SPECIAL REPORT: Core crossover

When it comes to building new real estate businesses, The Blackstone Group has been known to ramp up quickly. Its latest endeavor in core real estate is no exception. 

In December, the New York-based private equity and real estate giant closed on the acquisition of a 29 percent stake in Edens from the previous interest holder, the State of Michigan Retirement System. The $718 million investment in the Columbia, South Carolina-based shopping center owner, which owns and manages 111 retail properties in such cities as Miami, New York and Washington DC, marked Blackstone’s first foray into core real estate. The firm also will be investing an additional $250 million in the expansion of Edens, bringing its total investment in the retail company to $968 million.

Since that initial deal, Blackstone has invested approximately $1 billion in total equity in the new strategy. The firm has struck a second core transaction – a large office acquisition in Europe – and is in exclusive talks on another core US office deal on the West Coast.

“The core and core-plus space is so much larger than what we do in opportunistic,” says Jonathan Gray, global head of real estate at Blackstone. “Opportunistic assets are assets that are overleveraged, under-managed or troubled. That, of course, is a small percentage of the overall real estate base, which is pretty stabilized for the most part. I think there’s a significant opportunity to make this a large business.”

Indeed, opportunistic real estate accounts for just 10 percent of institutional real estate allocations, Blackstone chairman Steve Schwarzman noted during an earnings call in January. To expand into core and capture a significantly larger percentage of real estate capital could signal even greater growth for Blackstone, which increased total assets under management by 40 percent to nearly $80 billion – some $51 million of which was fee-earning – in 2013. 

An investor-driven business 

Investors began approaching Blackstone about expanding into core a couple of years ago, when the firm still was marketing its largest real estate opportunity fund, Blackstone Real Estate Partners (BREP) VII. “At the time, given the state of the world, it was not something we were able to entertain,” says Kathleen McCarthy, the senior managing director who oversees investor relations and business development in real estate.

The conversations around core persisted, however, as investors sought to reduce their stable of managers to a select group of the best-performing firms. At the same time, many of these institutions were disappointed with the performance of core investments that they had sourced on their own or through existing core managers.

Blackstone’s crossover into the core space didn’t start until early 2013, when discussions began on the Edens deal. “Edens was really the first actionable situation,” McCarthy says.

The Edens acquisition, however, didn’t fit within the higher-risk, higher-return mandate of Blackstone’s flagship BREP series because it didn’t offer a controlling stake in the company, it had low leverage and the underlying assets generally were stabilized. Therefore, the return on investment would be lower than Blackstone’s typical 20 percent target for opportunistic deals, creating the need for a new investment model. 

A major step in formally launching Blackstone’s core platform was selecting someone to head up the new business. So, earlier this year, the firm tapped AJ Agarwal, a senior managing director who formerly focused on opportunistic investing in North America.

“Like most new offerings at Blackstone, core is investor driven,” says Agarwal, who currently is the sole Blackstone partner dedicated to the new strategy. “Our investors have expressed increasing interest in having Blackstone assist them in accessing core and core-plus opportunities on a global basis.”

The core platform will focus on the four main property types of multifamily, office, industrial and retail and will mirror the global scope of Blackstone’s overall property business in the US, Europe and Asia. While the firm did not provide specifics, other deals in the pipeline include transactions involving office assets in Europe and Asia and office, retail and industrial properties in the US. 

Capitalizing the business 

With all three of its inaugural core transactions, Blackstone is investing capital raised through separately managed accounts. For example, the State of Wisconsin Investment Board committed $200 million to the Edens transaction, according to the pension plan’s fourth quarter investment report. And, although Blackstone declined to comment, PERE understands that the firm is expected to launch its first commingled core real estate fund sometime this year. 

A target for the fund has not yet been determined, but it is likely to be in the billions of dollars based on the investment profile for the business, which calls for equity commitments of $100 million to $200 million per transaction. That higher equity commitment is due to core investments typically requiring twice the equity of opportunistic deals, given their lower leverage profile. Blackstone’s three initial core deals, however, will not become seed investments for the vehicle.

