SPECIAL REPORT: Back for another round

Even though less than half of its $33 billion of assets under management have been acquired via opportunistic strategies, Morgan Stanley Real Estate Investing (MSREI), the real estate investment management business of US investment bank Morgan Stanley, is best known for its Morgan Stanley Real Estate Fund (MSREF) global opportunity funds. 

It is not difficult to see why. The series, which has been running for more than two decades, has attracted almost $27 billion in institutional equity, including a then-record $8 billion-plus for its sixth international fund (G6) in 2007, and has been used by MSREI to take down some of the highest profile real estate investments globally. 

But so high was its profile in the marketplace leading up to the global financial crisis that the poor performance of G6 – which suffered from a number of overpriced and overleveraged deals – post-crisis meant that the reputations of both the fund series and the firm were in tatters. As investors withdrew their support, senior executives departed and regulators circled, many onlookers sounded the death knell for what had been until then one of the sector’s stalwart investment houses.

With its rival investment bank platforms having either closed down, merged with other businesses or left the opportunity fund space entirely, few would have predicted that approximately five years after holding a final closing for its G7 fund, MSREI, replete with entirely different leadership, would close on a successor fund. 

Yet that is what happened this summer. As PERE revealed, MSREI held a final closing on $1.7 billion for North Haven Real Estate Fund VIII (G8) and associated sidecar vehicles. That figure was considerably smaller than the mega-funds raised before the crisis, but for the platform’s co-chief executive officers and co-chief investment officers, Olivier de Poulpiquet and John Klopp, it nevertheless crystalized a comeback and injected belief within the approximately 200-strong business that the former heavyweight had stepped back into the ring to deliver some hefty punches.

PERE caught up with de Poulpiquet on a visit to London last month to hear the firm’s take on what this pivotal fundraising means:

 PERE: New team, new fund, new fund name even. New start?   

ODP: MSREI has been one of the largest and most global real estate investors for almost 25 years. We are stronger for all the experience we have, good and bad. So it is not a new start but a continuation, with an improved team and different philosophy of investing. That’s the way I’m looking at it.

PERE: You raised $1.7 billion for G8, but 2007’s G6 fund was once the world’s biggest opportunity fund at more than $8 billion. In light of the past, how should investors consider MSREI’s opportunistic fund series today?

ODP: Today, we are fundamentally real estate investors who have gone back to our roots. We invest globally, but every deal we have done is asset-driven as opposed to simply taking a big-picture, macro view on where to invest. And so it is a continuation of our DNA. But there has also been a philosophy change in terms of discipline, leverage, and how to create value at the asset level.

 PERE: When would you pinpoint the philosophy change as happening?   

ODP: It was progressive, including what we learned during the crisis and how we rolled up our sleeves to manage our assets post-GFC.

PERE: What would you say were the principal lessons learned from how MSREI was engaging with private real estate investing as an asset class? 

 ODP: We have learned many lessons: discipline, centralization of decision-making, focus on asset-level fundamentals and a conservative approach to leverage. Today we apply very strict rules in terms of how we deploy capital. 

Let me pick one: centralization of decision-making. When you grow beyond a certain size, the only way you can keep growing is by hiring people and decentralizing decisions. Otherwise you just can’t keep up with the growth of assets. What we have done is exactly the opposite. We have recentralized decision-making and focused on what we know we can do well. It does limit the amount of investments we can make, but it also ensures we have consistent underwriting and discipline applied on a global basis.

PERE: That is possible when you have a smaller fund. But if it were $8 billion again could you afford to be centralized?  

ODP: If we had an $8 billion fund, I don’t know if we could. Real estate is local, and either John [Klopp] or I (and most times both) see every investment we make. With G7, we committed $3.5 billion of equity over approximately four years from early 2010 through early 2014. For G8, we established a shorter investment period and we are comfortable with a smaller fund size. 

PERE: You won’t be comfortable criticizing the old regime, but is there an inference here that you inherited a platform that wasn’t doing these things?  

ODP: I don’t want to speak about the old regime. I was part of it up until 2004 so it’s hard for me to criticize. But I think many of the issues were a function of growth. What drives us today is performance, pure performance. Size is important, but not everything. 

