FEATURE: A REIT resurgence

After the battering the public markets have received of late, you could be forgiven for assuming REITs would not have the chutzpah to tap institutional investors for private equity-style funds. After all, billions of dollars have been wiped off investments in public companies.

However, as summer ends, there are signs emerging that various public groups are reaching out to investors about plans to launch private funds or to beef up existing ones. Should such plans materialise, it would represent something of a rebound in fortunes. 

In the aftermath of the global financial crisis, REITs with large fund businesses were penalised by the stock market, suffering more significant losses in stock prices and public market valuations than those without a fund. Paul Adornato, senior REIT analyst at BMO Capital Markets, says: “Many companies reduced their exposure to the fund business in response to the change in investor sentiment regarding funds within REITs. When we entered the real estate and economic recession, fund structures within REITs were looked upon negatively, so they disappeared altogether or shrunk.”

With the US economy on a slow path to recovery, the funds “seemed to be coming back to some degree,” says Adornato, albeit not as prevalent or as large as they were before the downturn. 

Jitter bug
As new recession concerns have surfaced in recent weeks, it is clearly too soon to tell whether the resurgence in funds will continue. However, Doug Sesler, former head of real estate principal investing at Bank of America Merrill Lynch, says current stock market jitters may actually spur the launch of new REIT-sponsored funds.

“There is interest by a number of the REITs in creating funds,” Sesler says. “In a market like this, where you’re seeing volatility in folks’ stock prices, I think the value of having an alternative source of capital…is greater than it used to be to REIT management teams.”

Kimco Realty is a live example. The New York-based retail REIT, which owns the largest portfolio of neighborhood and community shopping centers in North America, currently is considering a third fund in its Kimco Income Fund series.

The REIT first entered the private equity business in 1999, when it formed the Kimco Income REIT fund in partnership with the New York State Common Retirement Fund. It now has about $10 billion in assets under management through its commingled funds and separate accounts.

ProLogis and AMB Property are longstanding proponents of the REIT-cum-fund manager model. The companies, which merged in June to form Prologis, have created Prologis-OPERF Global Industrial Venture with the Oregon Public Employees’ Retirement Fund (OPERF), in which the public pension has made an initial $100 million commitment to the developer’s open-ended Europe Logistics Fund. The investment is part of a $500 million allocation to the new venture, which will be structured as a feeder account and enable OPERF to invest in existing and future Prologis funds.

Both of Prologis’ predecessor companies – ProLogis and AMB – were public REITs that sponsored private capital funds; AMB, moreover, started out as real estate investment manager in 1983, years before it became a REIT and a developer. The newly combined company has 21 current funds that account for half of its capital.

As a merged entity, Prologis decided to continue the private equity business for the same reasons its predecessors had created their fund arms, according to Guy Jaquier, chief executive officer of private capital at Prologis and former president of AMB Capital Partners, which had been that REIT’s private fund arm. “With real estate being a capital-intensive business, you have to have access to capital,” Jaquier says. The fund arm gives the REIT “another avenue to access capital and grow our platform.”

Defined benefits
REITs have three primary sources of capital available to them, according to Scott Onufrey, senior vice president of investment management at Kimco. One main source is public equity, or shares issued on the stock market, but that option can be very expensive, he notes. Another is public debt, or bonds, “but that increases leverage, which increases risk,” he explains.

“Private equity has the advantage of not diluting shareholders or increasing leverage,” says Onufrey. In a fund, an equity investor’s risk is limited only to the properties being invested in, so the risks for the common stockholder or bondholder are limited, he explains.

In addition, a REIT benefits from an institutional investor’s lower cost of capital. “The typical cost for that capital can be lower than an equity investor that is putting money in the stock market and is expecting very high returns from their stock portfolio,” says Onufrey.

The fee structure for funds within REITs are similar to other private equity funds, says Jaquier. An institutional investor typically pays a base management fee plus promotes or incentives fees if the fund exceeds certain performance hurdles, as well as ancillary fees paid for services such as property management or development.

About $25 billion of Prologis’ $45 billion in assets are held in the REIT’s private equity funds or ventures. “Half of our portfolio is comprised of investments that private equity is helping to fund,” Jaquier says. “It basically let us double the size of our business, double the size of our network and double the size of our footprint.”

