Private equity real estate firms add value—and earn their carry—by transforming property assets. PERE looks at three real-world examples. By Paul Fruchbom

CASES IN POINTSelected case studies in asset transformation

Canyon-Johnson State Place Chicago $96
Morgan Stanley Ebisu Prime Square Tokyo $400
Terra Firma Annington Homes England, Wales £1,700

Sometimes, the best way to transform an asset is simply to demolish it.

“We underwrite the real estate, but we also underwrite the community.”

“Oftentimes, it's more expensive and risky to retrofit an existing building than it is to tear it down,” says Bobby Turner, managing partner of Los Angeles-based private equity real estate firm Canyon-Johnson, which specializes in urban infill.“You never know structurally what's behind the walls.”

What was behind the walls of 1121 State Street in the South Loop district of Chicago was, presumably, not pretty. For seventy years, the Chicago Police Department maintained its headquarters there, a 13-story building populated by the cops, robbers and other denizens of this once disreputable neighborhood. Though the building had an interesting history—the death mask of infamous bank robber John Dillinger was long stored on the fifth floor—it was equally well known for its filth: sewage leaks, rats and roach infestations were common.

“You can size it up: it's a dump,” said Lille Yarber, a building employee, in a Chicago Tribune article ten years ago. “This place needs to come down.”

Thanks to a consortium of real estate investors, come down it did. In 1998, the police department moved to nicer surroundings and in September 2000, the city of Chicago issued an RFP for the vacant site. Local developers Mesirow-Stein and Northern Realty were awarded the project in November of that year; Canyon-Johnson came in later as an equity partner. The purchase price for the site was $6.2 million.

The plan put in place called for the demolition of the existing building, at an additional cost of $2 million, and the construction of a $96 million mixed-use project. The new development, christened State Place, consisted of four condominium towers with a total of 260 units, more than 60,000 square feet of ground-floor retail and an enclosed parking structure with approximately 400 spaces.

Though tearing down a dilapidated building and replacing it with a new one might seem like a simple task, Turner points out that urban infill projects are complicated, particularly given potential conflicts between the developers and the local community.

“Two words define urban revitalization: arrogance and distrust,” Turner says. “Arrogance on the behalf of developers and distrust on the behalf of the community.”

Turner credits Mesirow-Stein, for one, with helping to address both issues. Not only did the local developer come to the table “with no ego whatsoever,” the firm also had significant experience in the Chicago affordable housing market and a proven track record of involving the community in the decision-making process.

In this particular instance, the community's involvement extended to more than just attending city-council meetings—Turner points out that at least 25 percent of the project's contractors were local businesses owned by women or minorities. In addition, a $10,000 rebate on the condominiums was offered to local teachers, Chicago fire department employees and, of course, city police officers. In fact, some of the very first condominiums sold were to local cops, eager, perhaps, to excise the memory of their old stomping grounds.

“What was important was to make this an inclusive process rather than an exclusive one,” says Turner.“We view it as a joint venture with the community and it's important for us to spend time with them to see how they would like this repositioned.”

According to Turner, that meant listening to the local population's demands for transit-oriented, affordable, market-rate housing alongside “community-serving retail.” Condos at State Place start at a reasonable $220,000; the building is next to a subway line and an L train stop; and a pharmacy, Walgreen's, is the anchor tenant.

“We underwrite the real estate, but we also underwrite the community,” says Turner. “And we're only going to work with progrowth governments. If they don't want growth, hey, we're not going to build it. Otherwise, I have no faith that a community will patronize the area and respect it.”

Respect for the South Loop was not always such a given. For many years, the area was a symbol of urban blight: overpopulated, dirty and dangerous—the presence of police headquarters did little to deter nearby crime. Today, however, the city has embarked on an ambitious redevelopment plan that is extending to the South Loop and includes the addition of parks, museums and the recent renovation of historic Soldiers Field, home to the NFL's Chicago Bears and only a few blocks away from State Place. Even today, Canyon-Johnson had to take steps to ensure that their development had state of the art security measures and no ground floor entry to the condominium towers.

“Chicago is Chicago,” Turner says. “There are crime, and challenges in every neighborhood, but this is a neighborhood that hadn't experienced a project of this quality before. Our job is to make money, but it's also to raise the bar for the community. We call it a double bottom line.”

Thus far, that bottom line looks pretty healthy. Turner says that only ten condominiums remain and the retail space, which is 85 percent leased, is under contract to be sold. “We exceeded our equity multiple and rate of return forecast,” he says.

No doubt Canyon-Johnson is looking to replicate that feat with another historic building in another historic area of the country. Last year, the firm purchased the Williamsburg Savings Bank building, the tallest building in Brooklyn, with plans to convert the offices into apartments. Transforming that asset, however, will be a bit different. Given the tower's landmark status, tearing the property down is not an option.

