It has been a little over two years since the peak of the US financial crisis and the beginning of the Great Recession, but the US economy so far has shown few signs of a strong recovery. However, many seasoned property investors are scratching their heads at the valuations associated with recent property sales, particularly the cap rates paid by buyers for well-leased properties with limited opportunity to add value.
It was in this environment that the participants of PERE’s US roundtable – Ed Casal, chief investment officer for the global real estate multi-manager team at Aviva Investors; Jeffrey Giller, managing partner and chief investment officer at Clairvue Capital Partners; William Lindsay, founding partner at PCCP; and Paul McDermott, senior vp and managing director at Rockefeller Group Investment Management – met on a rainy, dreary day at the end of September in midtown Manhattan. Through the course of their discussion, the roundtablers provided their respective outlooks on the US real estate markets and its attractiveness to foreign capital; on the office sector and the lending markets; and on what it takes to survive in the current environment.
The roundtablers began their discussion by sharing their views on the US market and its relative attractiveness as a place to deploy capital. For the most part, they agreed that American real estate stacks up well against opportunities elsewhere in the world.
“For the first time in a long time, investors are looking at the US markets as being attractive,” Clairvue’s Giller said. “In the past cycle, the US had gotten so pricy that those who manage capital were searching for alternatives quite far afield, including some of the emerging markets.”
Fast forward to the new era, where property prices have fallen precipitously in all markets and the US is attractive once again. “What we are hearing from limited partners is, why would you go to markets where there is risk or even markets far afield that you may not understand when there appears to be opportunity in the US to find attractive risk-adjusted returns?” Giller said.
PCCP’s Lindsay thinks the US market’s attractiveness isn’t just limited to the current cycle. “I think the US is always going to be an attractive market in all cycles,” he said. “If you compare it to a lot of other markets, we are much more transparent and easily understandable.” In addition, there are certain risks that are minimised in the US market. “If you are a foreign investor, you are going to be able to get your money out of this market, and there is not much risk of nationalisation of your investment,” he added.
Aviva’s take on the market is a bit more subdued. “The price points today, with real estate having come down 40 percent or so, are much more attractive than they were in the past. Still, our macro view would be very cautious,” Casal said. “We think this is a grinding recovery. The consumer is still in a deleveraging mode and the financial sector is as well. There are good entry points and yield spreads are strong, but job formation is very weak, which means absorption is going to be weak.”
AddEd Casal: “The good news is that there isn’t much new supply in the pipeline, but you do need demand in order to grow the rents.”
Caution may be prudent, but most investors are seeking more than just an opportunity to buy stable assets. “We are in markets such as New York and Washington, DC, and cap rates in the 5 percent range are common for quality properties in those markets today,” Rockefeller’s McDermott said. “What we are observing is 2007 capital markets executions against 2010 real estate fundamentals, so I don’t want us to get too far ahead of ourselves. A few investors have an appetite for stabilised cash flow and current yield, but they are going to pay up for it in most of these core markets.”
As managers of private equity real estate funds, the roundtablers have attracted capital from numerous sources, but increasingly more and more of the capital is coming from overseas.
Many of Aviva’s investors are from outside of the US, and while those investors had previously been quite cautious about the US, they increasingly are interested, particularly in real estate. That said, “many foreign investors are a bit confused about what to do,” Casal said. “Should they participate on the debt side or should they come in on the equity side? They know development is not attractive, but they could come to restructure existing transactions. If so, what property type?”
Of course, one of the biggest hurdles for foreign investors is the Foreign Investment in Real Property Tax Act (FIRPTA). “It seems we put enough roadblocks up at every turn to keep foreign capital out, many of them in response to the Japanese acquiring assets in the 1980s,” Giller said. “It is an issue because it is hard for them to invest directly in property without creating some complicated structures.”
Although legislation was introduced in Congress earlier this year that would remove some of the tax barriers to foreign investment in US property, the bill has not gained much traction, as it remains politically difficult to fix FIRPTA. “Especially in this environment, where we are looking for ways to fill our coffers, not reduce taxes,” Giller added.
Despite the hurdle of FIRPTA, foreign investors that want to invest in the US usually will find a way. For example, Rockefeller Group is focused on aligning its various investors’ needs and, depending on the transaction, has preserved up to a 49 percent interest for offshore investors to be deployed in conjunction with its own equity. “If you want to bring in fresh capital, you need to be flexible – to a point — in your structuring,” McDermott said.