A REIT also gains a greater market presence with a fund structure, points out BMO’s Adornato. With private equity funds, a REIT that owns $2 billion worth of property may manage $10 billion worth of property, giving it more weight and influence in the market, he explains. “There are definite benefits to size in the real estate world, and having a fund structure helps achieve that,” he adds.

And with scale comes efficiencies. “By having more properties in any particular market, we can spread the costs of our platform across more properties, so it’s going to be less cost per property,” says Onufrey.

Publicly traded REITs have defined investment strategies that are articulated to investors, but “from time to time, opportunities come along that don’t necessarily fit stated investment parameters,” says Mitch Roschelle, a partner at accounting and consulting firm Pricewaterhouse-Coopers. “By having a private vehicle that has incremental flexibility, they can take advantage of opportunities when they come along.”

Jaquier would argue LPs benefit from investing in funds sponsored by REITs as they are investing directly with the operator, notwithstanding the loud objections made by Dutch asset manager APG towards ProLogis European Properties earlier this year, which eventually led to ProLogis having to take the listed fund private. APG, which was a shareholder in the European-listed company, objected to a perceived lack of corporate governance in a set up involving ProLogis as a shareholder in the company as well as being the external manager.

“The model allows the investor to avoid double promotes and double fees typically associated with funds sponsored by investment management firms, which often do not operate or build the properties themselves and instead partner with a local company,” Jaquier explains.

In addition, co-investments by REITs tend to contribute a greater portion of the capital than private equity firms, says Jaquier. Prologis typically co-invests an average of 30 percent of the capital in a fund, compared to traditional investment management firms, which usually invest well less than 10 percent, he notes. “Our co-investment dollars in the fund frankly outweigh the fees we’re getting, so it means that we’re investing the capital for investment returns, more than just for fees,” he adds. Expected returns depend on the nature of the fund, such as whether it focuses on mature core markets or emerging markets.

Brad Child, senior real estate investment manager at OPERF, says it works well for pension funds to utilize teams that already are up and running. The $60 billion pension plan has invested with Jacksonville, Florida-based retail REIT Regency Centers through a separate account for the past decade and New York-based office and retail REIT Vornado Realty Trust through its commingled fund, Vornado Capital Partners, for about a year.

“Public REITs have the operations, they have the due diligence, the reporting capability that we need and the fiduciary responsibility we want because they have been doing this in public securities all along,” Child says. “You can easily take a look at their performance going back.”

Like pension funds, public REITs tend to be long-term investors and therefore are well suited for core and some value-add opportunities, says Child. Traditional private equity firms, on the other hand, are more appropriate for shorter-term, opportunistic plays, he notes.

The opposite, however, is the case for a REIT’s public shareholders. “The fund structure within a REIT tends to be viewed with a little more skepticism” because of the greater level of complexity and potential conflict of interest, says Adornato.

The specifics of the agreement between the REIT and the fund investor – such as the fund structure, fee arrangement, financing limitations and the obligations of each party – are often unknown to the public shareholder, according to Adornato. “I’ll probably have some general idea, but I may not have all the details,” he says. “All of those things are questions I have to ask, instead of them being listed in the SEC prospectus.”

Public fear
Public shareholders “might be concerned that Kimco as the operating partner may not be able to operate the properties consistent with their strategy because you have another partner that has a say in what’s happening,” says Onufrey. But rarely is there a conflict where Kimco is not able to demonstrate to the partner why its management decision is the best for the property, he would say.

Another concern of public shareholders is whether a transaction will go to the fund or the REIT itself—and which one gets the best deal. “You need to have a very clear, transparent, documented allocation policy,” Jaquier says. For Prologis, that policy stipulates that, if a fund has capital available for a particular investment, it will go to that particular fund. The only time the REIT’s balance sheet will do an investment is if it would be in a market or a type of investment for which the REIT has no fund, he notes.

As for private investors, there can be conflicts there as well. “In some of your funds, not all of your LPs have the same goals and objectives over the entire investment period,” says Jaquier. “You may have certain investors that want liquidity now and certain investors that want liquidity two years from now. You just have to use your best judgment as to what maximizes total return.”

Public REITs have a mixed outlook on how prevalent the fund structure model will become. Onufrey says many of Kimco’s peer companies have private fund arms, and he expects them to continue to follow this model because “partnering with institutional capital makes a lot of sense, given the nature of real estate being so capital intensive.”

“We see this as a way for the future because, if you’re going to continue to grow your business, there are limited sources of capital,” says Onufrey. Pension funds and other institutions own the majority of the real estate in the US, while REITs are among the largest real estate managers, so “it makes a lot of sense to team up.”

