How is the US faring as a place to invest compared to the rest of the world? It may seem like a disarmingly simple question, but it is one laced with a myriad of connotations, as three real estate professionals appreciated during PERE’s US roundtable, which was held in New York at the end of September.
On deck to answer that question and others were Joseph Stecher, managing director of the New York-based real estate group of Morgan Stanley Alternative Investment Partners (AIP); Peter Falco, co-managing partner of White Plains, New York-based Rockwood Capital; and Mark Grinis, partner at the global accounting and advisory firm Ernst & Young.
Considering the large deals taking place and the surplus of investment opportunities, relatively speaking, private equity real estate in the US isn’t doing too badly. Of course, there are some big challenges ahead for both foreign and domestic investors.
Snapping back
Morgan Stanley AIP’s Stecher believes the US is a comparatively attractive market in which to invest, although that judgment has as much to do with the opportunities there as it does with his observation that “Europe is the world leader in distress.” With the issues many European nations are having with their banks, as well as other macroeconomic concerns, he finds it difficult to see the degree of recovery in Europe that is expected in the US.
“We don’t expect the US to snap back beautifully, but there’s a big difference between 1 percent growth and 2.5 percent growth for several years,” Stecher says. “So right now, relative to the rest of the world, the US looks pretty good.”
Rockwood’s Falco agrees. “As people are starting to recognise that recovery in the US will be slow, they’re revising their growth assumptions and rental rate assumptions down,” he says. “Nonetheless, they’re revising it down from ‘too optimistic’ to something more realistic.” That ultimately should lead to “a very good investment horizon.”
Indeed, the three participants were all in agreement that the US was where foreign real estate investors should look for opportunities. However, Ernst & Young’s Grinis points out that, although “the US is a terrific place to invest,” managers that diversified their portfolios typically fared better during the recent downturn.
Speaking of Europe, it appears as though the crisis overseas will affect – and in some ways already has affected – the commercial real estate market in the US. “A slow Europe has an implication for a slow US, and that has an implication for the broader global economy,” Grinis says. “That’s going to drag on for awhile.”
For proof, look no further than the property finance market. Falco notes that, although the market in the US recovered extraordinarily quickly following the recent downturn, there has been a very marked change over the last three months. “Spreads have widened out considerably,” he says. “Debt, which used to be abundant, has pulled back in all property sectors. In the hotel sector, it has virtually disappeared now. As a result, the initial wave of debt capital that was aggressively priced has pulled back and is being more appropriately priced.”
The European market dragging down the US isn’t the only problem facing fund managers targeting the US. Diversification – or lack thereof – has been a problem in the private equity real estate sector, not just in terms of nations but also for regions within the US. Indeed, a great deal of money is being pumped into a very finite number of property types and markets. “There is a lot of money flowing into a very limited number of markets, such as New York, Washington DC and the San Francisco Bay area,” says Falco.
A substantial amount of capital also is going into core products. Core is not only massively popular in the US, but it is massively overpriced. In fact, Morgan Stanley AIP thinks that deferring commitments to overpriced core products for the moment and committing to more attractively priced ‘transformational assets,’ such as those with vacancy and deferred maintenance, may be a prudent approach.
Still, Grinis points out that, in terms of how the country is perceived by foreign investors, sovereign wealth funds “think the US is on sale.”
Investment considerations
When considering a real estate manager, the roundtable participants do not offer a consensus as to which was preferable, going with mega-funds or keeping one’s boots on terra firma.
Rockwood’s approach is focused on having boots on the ground. Ultimately, real estate investment is “about local knowledge, local players, leasing and relationships,” according to Falco. In other words, those investors that succeed in the field are those that maintain relationships with the developers, builders and managers – something difficult to do with a mega-fund.
Grinis, on the other hand, isn’t so certain. Following the global financial crisis, he notes that LPs were focused on moving away from the mega-funds. Although there still is a focus on and value seen for targeted investors, separate accounts and joint ventures, the pendulum is swinging back to the mega managers.
Indeed, there has been activity of late at the largest of levels, although the roundtable participants did raise questions over the dynamics currently at work in the market. “There definitely is going to be a lot of opportunity for the mega-funds, especially on big loan transactions, which they are very good at executing,” Stecher says. “However, there’s an awful lot of competition, and it’s not entirely clear that the prices being paid are in line with the assets being acquired. We looked at a very prominent loan portfolio with another manager and passed at the outset partially because of price. It turns out even that manager was ultimately outbid.”