Indeed, the core strategy is anticipated to be a key focus of Blackstone’s real estate fundraising efforts in the months ahead. That is particularly true now that the firm has completed its latest BREP Europe fundraise and is wrapping up efforts for its debut Asia-focused real estate vehicle. “In regards to resources, we have the full attention of our IR team,” says Agarwal.

With Blackstone only about 60 days into its core business, the firm declined to comment on how it plans to scale the new platform. However, the potential future growth of the business can be likened to that of its Blackstone Real Estate Debt Strategies platform, which launched in 2008 and today manages $10 billion in assets.

Crossing over 

Blackstone is not the only opportunistic real estate manager that recently has decided to pursue a core or core-plus strategy. Boston-based Rockpoint Group, for example, began marketing Rockpoint Core Plus Real Estate Fund – its first lower-risk, lower-return investment vehicle – late last year. Rockpoint is seeking to raise $1 billion for the new fund from a handful of existing institutional investors.

For some industry observers, a move from opportunistic to core makes sense. “I have always thought it’s easier for opportunistic firms to move to core than core firms to move to opportunistic,” says Ted Leary, president of Crosswater Realty Advisors. “Opportunistic firms tend to be more creative and flexible as opposed to core-only firms and probably try to make the case that they can squeeze more value out of a core investment strategy.”

Still, such a crossover raises a number of questions, including how opportunistic-cum-core managers will structure compensation for their core investments. Gray, however, points out that Blackstone already has a lower fee-earning property platform with its real estate debt business, which is said to have a net return target of approximately 10 percent. “We do recognize that this is a lower-returning business, so we’re going to have lower fees and carry as a result,” he says of the new core platform. 

Core-plus strategies, on average, target net returns of 8 percent to 10 percent versus 7 percent or 8 percent for core and 15 percent to 18 percent for opportunistic investments. Management fees can vary widely but, broadly speaking, managers typically earn fees of 100 basis points or less on core and 1.5 percent on opportunistic investments, with core-plus
averaging about 1.25 percent.

The key challenge for Blackstone, however, is entering the core real estate market at a time when both interest and cap rates are at historic lows, since rising rates potentially could slash property values in the absence of significant rental growth. Gray asserts that the core market still has a favorable supply-demand landscape, given the lack of new supply that has come to market over the last few years. However, he acknowledges that the days of deep distress, when investments could generate excess returns, are over. 

“It is a more competitive environment for stabilized assets,” Gray says. “I still think you can generate decent returns in core, but I think your expectations have to be moderated versus what might have been a couple of years ago.” 

Late to the party 

Of course, not everyone agrees that core real estate is a good bet. One sizeable limited partner, for example, is planning to pull out of all of its core fund investments, given its view that core real estate will be vulnerable to rising interest rates going forward. And PERE understands that there even has been some internal debate within Blackstone over whether its entry into core is a wise move in light of anticipated interest rate increases.

Still, what opportunistic-cum-core managers often have stressed is a focus on core-plus rather than core real estate. “In our opportunistic business, we have a ‘buy it, fix it, sell it’ mandate,” says McCarthy.  “Given our expertise on the ‘fix it’ side, we’re hearing from our investors that they’d like to see things that have a little more ‘fix it’ and not just that 98 percent leased trophy office building.” For example, the additional capital that Blackstone is planning to invest in Edens will go towards the acquisition and renovation of properties. 

“Core-plus is a different animal because you have some ability to influence cash flow at the asset level,” said one traditionally opportunistic manager that now is pursuing a core-plus strategy. “With core assets, the cash flow is pretty locked. Pure core, because of where interest rates and cap rates are, is not particularly compelling right now.”

Gray notes that Blackstone’s biggest advantage as a newcomer to core will come from both the size of the deals that it pursues and its access to deal flow that may not be available to others. The Edens deal, for example, was brought to Blackstone’s attention by the State of Michigan, a long-time investor, while the impending West Coast office deal also emerged from another long-term relationship.

“When you’re the largest buyer, seller and borrower in the world, it’s a real competitive advantage,” Gray says. “We feel it’s one that can extend beyond the shores of opportunistic real estate investing.”