Prologis’ private equity business also “has a great future,” according to Jaquier. Last year, AMB had a record year of fundraising, with $760 million in equity raised, and prior to the merger, the REIT had raised $1.3 billion in the first half of this year, he notes.

Barriers to entry
Jaquier, however, expects few REITs to create new fund arms going forward. While some REIT executives initially may find an investment management business to be appealing because of the greater access to capital, “unless they’re really willing to make the commitment, there are just barriers to entry that make it very difficult,” he says.

For example, creating a fund – from the initial concept to putting together the private placement memorandum to marketing and closing it – can take 12 to 18 months. “It’s a little bit daunting when people actually realise what it entails,” he says.

Also, in the current economic cycle, “there are fewer LPs today that are willing to take the risk on a start-up manager, someone who hasn’t done this before and someone they either don’t have a relationship with or haven’t watched them zig-zag for about 10 years,” says Jaquier. “It’s harder for a REIT or someone else who hasn’t done this before to raise that first fund.”

Further blurring the lines
Private equity real estate firms are eyeing unlisted REITs, just as REITs are eyeing private funds

Later this year, New York-based real estate investment manager Clarion Partners is expected to launch its first non-traded REIT, Clarion Partners Property Trust. The publicly registered REIT, with which the company is looking to raise $2.25 billion, is Clarion’s first product for the retail investor, targeting eligible high-net-worth individuals for minimum investments of $10,000. The REIT, which Clarion first filed with the US Securities and Exchange Commission in 2010, was declared effective by the SEC in May this year.

The plan is notable as a live example of how the lines between public and private real estate firms are getting blurred. Indeed, as REITs have turned to private investors in a time of economic instability, so too has private equity been examining quasi-public routes for alternative sources of capital.

It looks like the beginnings of a trend, with MGPA recently signing an agreement with Orlando, Florida-based CNL Financial Group to provide investment advisory services to two REITs, Global Growth Trust and Global Income Trust. MGPA sees the move as a good way to supplement the capital in its private opportunity funds with capital from retail investors.

Added to the list can be Northstar Capital and Starwood Capital Group, both of which are eyeing non-traded REITs, according to Doug Sesler, former head of real estate principal investing at Bank of America Merrill Lynch.
While firms like Hines and Richard Ellis have been in the REIT business for about six years, Sesler says: “It has really been in the last two years that I have gotten calls from people wanting to get in this business, as they have seen it as a place to raise capital when other markets have closed.”

Clarion, which is now independent of Dutch bank ING Group, has not launched a non-traded REIT previously because it had been focused on the institutional market, while the individual market involved a very different distribution channel. According to sources, the firm now sees an opportunity with retail investors, who increasingly have become responsible for their own retirement planning as the defined contribution market has grown.

Mitch Roschelle, a partner in the real estate advisory practice at PricewaterhouseCoopers, says traditional private equity is not terribly interested in the retail investor. He asks: “Why wouldn’t you access capital from institutions in much bigger increments rather than raising capital from much smaller investors?”

That said, a non-listed REIT makes sense for a company like Clarion, which some see as more of a money manager that frequently is rolling out new products in order to grow both its assets under management and fee business.

Out with the old
The timing may be right for a non-listed REIT in light of what some see as the early stages of a new real estate cycle, where both the economy and the real estate market are poised to trend upward. REITs also appeal to investors because of their tax-efficient structures.

Furthermore, Clarion Partners Property Trust has been designed to address some of the issues that have plagued older non-traded REITs, particularly the very high upfront fees, sources say. The new REIT will have a much lower fee structure, and each share will be valued daily based on the fair value of the REIT’s investments. That is quite different from traditional non-traded REITs, which do not change in net asset value for extended periods of time. Shares in the new REIT will be sold through financial advisors and brokers.

The REITs filed by Clarion and others, such as Cole Capital, are part of what Sesler calls the new generation of non-traded REITs, which typically have low leverage and much more robust liquidity than the older generation.

“There is a big push to create this new generation of product,” although it won’t necessarily come from private equity firms, according to Sesler. Given the current risk-averse investment climate, where people are seeking a vehicle that offers a current dividend, moderate risk and some inflation protection, “there’s a lot of logic for it to succeed in this market,” he says. “Time will tell how successful it eventually becomes.”