Despite a great deal of opportunity for buying distressed assets, some believe that even now there is room for new construction. Rockwood, for example, currently is building a new hotel in New York on West 37th Street between Eighth and Ninth avenues, even though it is aggressively pursuing the distressed debt space.
Grinis notes that the market still has a ways to go before there’s going to be real demand for new space, as the economy has yet to create new jobs to fill the space already in existence. That said, he points out that, further down the road, there could be “very unique niche opportunities for development.”
Morgan Stanley AIP’s real estate team generally has avoided investments that involve US property under development, at least for the time being. “The developed world doesn’t need any more enclosed space,” says Stecher.
Indeed, after seeing some major sales in the distressed real estate space in the US, the participants agree that loan sales certainly are a fruitful area. One recent example is the sale by Anglo Irish Bank of a nearly $10 billion loan portfolio to Loan Star Funds, JPMorgan Chase and Wells Fargo in August. Another is Bank of America selling a portfolio of commercial mortgages worth roughly $880 million to a venture between Square Mile Capital Management, Invesco Real Estate and a fund managed by Canyon Capital Realty Advisors in September.
“We’ve had two or three major portfolios move through the market recently, and they provided an opportunity for a lot of capital to be deployed on a single transaction,” says Grinis. “That said, if you look at the amount of available capital in the marketplace, the market can probably digest a hundred of those. As a result, there continues to be a dichotomy between the amount of capital and the amount of deals in the marketplace.”
However, opportunity depends upon the specific market and property type. As Falco notes, the opportunities are there if know where and how to find them. For example, office rents are recovering rather slowly, and there are certain markets like Los Angeles where recovery in that sector is probably three or four years out. However, in an area like Phoenix, where a population influx has begun and job growth has returned, the sector may be recovering faster than average.
For Stecher, that opportunity lies in the $400 billion gap between the amount of debt coming due in the next two years and the amount of money that is available to refinance it. He estimates that roughly $260 billion has been raised for opportunistic funds across all strategies globally over the last four years, and probably half of that already has been deployed. Meanwhile, REITs have raised only about $40 billion in that timeframe and already have deployed most of it. “There’s just a huge difference between the amount of money that’s been raised and the amount of opportunity that is going to present itself over the next two years,” he says.
Falco takes the idea step further, pointing to an interesting disconnect in the market. “There’s a large amount of money available for real estate investment, but it doesn’t quite meet the opportunity,” he says. “Some of it is seeking lower-return core product, but the rest of it still is seeking 15 percent to 20 percent returns, which are much harder to find. However, there is a place in the middle, where you can get returns in the 12 percent to 15 percent range, which is a very attractive place to be working.”
Tipping point
Aside from large loan portfolio sales like those of Anglo Irish Bank and Bank of America, lenders more often have resolved their debt problems by establishing and maintaining a high level of transparency with regard to what it has and how much it’s worth. “Over the last three years, everybody is beginning to understand what everyone has and what their positions are, and that visibility is a real stimulus for transactions,” says Grinis.
Lenders have been extending mortgages and other debt financing for two to three years, while the borrowers have not been investing so much as just paying the interest because they often don’t see the point in investing in a property that the banks eventually are going to foreclose on. The combination of banks’ increased ability and willingness to extend loans and borrowers saying they can’t pay anymore is likely to lead to repayment, discounted repayment or foreclosure.
“We are getting close to the point of capitulation, where lenders understand what they have, the owner operators understand what they have and regulators are looking at the books and asking questions,” says Grinis. “All of those elements put together say we know now what we have and what we are going to do about it.”
Indeed, while there have been just a handful of large portfolio sales of late, far more prevalent are the number of smaller opportunities coming from lenders. Many of the larger banks are now rebuilding their balance sheets and therefore are able to recognize certain losses in a limited way. These lenders ultimately are trying to match their quarterly profits with a certain amount of losses that they can afford to take. If lenders can underwrite and close on a property before the end of the quarter, they’re often willing to trade at a price reflective of capitulation.
When it comes to pursuing US real estate at discounted levels, there are three possible routes: buying the note from the lender at a discount and fighting it out with the borrower; buying the foreclosed building from the lender; or coming alongside the borrower with fresh capital as well as operational expertise, a recovery plan to address deferred maintenance and vacancy and an exit strategy. Partnering with a borrower in distress presents opportunities, but it will require work as some owners have either not been able to or chosen not to put money into their properties for almost five years now.
“We’re certainly seeing that on the hotel side, which by definition needs to make a significant investment every five to seven years,” notes Falco. “The trick is to figure out how best to structure that distressed capital so that new money both has preference and is protected.”