If demolition is one end of the property transformation spectrum, then the other is doing nothing at all—at least, not physically. Many private equity real estate firms, in fact, often take this tack, making relatively minor changes to a building's physical attributes; instead, they concentrate most of their energies on increasing the building's cash flow by boosting occupancy levels, renegotiating rents and cutting operating expenses. It sounds simple and, in most Western countries, it can be—such strategies constitute the basic blocking and tackling of real estate. But tactics that are commonplace in, say, the hardscrabble city of Chicago, become much more difficult to implement in a city such as Tokyo.

“In the Western approach to management, these are things that we do all the time,” says Rei Umekubo, a Tokyo-based executive director with Morgan Stanley, referring to the aforementioned strategies. “But when you come to a place like Japan, it's very strictly governed in terms of how things operate, whether socially or in business—it's very difficult to confront or negotiate with employees.”

In 2001, Morgan Stanley found out just how difficult when it acquired Ebisu Prime Square, a major mixed-use complex in central Tokyo consisting of a 22-story office tower, a 62-unit residential building and 75,000 square feet of retail space. The seller, Chiyoda Life, a distressed life insurance company, was in the process of divesting all their real estate holdings; according to Umekubo, Ebisu Prime Square “was their jewel.” At a purchase price of approximately $400 million, it was also one of the largest single-asset transactions of that time period.

“It is still very rare for the market to sell a major class-A office building,” Umekubo says. “And at that time, it was unheard of.”

Even more unheard of in Japan was the business plan that Morgan Stanley put in place after acquiring the property. Though the building was in good, physical shape and had strong occupancy levels across most of the complex, there were certain problems hindering the building's performance: several retail tenants were not paying rent, a master lease on the property had office rents 20 percent below market and the building's corporate ownership had contributed to a bloated cost structure.

To address these issues, Morgan Stanley quickly evicted the delinquent tenants and replaced them with stronger retailers and restaurants, bought out the master lease in order to raise rents, opened up the building's maintenance contract to outside bidders and negotiated with the utility company to reduce its heating and electric bills.

Sounds simple, right? Well, according to Umekubo, none of it was straightforward. Because there had been so few large, hard assets purchased by foreign investors at that time, the Tokyo real estate market was relatively unfamiliar with these Western styles of property management.

For example, Umekubo notes that the owner of the master lease was one of the largest leasing companies in the city, with contracts all over Tokyo, yet no other landlord had ever approached him to discuss buying his interest out and replacing it with a property management contract—it took Umekubo's personal relationship with the president of the company and several months of negotiating and hand-holding, including walking the master tenant through all of the numbers, before a deal was reached.

Negotiating with the existing maintenance company, however, was even more difficult. Japanese companies, Umekubo explains, are often part of larger entities that share services across the group; in this situation, the building's maintenance was performed by a company within the same corporate group as Chiyoda.

“The [building operations company] was shocked that we would come to them and tell them ‘You will have to re-bid alongside four other building companies,’” Umekubo says. “Their response was ‘We don't do that.’”

Eventually, of course, they relented, but Umekubo stresses that this conversation required a delicate touch and many months of explanation. Nonetheless, it allowed Morgan Stanley to reduce its operating costs by 30 percent.

Other changes implemented by Morgan Stanley had less to do with confronting different business cultures than with simple common sense. Of the building's 200 parking spaces, the building received no rental income from approximately 15 spots because they were reserved for certain employees. “And these people didn't even have cars!” Umekubo says. “They took the subway.”

In another instance, Morgan Stanley redesigned the lobby—perhaps the biggest physical change made to the building—and brought in retailers such as Mailboxes, etc; Segafreddo, a European coffee shop; and a bank with an ATM. Not only did this generate rental income where none had been before, the stores also provided services to the building's tenants.

“Many of these large, class-A buildings have vast lobbies that they make no use of,” Umekubo says.

He adds that Japanese landlords typically don't do many of the little things necessary to maintain or promote their buildings. For example, although Ebisu Prime Square was only four-years-old, the exterior was dirty and there was no signage on the building, issues that Morgan Stanley moved to redress.

Another atypical move that the investment bank made: holding bi-annual parties for the building's tenants. “The courtyard has a beautiful space with trees,” Umekubo says. “In the summer, we would have the Japanese equivalent of a barbeque and in the winter, a small carnival.”

Last year, Morgan Stanley held a small party of its own. With rents 15 to 20 percent higher relative to 2001 and the building fully stabilized, the firm sold Ebisu Prime Square to insurance giant AIG for $650 million, reaping significant profits in the process.

In the two case studies above, the transformation of the asset was the most critical part of each firm's investment strategy. Of course, the ebbs and flows of the underlying market are always a consideration: a rising tide can bail out a poor investment plan and a falling market can sink even a sound business strategy. But for the most part, many real estate professionals believe that the true value-add comes in how effective a firm is in transforming and developing the property that they have acquired.

