True value

Private equity real estate funds value their holdings in a number of different ways. But does it matter in a bull market? By Aaron Lovell

While valuing private transactions has always been a bit tricky—just look at the ongoing debate over fair-value accounting in the private equity sector— figuring out how much real estate is worth has usually been a relatively easy activity.

For example, as one market watcher put it, a partially occupied, class-A office building in suburban Cincinnati can be easily compared to a similar asset or—in some cases—even a neighboring property. But put that office building in one of the emerging markets of Eastern Europe or invest in a former-shoe-factory-turned-condominium-complex in an up-and-coming city neighborhood and valuation can get a bit more complicated.

While there are market precedents for investments in different geographies and with varying redevelopment profiles, the office building in Cincinnati is surely a much easier asset to value than a project on the Dalmatian Coast of Croatia or the Bushwick section of Brooklyn.

“You have an asset class that is a private market investment activity, so there is no public way to value it,” say Stephen Hansen, a portfolio manager at ING Clarion Partners. “The basic method is that netasset value is decided by an appraisal opinion rather than what two people would agree to trade it at.”

Valuation first became an issue in the early days of the private equity real estate fund industry when GPs primarily bought packages of non-performing loans backed by real estate—a difficult asset to value in any market, but particularly one with relatively little liquidity. Between 1990 and 1994, the appraisal issue became increasingly important, as LPs wanted to know the current value of the buildings they were investing in, particularly given the recent correction in the property markets. Today, however, as firms buy operating companies with significant real estate assets or other properties that are much harder to value regularly, the issue has become of even greater importance. Rather than simply appraisals, investors often have to rely on the judgment of their GPs.

“Traditionally, you have been relying on a value estimate by the manager,” says Ron Donohue, director of research at Florida-based real estate group Hoyt Advisory Services. “It's not like [an investor] who can look at a stock and see what it's trading at.”

Murray Greenville, the chief executive officer for New York-based Sterling Valuation Group, an independent valuation firm that works with a number of hedge funds, says his company starts its valuation process by working with a law firm to look at the investment documents, particularly the partnership and ownership structures. The next step is talking to real estate professionals to come to a valuation of their client's investment position in the asset.

Yet the methods for valuing a fund's assets are as varied as the spectrum of private equity real estate fund strategies. While the terms for reporting asset value are set out in the terms and conditions of each individual fund, core fund managers oftentimes offer quarterly, independent appraisals, while opportunity funds often offer less regular periodic assessments—from once a year to once every few years—if any.

John Baczewski, head of Boxford, Massachusetts-based consulting group Baczewski Associates, says many institutional real estate investors are looking for an independent valuation at least once every 36 months. He adds that, because many core funds are open-ended and have investors entering and exiting at all times, they need more frequent appraisals.

For example, ING's Clarion Lion Properties Fund vehicle is an open-ended core fund that has a third-party appraiser value each asset every 90 days. But this sort of comprehensive analysis is usually only employed by vehicles investing in stable, income-generating properties.

In some funds, a yearly third-party appraisal is buttressed by more regular in-house valuations. Sometimes, particularly with funds further out on the risk spectrum, there can be even less valuation. Often, the value of a particular investment doesn't change until the asset is sold. “[Investors] may have no expectations,” Hansen says. “The fund may hold [the property] at cost until it is liquidated.”

In the case of some separate account funds, he notes, the institutional investor will even hire a third-party appraiser and then inform the fund of its findings. “Underwriting and due diligence are really the key,” Donohue says. “You are bringing someone in to review your due diligence, not do your due diligence.”

Donohue adds that independent appraisals are not uncommon in riskier investments as well, where it could prove equally valuable. “We all know how it ends up when you find [there's a problem] out at the end,” he says.

Market watchers are quick to point out that LPs trust their fund managers with millions of dollars; part of that trust encompasses how those managers value the real estate being bought and sold. “There have been tens of billions of dollars of capital that have been pooled into vehicles with little or no appraisals,” says Hansen.

Assessing the value of real estate can be a relatively straight-forward process. Taking into consideration market conditions and the value of similar properties—and poring over property management reports—fund managers or appraisers can assign a value to a property relatively close to how it would trade on the open market.

“It's not like [an investor] who can look at a stock and see what it's trading at.”

But all sorts of complications can arise when that property is held by a fund—partnership interests and operating businesses can affect the way a building or portfolio is valued. For example, if an opportunity fund shares ownership of a property with a local operating partner, the market value of the share could be debated. “How do we value an interest in a piece of real estate?” asks Hansen. “Is it really 50 percent of what you could get for it on the open market or is that encumbered by the partnership interest?”

Additionally, as more and more players invest in larger transactions with operating business components—witness the myriad deals done in the hotel sector over the past 12 months—valuing these partnership stakes will no doubt become increasingly complex— and increasingly important. The valuation process in these deals not only needs to appraise the actual real estate involved, it also needs to require a private equity-like appraisal of the operating business sitting on top of it.

Andrew Wood, the chief operating officer of Macquarie Global Property Advisors, points out that much of the difficulty comes down to analyzing the goodwill value of the acquired business. If a fund has paid a premium because of a company's growth potential, it is sometimes hard to incorporate that growth into a realistic valuation.

“How do I report that in a standard manner?” he asks. “It is very difficult because general accounting standards don't allow you to recognize that.”

Nevertheless, Baczewski notes that while operating businesses or nonmainstream sectors can make valuation more difficult, the preponderance of these deals itself helps with the valuation process. “There are enough hotel investors and enough trading, so that makes valuation easier,” he says.

Greenville adds that information is important for the valuation of any real estate asset, particularly operating properties like hotel and senior living investments. “With those valuations, there are a lot of industry measures we look at,” he says. For hotel transactions, for example, his firm looks at comparable transactions, as well as lodging statistics like revenue per available room.

In the current investment environment, there seems to be a relatively limited discussion regarding portfolio valuation, perhaps due to the overall buoyancy of real estate values. When the asset class is awash with capital and properties are fetching evermore attractive prices, there is little reason to complain or nit-pick about valuation.

But, as Hansen points out, fund managers can be overly optimistic when the market is in a downswing. “When the tide goes out, then you have issues where managers are reluctant to write down values,” he says. “Then it gets interesting.”

Still, Greenville says that many funds take a conservative approach to valuing their assets. When the asset is performing in line with the expected results, the IRR is accreted accordingly. “If the investment is doing better than expected, they would continue to value it in line with initial IRR,” he says. If it is doing worse than predicted, he adds, it would be valued accordingly.

Donohue concurs: “You really want to make sure you value things at a reasonable level.”

In the end, he says, investors are most concerned that fund managers are looking at two factors. They want to make sure that GPs are keeping track of the value of the individual properties in a fund portfolio, as well as keeping a sense of the broader market.

As long as the fund is monitoring those two things—and the market moves the right way—there will probably be few problems.

“Why would anyone be complaining about valuations when values have been trending upwards for a number of years?” asks Baczewski.