PERE: Certain investors have told us that they like MSREI’s current performance, but require two funds’ worth of breathing room from G6 before they can commit to the opportunistic series. The inference there is that G9 could be significantly bigger than G8. Can you stick with your centralized structure if that happens?  

ODP: I believe there is a limit in terms of how much you can invest prudently per year. So we will size the fund in terms of the capabilities we have, and stick with the centralized model. The limit? Hard to say; it depends on the length of the investment period. For G8, we have a two-and-a-half year investment period. If we have a four-year period, and depending on market conditions, then the next fund could be significantly larger. The reason we put a shorter investment period on G8 was to match the current cycle which we think will be shorter.

PERE: What you are saying chimes with other fund managers who talk about wanting to deploy quickly in order to raise again and be ‘cashed-up’ before the market corrects and, the inference being, investors then reduce their commitments to managers. Is this not a dangerous time for investment managers when mistakes might be made?  

ODP: Potentially, but for opportunistic strategies we think the key is to have a flexible, global mandate coupled with a local presence. The flexibility is critical because cycles are different in different countries and regions. Right now, being ‘cashed up’ to do opportunistic investment solely in the US, for example, I think is very challenging. Pricing in the US has gone up so much that in order to get opportunistic returns you need to go very high up the risk curve. If there is a market correction and you are doing, say, leveraged development deals, that could be a recipe for disaster. In contrast, investing in selected European cities like Vienna, Milan, Rome, or Budapest today is very interesting: you find very attractive yields. Liquidity in these markets is increasing, but it’s still a fraction of what it used to be and what it is in other markets. There’s a sizeable pool of assets and few managers with history and knowledge of these markets.   

PERE: Can you walk me through a deal per region for G8 that best represents what you’re trying to do?    

ODP: Let’s start with Asia. We bought an office asset in Tokyo in August last year for a lease-up play. The seller was a manufacturing company that had built the building in 1994, then master-leased it to a local real estate company for 20 years. Fast-forward 20 years, the master lease was expiring and the property was only 75 percent occupied, the corporate owner wanted out, and they wanted a quick, quiet deal. We stepped in and bought the asset for $100 million with a plan to spend a few million more upgrading the public spaces and leasing up the vacancy. The renovations are now complete, leasing is underway and we are getting a pretty attractive cash-on-cash yield along the way because we’re financing at one percent. The investment thesis in Japan is to play the bottom of the leasing cycle while getting an attractive cash-on-cash yield and adding value through asset management.

In Europe, our Vienna asset is the best example. We bought a one-million-square-foot mixed-use asset that includes a top-ranked shopping center and an iconic office tower. Owned by a German fund whose life was expiring, we tracked this deal for 18-plus months and ultimately were able to buy it at a 7 percent going-in yield. An asset of this quality in Germany would trade at 5 percent or below and Austria is a AAA country. We believe we can increase the cash flow on both the office and retail, but in the meantime we clip the coupon and watch cap rates compress. Buying defensive cash flows with some upside, that’s typical for our deals in Europe.

In the US, the only things we can find in today’s market are pretty deep repositioning plays. For example, we invested in the redevelopment of a de-commissioned school in Manhattan for conversion to for-sale residential condos. That’s more risky than buying cash flow, but here we have an all-in basis of about $1,000 per square foot in a market where land costs have already topped that level and it is a ready-to-go project that is expected to start pre-sales within the year. So again, we think we have downside protection.

PERE: Let’s touch on performance. For G7, given the Russia-Ukraine conflict and that you have bought two large malls in the country, what has happened to the fund’s performance?   

ODP: I can’t talk about specific returns, but we’re exceeding our gross and net targets for G7 taking into account our interests in the malls. And the fund is in active monetization mode, with about $3.2 billion returned to investors, so a substantial portion of those returns are now realized.

PERE: How much equity from G7 was deployed into those malls?   