Still, even with the increased comfort level of co-investment, investors are looking for more assurance. “Interestingly, the first question at most presentations we go into is: what is your view on the US economy?” McDermott said. “Investors may say, ‘We understand the core product; now tell us your employment growth projections and your view on interest rates over the next several years.’ It is really a different dynamic and drives back to the economic fundamentals and their respective impact on the real estate product. Once they are comfortable that you have acknowledged and addressed their concerns, I think things become more collaborative. International investors are aware that we have a very strong parent company in Mitsubishi Estate, as well as our co-investment ability. If not, it would be a lot more challenging.”
Casal believes the issue of macro is a fundamental question, and always has been. “I think in the real estate industry we kind of ignored it for a while because life had been good since the early 1990s,” he said. “Now, everyone is looking at the economy, but there is still significant debate about how this plays out.”
Posturing aside, what all of this analysis really boils down to is investment strategy, more specifically how to price and underwrite property. “Speaking for Clairvue, we are at the point where we are not underwriting market decline anymore,” Giller said. “We are looking at a very long, flat bottom, which makes it hard because you need to take your value and discount it due to the lack of market growth. I also think you might be overly punitive to underwrite further market decline. It could happen because no one says we are out of the woods yet with a double-dip recession, but most of us are looking at a long, flat, slow recovery.”
Office space limited
When considering a recovery in the US real estate markets, the property type most investors think of first tends to be office space. Therefore, it only seemed appropriate for the roundtablers to discuss the most important considerations they take into account when investing in the office sector, particularly given the cautious nature of investors these days.
As with any property sector, the office market has its haves and have-nots. “When we go through economic adjustments like the current one, we always start to worry whether office makes sense,” Lindsay said. “There are 5 percent cap rates in the [central business districts] of 24-hour cities and who knows what the IRRs are for being underwritten there, because we all struggle with whether the rent roll is going down or staying flat. Then you have brand new suburban office that you can buy at a very steep discount to replacement cost because everyone is trading up from Class B to Class A, but one needs to question when new jobs will be coming to suburban markets.”
Given that perspective, Lindsay believes office right now is not being driven by fundamentals, but rather by capital. “Capital needs to go to work,” he said. “It has made a fundamental bet on the long-term attractiveness of certain markets, and it’s driving price in the opposite direction of fundamentals.”
Casal agreed, noting that a similar pattern emerged in the UK. “When the capital came back, it was chunky and it went into some of the best CBD office around,” he said. “Cap rates compressed quite a bit, but that new capital started to draw out new supply and the values started to come down again. My guess is we are going to see some of that in the US, particularly in these 24-hour cities. Eventually, though, this space will fill up, as the US is a growing country with a resilient economy.”
In delineating the haves and have-nots, cities with historically good economic drivers, such as Washington, DC, San Francisco or New York, make the grade in Casal’s book. “The second cut we would make is newer high-quality buildings, as there is a growing obsolescence of some of the older properties, whether it is for environmental or aesthetic reasons,” he added.
Giller agreed with the two-tiered assessment of the office market, expounding the dangers of have-nots like suburban office. “As rents drop and tenants can afford to improve the quality of their locations, they will move up and what gets left in the dust is Class B suburban office,” he said. “As a result, we are terrified of Class B suburban office with any level of tenant turnover or vacancy.”
On the Class A CBD office side, however, Giller is more upbeat. “The great thing about office space relative to hotels or multifamily is that they have long-term leases, so the effect of the recession on the Class A CBD office market has been somewhat delayed or muted because many leases were put in place round the market’s peak when everyone was spending and taking on additional space,” he said. “Most of these tenants are carrying that space until their leases expire and then they will give some of it back, resulting in higher vacancy and lower rents. What will happen then is that Class B tenants from the suburbs will move into that vacated space, taking advantage of lower rents. As a result, we will see flattening rents and stabilising vacancy in the core CBD space and suffering around the fringes.”
Shadow of debt
Another major factor to consider when investing in US real estate is the lending market, which currently is a shadow of its former self. The lending market is the fuel that makes many commercial real estate transactions happen, but right now much of that market is still reeling from the financial crisis, for which it is partly responsible. Among the roundtablers, views were mixed.
“We are seeing a surprising amount of debt capital come from insurance companies to pick up some of the slack left by the CMBS market, which is trying to get its legs back,” Casal said. “We are starting to see some CMBS deals out there, but it is a fraction of the market’s volume at its peak.”
Giller, meanwhile, sees the debt markets coming back on all fronts. “The CMBS market is recreating itself, the life companies have continued to be active and banks are starting to think about it as balance sheets are rebuilt,” he said. “In addition, there have been a number of new private equity debt funds raised that are first mortgage lenders.”