Furthermore, the financial crisis has created a lot of opportunity for secondary acquisitions of LP interests, as well as for co-investment alongside funds. In both cases, Stecher says the reason is that LPs are looking to better manage their liquidity. One way is by selling out of funds that are illiquid, and the other is by “tapping the brakes on commitments to new funds,” which means managers are either raising less money than expected or wondering how long it will be before they raise their next fund.
With regards to the current fundraising environment in the US, the mega-funds have been successful powering through, despite the fact that the larger LPs are scrutinising how their portfolios performed during the downturn. As an example, Blackstone already has seen a great deal of success with its latest vehicle, Blackstone Real Estate Partners VII, which closed on $4 billion – more than a third of its $10 billion target – just four months after launching.
Still, for a number of fund managers that aren’t behemoths like Blackstone, it has been a tough environment. Although mega-funds have made a bit of a comeback and are seeing some success, the amount of capital being raised is still less than half of what was being raised prior to the global financial crisis.
As for foreign GPs, the roundtable participants haven’t seen a great deal of them active in the US. “We see a lot of interest by sovereign wealth funds and the larger investors, but we don’t see much money coming inbound from the international markets through foreign GPs,” says Falco. He added, however, that some of the larger insurance companies and fund of funds are starting to open American offices with the understanding that there will be demand for international investment coming inbound to the US further down the road.
Uncertainty ahead
In terms of the outlook for 2012, things are looking rather rocky, particularly with the US gearing up for a potentially contentious election year. However, three to five years down the road, things may indeed pick up, assuming the economy kicks back in.
“It’s hard to see many blue skies in the next 12 months, given a political climate that’s going to have a bigger influence on our industry than it ever has in the past. Twelve months or so of uncertainty creates a negative outlook, but it doesn’t necessarily make it a negative environment to invest,” says Grinis. “It may be a positive environment to invest, assuming that your belief is that, after 12 to 15 months, we’re going to get much more certainty around our fiscal house.”
“The next couple of years are going to be tough,” adds Stecher. “We’ve tailored our investment approach around that economic reality, as well as the expectation that capital markets and fundamentals are going to start to come back three to five years out.”
“It will be a very attractive environment, provided you’re not overly optimistic in your assumptions as to the rate of recovery,” says Falco. “Americans tend to be impatient and want to recover immediately, but I think the recovery will take longer than we would like it to.”
Joseph Stecher
Managing director
Morgan Stanley Alternative Investment Partners
Stecher is chief investment officer and head of Morgan Stanley Alternative Investment Partners’ real estate fund of funds group. He is responsible for identifying, selecting and managing investments in private equity real estate funds. He joined Morgan Stanley in 2008.
Prior to joining Morgan Stanley, Stecher was a managing director at Goldman Sachs, where he managed a global program of real estate fund of funds and separate accounts for institutions and high-net-worth individuals. Prior to Goldman, he was at General Motors Asset Management – now Promark Global Advisors – where he invested nearly $2 billion in private equity real estate funds and acquired 47 million square feet on a direct basis.
Peter Falco
Co-managing partner
Rockwood Capital
As one of the founders of Rockwood Capital, Falco co-manages the White Plains, New York-based firm, with a particular focus on portfolio and asset management, investor relations and business development. He serves on various portfolio management and investment committees, as well as chairing the firm’s new business and investor strategy committee and its finance, budgeting and operations committee. He previously served as head of Rockwood’s capital markets team and as chief operating officer.
Falco has 34 years of experience in the real estate industry, beginning with land use planning and development before evolving into investment and management facets of the business. From 1988 to 1995, he was a vice president of planning with Trafalgar House Property, where he was responsible for pre-acquisition feasibility studies, due diligence and environmental clearance, site planning and engineering and project entitlement for the firm’s commercial developments.
Mark Grinis
Partner
Ernst & Young
Grinis is a partner in the real estate group at accounting and advisory firm Ernst & Young. He leads the transaction real estate practice for the Americas and heads up the firm’s global real estate private equity practice. For the past 10 years, he has advised various ministries of finance and control banks for eight countries on strategies to address nonperforming assets.
Grinis has more than 26 years of experience, having been at the centre of distressed property markets in Texas in the 1980s, California in the 1990s and Asia throughout the Asian economic crisis. While in Asia, he was the managing partner for Ernst & Young’s Asian real estate practice and advised such clients as the leading securities firm in the Japanese government and the largest city banks and insurance companies. He also served as lead advisor to the major investment banks in the underwriting and acquisition of real estate and nonperforming loans.
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