German banks with a licence from the German Financial Supervisory Authority (BaFin) to make loans again. Covered bonds, of course, are securities backed by income from high-quality mortgages and public-sector loans, but they stay on the balance sheet and are ring-fenced from insolvency. In recent times the bond market has became the banks’ source of wholesale funding thus increasingly liquidity, and ultimately allowing participants to issue new loans. A big stimulus was a decision last year by the European Central Bank to buy €60 billion of covered bonds.

Thaker notes that for deal sizes of €100 million and more, these have typically been provided by clubs of banks. Even in recent weeks, there have been some signs of further liquidity as secondary banks have returned to finance new deals. (See chart, Playing the debt markets, p.72) Thaker believes there are great opportunities to restructure and re-price deals of 2004-2006 vintages, and of course, to do new deals at what he calls the “correct price margins” at last.

The conversation on anemic economies leads to the question of why invest in real estate in some parts of Europe. Brendan O’Regan asks: “In that environment can one see capital appreciation? In some European countries, we have ended the decade with values pretty much where we started,” he adds.
The investor suggests that opportunistic returns are hard to achieve from real estate when one can’t get financing beyond 60 percent to 65 percent loan-to-value.

This prompts Thaker to ask if Ireland’s NPRF would take into account the benign environment, and lower its threshold of return expectancies.

O’Regan says the pension fund is currently doing an internal strategic review, but encouragingly he says the NPRF still has an “appetite” for real estate. “We are taking into account all the different risks and opportunities that are out there,” he says. O’Regan says he currently has more comfort for core and core-plus managers than for those with an opportunistic strategy. 

“In the near term of 12 months to 24 months I think it unlikely that we will go up the risk curve until a sustainable recover is evident. I expect we will be more in the core/core-plus and maybe value-added sphere, and that position is not unlike where most LPs are right now.”

That gives firms like Rockspring some grounds for confidence, at least. “I feel confident because the overall way the property market it going favours people like us,” says Craston. “Yet I still feel challenged because all the other things we have spoken about make it hard to know where and how to invest and avoid pitfalls.”

I feel confident because the overall way the property market it going favours people like us

Edmund Craston, managing director, Rockspring Property Investment Managers

When Craston was weighing up his options upon leaving Lehman Brothers, he decided against working at an opportunity fund. That’s not to say he doesn’t think some will do fantastically well for their investors.
Some “vulture funds” picking over the carcasses of real distress will do well, and over a period of time make dramatic returns, he supposes.

O’Regan replies: “It is difficult for opportunity funds to get the leverage they need to generate their target returns. A lot of GPs are looking at raising debt funds right now and anticipating equity-like returns. There are opportunities there, and a lot of managers are changing their focus to target this sector. However, they may not have the requisite skills or experience to execute that strategy.”

O’Regan says investors are again focused on the benefits that real estate can offer, such as diversification and attractive risk adjusted returns, underpinned by income. These attractions can now be found at the lower risk-return end of the scale by investing in core/core-plus. “If we see a faster and more robust economic recovery, well, the returns will be even better.”

That is one sentiment all four can agree on.