It is widely accepted there currently is a wall of institutional capital chasing private real estate investments. For investment managers accessing that capital, that oftentimes means compliance with one of a small handful of powerful consultants, particularly when it comes to luring American dollars into the less securely regulated markets of Asia. Over the summer, PERE caught up with one such gatekeeper, Johnny Adji, hard assets consultant at Cambridge Associates Asia, to hear how the firm approaches private real estate investing and what managers must know if they are to obtain its firm’s approval.
PERE: Could you explain Cambridge’s approach to private real estate investing in Asia on behalf of its clients?
Adji: After the global financial crisis, the consensus at Cambridge was that economic growth would be slow in the US and Europe. Asia was primarily export-driven and the region’s two biggest customers had just tightened their belts and stopped buying. Given that backdrop, and projecting that against the underlying fundamental growth drivers of real estate – rent or capital gains, minimal expenses and leverage and, of course, cap rate compression – if global growth is weaker, and in a low interest rate environment, where does rent growth and cap rate compression come from? With that question in mind, our investment thesis for Asian real estate from 2010-onwards was to favor strategies less dependent on rental growth and leverage. We preferred investments that are shorter duration in nature. A seven-year hold is still fine, but it has to be at a higher yield so my clients get their equity back quicker.
PERE: So what does that imply in terms of returns?
Adji: The traditional return from opportunistic funds in Asia is 2x equity and 20 percent IRR. We could live with 18 percent or 19 percent. But I want to be senior in the capital stack. I’m willing to accept a shorter tenure, say 3 years at an 18 percent IRR. The multiple would be 1.6x or 1.7x, but 2x today means more elements in the equation – invariably a longer holding period, cap rate compression or underlying growth or reliance on capital markets. Why entertain such uncertainty?
PERE: That doesn’t leave many types of real estate investment. So, specifically, what are you favoring right now?
Adji: That’s true. One thing we do currently favor is debt for control investments. You buy the debt to control the real estate at, say, 15 percent to 20 percent cheaper than your competitor because you buy both quality and junk assets together. Japan has offered that, particularly since the Fukushima incident.
But in terms of the capital stack, if you get paid a comparable return to equity by investing in the debt you, receive cash in the form of the coupon and that is coming from the real estate’s underlying cash flow. Returns can be in the mid-to-high teens, in cash. For another few basis points, is it really worth being the equity? That is a fundamental question we ask. Here the equity multiple suffers, but does that matter if the manager can reinvest the principal?
We favor logistics property too. The levers: growth in Asian middle income will remain a constant theme. Income equals consumption and that equals retail. But if you look at some of the retail yields around Asia, they are low so it takes longer to recoup your investment. So to play the consumption story in a smarter way the answer is logistics. Unlike competitive retailers, logistics doesn’t require much money to maintain.
PERE: What do you look for when conducting due diligence on an investment manager?
Adji: Our firm focuses a lot on alignment of interest and we look at it in different ways. In terms of capital from principals, for example, a 2 percent co-investment is the norm. We might consider that sufficient but we might instead ask what percentage of your net worth are you contributing? We also take into account the relativity of the number. If 2 percent co-investment is $5 million and your net worth is $1 billion we might question the alignment.
Then there is valuation methodology. Of course we believe it to be best practice to value through independent third parties. And the more frequent the better. But we also ask how you appoint your valuer and what is the basis of their valuation? Is the valuer local or flown in? is the valuation conclusion based on market comparables, discounted cashflow or replacement costs? Does the valuer rely on one method, two or all these methods?
And we look at a GP’s P&L. Has the management fee become a profit center? We want them motivated to pursue carried interest. We look at the fund set-up cost and other line item numbers as well and where they are charged. Is it charged to the fund? Our preference is not for an open-ended cost based on a fixed percentage of total capital raised but for a fixed set-up cost.
PERE: What is the most important thing you look for?
Adji: Most important of all is that the manager does what he says he will do. Discipline in executing strategy consistently is top of the agenda.
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