AMERICAS NEWS: The green, green grass

It can sometimes be a foolhardy effort to covet the greenness of the grass growing in your neighbour’s garden. But when your grass is scorched and shows only a slight chance of recovery, your neighbour may well have an answer or two for your gardening woes. Private and public real estate in the US is, at the moment, no different.

After more than doubling its market capitalisation over the past two years, the US public real estate market has left its private neighbour lagging. For private equity real estate fund manager RLJ Development, however, that public surge could pose a solution to exiting its 2006 and early 2008 vintage private funds.

Robert Johnson,
RLJ founder

The Bethesda, Maryland GP currently is in talks with LPs about consolidating its Urban Lodging Fund II and Urban Lodging Fund III into one platform ready for a possible IPO as a REIT. The vehicles, which raised $743 million and $1.2 billion in commitments respectively, have a current equity multiple of just 0.8, according to second quarter 2010 performance documents from the State of Connecticut Retirement Plans and Trust Funds. Furthermore, net IRRs are -10 percent for Fund II and -38.3 percent for Fund III.

RLJ, co-founded by Robert Johnson and Thomas Baltimore, declined to comment on the IPO roll-up of its funds. But for the GP and its LPs – 15 in Fund II and 16 in Fund III, many of whom re-upped – there are two overwhelming reasons to consider such a strategy: increased liquidity for existing investors and greater access to capital and growth opportunities for management.

“For investors, public REITs obviously provide greater liquidity,” said Jason Myers, counsel in the New York office of Clifford Chance who focuses on REITs. “But from a management perspective, there is much more potential for growth in terms of investment opportunity. In addition, as a public REIT, a company has better access to capital – from equity to debt to the preferred markets – as well as the investment banking community.”

However, as the cliché goes, the grass isn’t always greener on the other side. For RLJ, the biggest hurdle it faces is pricing a potential IPO.

Indeed, the US REIT market is no longer awash with indiscriminate ‘tourist’ equity eagerly looking for yield and willing to invest in real estate at, almost, any cost. Instead, Myers said, private fund managers rolling up their funds have a “smaller group of investors to work with. These investors now have much more leverage to dictate what your pricing is going to be.” And, just as in the private markets, what they’re focused on is quality assets and lower leverage.

The US hospitality sector may be seeing the beginnings of a recovery, but it undeniably took one of the hardest hits during the downturn and the climb back will be arduous. For RLJ, that is certainly reflected in its recent returns. According to Connecticut’s performance documents, the two hotel-focused vehicles generated net time-weighted returns of -23.4 percent and -17.6 percent in the year to the end of June 2010. In the second quarter alone, Fund III – which still has “significant” equity to invest, according to Connecticut – delivered -4.6 percent returns in the second quarter of 2010 compared to zero percent for Fund II.

Furthermore, for RLJ’s Fund II, leverage is an issue. With a fund-level LTV of 88.2 percent, RLJ has struggled with its debt structure, having already restructured $478 million in loans affecting 32 assets. Fund III has a current LTV of 74.1 percent, but even that is well above the appetite of most REIT investors today. Unless a major debt reduction is in the offing, few GPs questioned by PERE about RLJ’s proposal expected a pricing that the Maryland fund manager and its LPs would be happy with.

And that is the critical issue. When it comes to pricing an IPO, the fund sponsor is not necessarily the one in charge. Management, in consultation with the bankers, will establish an estimated company valuation and IPO price and allot LPs the appropriate number of shares according to their interests in the original fund. But it is public REIT investors that ultimately determine what the IPO entity and its underlying portfolio is worth and what existing investors ultimately will receive in terms of actual value.

The danger in RLJ asking its LPs to consider a roll-up of its opportunity funds is in finding out that public investors consider the grass on the private side decidedly less green than their own.