Brimming with inefficiencies, the real estate asset class has long been of interest to private equity firms eager to tame the world of bricks and mortar. Ever since the opportunity fund model broke ground in real estate more than two decades ago, generalist private equity shops have been active participants in commercial and residential property, some of them becoming the best-known names in the business.

However, a new wave – or second generation – of private equity interest in real estate is emerging, as the appointment of former Goldman Sachs veteran Ralph Rosenberg by Kohlberg, Kravis & Roberts shows. Indeed, speak to any number of property GPs and it is private equity that is expected to become a significant source of competition for today’s real estate fund managers.

Zoe Hughes

KKR, the hiring of Rosenberg marked the culmination of a more than two-year process as it tried to enter the real estate space, initially looking to hire established industry names to lead an in-house property team before exploring platform acquisitions (ING Real Estate Investment Management) and eventually returning to more organic growth. The foundation of it all was a bid to take advantage of the expected distress in the market and an effort to augment its existing private equity activities with real estate expertise, not least in light of the firm’s public listing ambitions.

KKR is certainly not alone in its thinking. In 2008, Apollo Global Management hired Joseph Azrack to build and develop a dedicated real estate group for the New York-based private equity firm for the same opportunistic and diversification reasons as KKR. Today, Apollo Global Real Estate has $6.5 billion in assets under management following bolt-on acquisitions of Citigroup’s real estate investment arm, Citi Property Investors, the Asia-focused platform Holdfast Capital and the launch of several funds and a mortgage REIT.

TPG Capital is another private equity firm that has significantly bulked up its real estate capabilities under the direction of former Colony Capital co-founder and TPG’s head of North American buyouts Kelvin Davis. In January, the firm hired former Westbrook Partners managing principal Avi Banyasz to help develop a real estate programme within the firm, as well as take part in the bidding for the ING REIM platform.

The appeal of real estate to private equity is two-fold. In terms of opportunity, a majority of the world’s real estate markets already have hit bottom and are starting – many slowly – on the road back to recovery. That coupled with the massive amounts of debt needing to be refinanced between now and 2014 and private equity recognises real estate as an asset class where outsized returns can be generated by those willing to get their hands dirty.

The second consideration, of course, is the withdrawal of a serious chunk of the larger bank and financial institution-sponsored platforms from the field. As some of the first generation of private equity real estate players downscale or retreat from value-added and opportunistic real estate investing, so the hunting ground for PE/RE 2.0 improves.

However, in targeting real estate, private equity faces some overwhelming challenges, not least the appetite of LPs for the allocator-based model of investing. Over the past two years, debate has raged among institutional investors over the pros and cons of capital allocators, particularly those with global opportunity funds, as opposed to real estate operators. Of late, the argument has been weighted towards operators thanks to years of poor or mediocre performance from some notable names, as well as LPs trying to take greater control over their investments by cutting out the middle man and going directly to the operating partner.

That’s not to say real estate allocators are going of business; LPs still have a place for them in their portfolio. But as investors continue to nurse the pain of their legacy investments, preference undoubtedly will go to those firms executing a niche strategy or real estate generalists with an established performance track record in the asset class.

The debate about the virtues of allocators versus operators undoubtedly will have an impact on any private equity firm opting to raise dedicated real estate funds in the future. As is already being seen in the current fundraising market, LPs are moving away from the mega funds of 2006 and 2007 and calling instead for smaller, more targeted commingled funds with significantly fewer investors. Even expectations by The Blackstone Group that it could raise roughly $10 billion for its next global real estate vehicle have raised eyebrows from a fundraising industry more cautious than ever when it comes to global mega funds. 

For firms used to closing north of $15 billion for their private equity vehicles, what scale of fund will be deemed sufficient, particularly given the opportunities expected to emerge over the next few years? While the start may be slow for many of real estate’s new private equity players, it would be foolish not to expect these titans of private equity to have serious ambitions for the asset class as they try to become leaders in this field. The unanswered question is how many the industry will support.