Guy Hands, founder of London-based private equity firm Terra Firma, takes a different view. “Our belief, which is not shared by the world, is that most development of property adds very little value,” he says. “Your real increase in value comes from what is going on in the market.”

And what is going on in the market, in Hands' view, is that the world is getting richer. And, as it does, society as a whole—and Western Europe in particular—is moving towards a “propertyowning democracy,” in which the desire to own one's home is increasingly becoming stronger.

Putting those two ideas together led Hands to the largest private equity real estate transaction in history: last year's €7 billion acquisition of the German housing portfolio Viterra. It also led, ten years earlier, to one of the most profitable: Annington Homes, the £1.7 billion purchase of residential housing units from the UK armed forces.

In 1996, the UK Ministry of Defense ran an auction to sell approximately 57,000 homes located throughout England and Wales. Under the proposed terms of the sale, the government would rent back the houses from the winning bidder, while also releasing a certain number of units each year for sale, re-lease or redevelopment. Although the process drew interest from 19 parties, including the Dutch financial services firm ING, the UK property company BritishLand and a group led by developer and Conservative Party fundraiser John Beckwith, it was Nomura's principal finance group, the private equity arm of the Japanese bank, at the time run by Hands, which emerged as the winning bidder. When the deal was announced, it was the largest single transfer of residential property in UK history.

Unlike the other bidders, whose plans called for knocking the houses down and developing nicer ones in their stead, Hand's philosophy, as delineated above, was much simpler: put as little investment into the houses as possible.

To that end, Nomura engaged in an ambitious yet modest renovation program, spending approximately £16,000 per house on small improvements such as putting in street lamps and new lighting, installing grass planters and changing the façades of each unit the theory being that there was a captive market of young, first-time buyers who, if offered a house at an attractive price, would be willing to put in their own time and money to upgrade the home's interiors. In an attempt to further increase the attractiveness of the community, the developers added curves and kinks into what had been long, straight and foreboding roads.

“The good point: they were very well built and quite large by UK standards,” Hands says. “The bad point: they were very uniform and built more for tanks to drive up and down the road rather than children. They didn't have any soul or community spirit.”

Once the firm was able to improve the physical look of the street scene, Hands' team embarked on a unique sales strategy— something he referred to as “the big bang sale.” Rather than running a traditional sales process utilizing a model home, Annington arranged for there to be a set day when all the renovated houses in a given neighborhood would go on the market. To encourage an efficient sales process, the company also provided buyers with full surveys, a mortgage and a price point that was five to ten percent below the market. It was a discount that Annington was able to support because of its minimal handling costs—and an opportunity that prospective buyers were eager to take advantage of.

“Because we had a set day that all the houses went on sale, people could choose which house in the neighborhood they wanted,” says Hands. “And so, people started to queue. And they have continued to queue for nine years.”

The fact that some buyers would wait in line for weeks, pitching tents and camping out in their cars, generated a significant amount of local publicity; Hands says that most of the developments sell out within seven or eight days. Grabbing even more headlines have been the returns that Annington Homes has generated: following the sale of more than 12,500 homes and two asset securitizations, Nomura's initial equity investment of £226 million has turned into a profit of approximately £1.6 billion, perhaps one of the most lucrative private equity real estate deals of all time.

“Our belief, which is not shared by the world, is that most development of property adds very little value.”

And given that the Ministry of Defense continues to release homes, there may be more riches yet to come. Such a sum of money, however, is sure to generate publicity of a different sort. In fact, Hands says that the most challenging aspect of the transaction wasn't the actual execution, but rather weathering the storm of controversy surrounding the deal, something which began as soon as the winning bid was announced.

“The most difficult part,” Hands says, “was the initial reaction of the press to the concept of a non-local buyer taking over what they saw as the soul of their society. In the UK press, you can imagine, a Japanese bank buying military housing didn't go down very well.”

That would be an understatement. Arthur Titherington, secretary of the Japanese Labour Camp Survivors Association, noted that “The Japanese are doing with money what they failed to do with arms.” Members of Parliament denounced the sale of the military bases as “Tory fat cats lining their pockets.” And Bruce George, the Labour chairman of the House of Commons Defense Committee, described the transaction as “insensitive, stupid and financially and politically motivated.”

Even ignoring the backlash from government ministers and UK newspapers, the acquisition of Annington raised eyebrows in the financial community as well. Industry practitioners in both the real estate and private equity industries openly questioned what Hands was going to do with such beaten-down properties. (Similar questions dogged Hands following his acquisition of both Deutsche Annington in 2000 and last year's Viterra transaction.)

Ten years and many dollars later, it seems those questions have been answered—once desolate communities have been become thriving neighborhoods and a relatively simple idea has become billions of dollars of profits.

And that, at the end of the day, is the most important transformation of all.