As for who is eligible for that financing, Casal once again sees a bifurcated market. “For debt with conservative loan-to-value ratios of up to 60 percent, low rates are available in the 4 percent range,” he said. “I think that is supporting the valuations on really high-quality properties and creating a perfect confluence of demand for trophy assets. As you move away from that type of quality asset, however, it s much harder to get financing.”
On the platforms that Clairvue is involved with, Giller is seeing debt available for acquisitions. “It is all low leverage of 50 to 65 percent LTV, but the money is there for the right assets, and not just CBD office,” he said. “The question we ask ourselves is, how will this low leverage conservative lending environment fit with the continued desire for opportunistic yields from institutional investors? I don’t think anyone has cracked the answer to that question yet.”
Lindsay believes now is an extraordinary time to borrow if you can do so under a fixed-rate loan. “There are record low interest rates, and spreads are declining rapidly because of a lack of alternatives in other fixed-income products,” he said. “In December 2008, insurance companies were making loans at 50 percent of distressed value at 8 percent, but today that loan is 65 percent at sub-5 percent. So, that compression is massive.”
Lindsay also has been surprised will the rapidity in which programmes have sprouted up in the conduit space. “Outside that, however, there are bids but, once you go off the fairway, it gets expensive,” he added.
The apartment markets are being strongly supported by agency financing and stabilised CBD office is being financed at 4 percent, but there are accretive opportunities beyond that. So once again, it is the haves and have-nots, and there’s a two-stroke or four-stroke penalty for going off the fairway.
McDermott noted that Rockefeller is looking at an asset in downtown Washington, DC, that has been a casualty of the recession at 70 percent occupancy. “We received a five-year quote from a life company for a full-term, interest-only loan at 250 bps over LIBOR, which combined with the swap rate was at 3.9 percent all in,” he said. “I was surprised that something came in at sub-4 percent, but five-year quotes are more aggressive than seven- and 10-year quotes, which today are tougher to match up.”
While it is good to know which lenders are active right now, Lindsay argues that it is the inactive segment that is going to drive the macro recovery. “The commercial mortgage market is about $3.5 trillion in the US, and 20 percent of that is legacy CMBS,” he explained. “Even if that comes back strong, it probably isn’t going to get to 20 percent again. About 15 percent comes from insurance companies, which are pretty active, and another 15 percent is other, which includes specialty lenders. They were all funded by CDOs, so that segment appears to be over.”
The remaining 50 percent is commercial banks. Until they are back in business, we are going to see pricing effects due to the lack of capital,” Lindsay said. “If we assume the mortgage market turns over about 10 percent per year — or $350 billion per year of need — and banks are actively reducing their balance sheets, then this is going to put pressure on what we see by the way of opportunities going forward.”
Who will survive?
After a long proliferation of real estate investment firms, it is now clear that not every firm is going to survive. Just as there are telltale signs that a firm is teetering on the brink of collapse, the roundtablers agreed that there are certain attributes possessed by firms that will survive and thrive going forward.
Having taken over the operations of two other funds last year, PCCP’s Lindsay believes a firm needs a number of attributes to thrive in this kind of environment. “First, you need some basic mass to be in the game,” he said. “If you have only raised one fund so far, it is critical that you raise the next one. Managing a pool of assets is a good job, and it is arguably one of the most important jobs today. If you can’t offer your employees opportunities as an investment firm, at least you can do so as an asset management firm.”
Another important attribute is to achieve a certain level of transparency. “This is to gain the confidence of your investors and they can tell other investors,” Lindsay said. “That has been a challenge in our business, particularly with firms not writing assets down appropriately or having investors challenge their marks. Those are all not great ways to advance your goodwill in the industry and survive.”
Finally, a firm needs to have a real asset-management mentality. “A lot of money is going to be made by firms that might have bought at the wrong time but worked hard and managed to preserve value over a much-longer hold period than they imagined,” Lindsay explained. “If you don’t have that mentality and it is all about new deals, you won’t have investor confidence and you won’t get the next round of capital. Once that happens, the staff will exit, leaving the founders to run the operation. Only then, absent extraordinary circumstances, will the LPs intervene.”
Surprisingly, the first is some of the large global allocators, which lost millions of dollars for their investors in the last cycle due to aggressive strategies. I think a lot of people are scratching their heads as to why they have been deemed survivors.
According to Giller, the interesting thing about this environment is how many funds still exist. “Going into the downturn, there was an absolute barrage of capital coming into the market, prompting a wave of new firms and spin-offs,” he said. “As a result, there are just too many managers right now, so there absolutely has to be a reckoning. The question is who is going to survive.”