ODP: We originally invested $550 million of G7 money into those assets –$150 million of the equity has already been distributed back from cash flow so our basis now is $400 million. It’s hard to see a tougher downturn in Russia than this one, but the center’s ruble sales are on average up about 5 percent. The real issue is our rents are in dollars. If our tenants’ sales are up 5 percent in rubles, their revenue in dollar terms is down basically 30 percent. As a result, we have granted temporary rent discounts to many of our tenants. We bought the assets at about 9 percent, but renegotiated hundreds of leases and increased net operating income (NOI) to almost 11 percent. It was incredible. Then the conflict happened and the market turned, but NOI is still above where we got in. If, and when, the ruble normalizes and the discounts expire, we think we will go back to 11 percent. If not, it’s not the end of the world to have two of the best shopping malls in Russia producing a 9 percent yield in a down market.

PERE: Okay, with that in mind, what proportion of G8 investors are repeat investors from G7 and what does that tell us? 

ODP: I’m proud to say that the majority of G8 investors are new to our platform. This, to us, underscores the confidence they have in what our team has accomplished since 2010 across G7 and the overall platform. Many investors in G7 are also investors in G6. Perhaps these guys originally thought they’d leave us, but I think now many are considering G9 as a possibility. New or old, we have consistently stayed in front of our investors to inform them of our progress and update them on how we are creating value. 

PERE: That sounds like a new start to me.  

ODP: It is a new start but we’ve not forgotten who we are and where we’ve come from. Some of our experience was learned the hard way.

Waylaying the naysayers 

Though MSREI’s fan base is undeniably growing once again, its fundraising this summer did little to silence its critics. PERE picked five of the more common slurs made against the platform and fired them at de Poulpiquet for a response

1) Your current strategy is a case of swapping property risk with currency, liquidity and political risk when you deploy meaningful capital in markets like Russia or Hungary.  

ODP: First of all, those types of markets make up a relatively small percentage of each fund. And second, we’re basing these investments on cash flow. Yes we’re taking additional risks because of the markets, but we price that in. What is more risky – investing in an emerging market but with very long-dated and stable cash flow, or investing in a more established country where you take on speculative development risk? It’s always a subjective argument, but we’ll discover who is right at the end of the fund. Look at Russia: we have 10-year financing, the assets are fully-let with strong NOI and cash-on-cash yields. Today, if we wanted to sell the assets, we’d make a profit, but not the profit we’re expecting. We’re taking a liquidity risk but the ability to stay long is very important.

2) You lost too many key senior executives to run a global platform as effectively as you once could and a number of your partners now need to acquaint themselves with new people.   

ODP: That I strongly disagree with. The point about strategy risk is subject to argument. Here there is no argument. We’ve scaled our resources to our current business and today we are just over 200 people so still one of the largest platforms in the business. We have 20-odd senior partners who have been at the firm for a very long time. The average tenure for the managing and executive directors in the real estate investing team is about 12 years, with some who have been here for 25 years. Even the new leadership team has been together for five years.

In addition, we have developed a number of shared functions – capital markets, risk, hedging, finance – that cut across our Merchant Banking & Real Estate Investing platforms. These free up all the investing teams (private equity, real assets and credit) to spend more time investing our clients’ capital.

3) MSREI will never be able to demonstrate effective alignment of interest as the staff are not invested enough.  

ODP: Those who say that simply don’t know the new platform. The senior staff working on G8 have significant personal investments in the fund as limited partners. It is real cash, our cash. Not future earnings. We chose to do this because we really believe in what we’re doing. If things were to go south, then it really would hurt. 

People remember the old regime, with a deal-by-deal promote structure. Starting with G7, we changed to a fully-crossed promote so we need to perform across the board, and our team is aligned with our investors. We wouldn’t have been able to raise a dime for G8 without ensuring a strong alignment of interest. 

4) Blackstone aside, the global opportunity fund model is less relevant to institutional investors which want to bypass allocators and forge their own series of JVs. 

ODP: For some investors that has merit, for others it doesn’t. We believe in our model. The primary advantage of a global fund is it gives us the ability to look across all the markets and choose where we think the best risk-adjusted opportunities are at any point in time. But you need a global platform to execute that strategy – and we have it.

5) MSREI needs to stop comparing itself with Blackstone. That comparison ended at the GFC.  

ODP: We stopped doing that a long time ago. Blackstone has done fabulously well and deserves all the credit they have gotten. But we’re not trying to be the biggest, just one of the best and we’re going to do it our way – the old fashioned way – focusing on performance, consistency and excellent service to our clients.