Giller believes there are two kinds of firms successfully raising capital in this difficult market. “Surprisingly, the first is some of the large global allocators, which lost millions of dollars for their investors in the last cycle due to aggressive strategies,” he said. “I think a lot of people are scratching their heads as to why they have been deemed survivors.”
“The second will be firms that are established, have critical mass, have strong pre-crash track records and, most importantly, were disciplined during the downturn, stopping or significantly slowing their pace of investment,” Giller said. “Meanwhile, firms that were exuberant investors going into the downturn, kept investing throughout and don’t have meaningful franchises are likely to dissipate heading into the next cycle.”
McDermott feels strongly that investors, particular international ones, want to align with a firm that knows how to own and operate real estate. “I think this has become a bit of a lost art,” he said. Limited partners want co-investment and other attributes, but they keep coming back to the real estate. In the long run, if you know how to run the asset class, I think you can survive.”
Who to hire?
With some firms consolidating and other ramping up for the recovery, a number of quality people will be changing firms over the next few years. There also will be a number of average people with impressive resumes muddling up the talent pool. Ever cautious, the roundtablers have a number of criteria to separate the wheat from the chaff.
Clairvue is recruiting pretty heavily right now, so Giller thinks about the skills he is looking for in new hires all the time. “First, with an existing portfolio, you need people that are good asset managers,” he said. “Given our principle focus on recapitalising funds, we also want to see managers with the ability to work out debt and navigate complex issues that can be either accretive or destructive to the fund. And on the acquisition side, we are looking for very strong underwriting skills.”
Most of the candidates that Rockefeller Group is speaking with for roles in the investment management business are people that have come out of an owner/operator model. “Like other deal folks, I have been an asset manager for the past two years,” McDermott said. “I worked the portfolio and tried to preserve and, in some cases, create value, so that is a skill set we are looking for in new hires. We also are seeking candidates with development experience because we will seek to utilise that skill when looking at higher yielding transactions. These opportunities may not be as prevalent today, but you know they are coming.”
Aviva also has been busy recruiting. “You never really know the next thing that is going to sneak up and bite you, but it is never the last one,” Casal said. “It has been particularly hard to find good senior people because we are looking for such a broad skill set. We want someone who has suffered through development deals, who has restructured deals and who has corporate finance experience – a skill woefully missing this last time around. Looking forward, I’m not sure where that landmine is going to be, so we are trying to build a team that is very strong on the macro side.”
Beyond the criteria everyone else mentioned, Lindsay only had two things to add: strong communication skills and, more importantly, a sense of ownership. “In the past year, we have done three or four transactions where I think we made a good buy because of deal fatigue on the part of the seller,” he said. “I want to make sure my team never gives up because then you leave something on the table. People want to move on to the next investment, but the old investments may still have money embedded in them. A lot of money is going to be made doing that basic work, and a lot of money is going to be lost. It is hard to find someone who has all the skills we are looking for and also owns the asset all the way through its lifecycle. To me, that intangible is one of the most important things.”
A question of liquidation
Given the current state of the US real estate market, it is not surprising that a number of funds and their managers are suffering at the moment. It also is not surprising that a number of funds have popped up that focus on acquiring and recapitalising these portfolios – including funds managed by a couple of our roundtablers. The bigger question is, are all these funds worth saving?
Bill Lindsay: We have seen some situations where we were asked to take over a fund and what was being sold was the net present value of a fee stream. But when we looked at it, we thought the NPV to the investors is higher if the fund is just liquidated now, provided the assets are saleable. I think we will see more of that in the future, when investors get a bit more thoughtful about their situation.
If you think about it, you have a pool of assets that is declining over time and generally you are paying fees not based on the value of those assets but rather some other metric, which may not make sense today. If you look at your NPV as an investor, then you realise your take will be higher if you sell everything today because you won’t be bearing this cost over time.
Jeffrey Giller: I was sitting down with a manager last week and he was telling me how his fund is going to do great relative to the market, but unfortunately the J-curve is killing the net returns. At the time, I didn’t consider that maybe he should just liquidate all the assets now, but it would be the smart thing to do.
Lindsay: All I’m saying is, in certain situations where there is obviously a market for the assets, that needs to be one of the choices. Sometimes the assets simply need to be managed into a better market, but we’ve seen at least one situation where I thought the assets could move right away and that was a better result for the investors. Unfortunately, I wasn’t talking to the investors; I was talking to the GP.