Real Estate Finance: The search for value

IFR Real Estate Finance 2007
10 min read

The expansion of private equity funds into property has become a worldwide phenomenon, thanks to factors such as growing competition in traditional buyouts and the rising values in many real estate markets. There are some concerns that the weight of money could affect future returns, but funds with a hands-on approach to adding value remain confident. Patrick McCurry reports.

When private equity was developing as an asset class, funds generally steered clear of investing in real estate. It was seen as a more difficult asset than industrial companies to mould and transform, and one that would not bring returns as high as those available in other sectors.

But in recent years the trend began in Europe to separate the property assets from the operating business in sectors such as healthcare and retail. This coincided with the long boom in property values.

“Separating the property assets allowed the buyout houses to release value and increase their gearing on a transaction, so private equity in general became more exposed to, and more comfortable with property,” said Andrew Roberts, a partner at law firm Travers Smith.

He points out that there have always been some firms that are hybrids, such as Bank of Scotland Integrated Finance, which have invested in property from a private equity perspective.

“More recently we’ve seen other funds such as GE specifically looking at real estate, and some of the mega funds like Carlyle setting up property funds within their private equity umbrella,” he explained.

Among the drivers for this have been the growing competition for assets in traditional private equity markets, plus the buoyancy in many global property markets.

“As the private equity deal flow began to dry up, property looked more appealing,” said Roberts. He adds, however, that historically, returns from real estate have not been as good as from industrial private equity, and that property has been regarded as safer and less exciting compared with turning around businesses.

But the fear of falling returns in business buyouts and the boom in many global property sectors have led to a surge in real estate fundraising at private equity houses. Blackstone is raising a US$10bn fund, Morgan Stanley a US$8bn fund and Lone Star is rumoured to be raising US$6bn. Funds with a global mandate are thought to have accounted for 45% of the capital raised in 2006.

The growth of private equity-style property investment in Europe is a relatively recent phenomenon, and the trend is now moving to Asia. But it was in the US that the market was born.

Unlike the UK, where traditionally investment for property was channelled through listed companies, in the US in the 1980s it was largely private investors that funded investment. After the savings and loan scandal of the 1980s, a number of US private equity funds focusing on real estate were established, and that expertise was eventually exported to Europe and the rest of the world.

Among the pioneers in Europe was London-based Europa Capital, which since 1995 has raised five real estate funds, including two pan-European funds. Europa Capital principal Charles Graham says that the funds are based on a private equity model, in that there is a major focus on the structure of deals.

“We bring in specialised management to look at a company, think strategically as to how it might be structured better, and maybe look at bits that could be spun off," he said. “We look at the capital structure and go in on a highly geared basis, similar to a traditional private equity fund.”

But equally important to the structure of deals and the use of debt and tax-efficient vehicles, is the fact that active or opportunistic funds have an angle on how to add value.

Doughty Hanson, which closed its second European real estate fund last autumn, is one of these funds. Julian Gabriel, a principal at Doughty Hanson Real Estate, distinguishes this type of active approach to some of the larger private equity/real estate funds launched by the really big houses.

“We are focusing on single-asset transactions and not the large corporate deals of €2bn or so some of these much bigger funds go for,” he said.

Gabriel argues that the approach of the larger funds is to buy in bulk and then sell down assets and to take more of an arbitrage play on the particular market they have invested in.

By contrast, opportunistic funds such as Doughty Hanson and Europa Capital are targeting a higher return and taking higher risk. Typically, they will be seeking to return around 20% on an annualised basis to investors, compared with the 14%–18% of the lower-risk funds.

“We invest in developments with rough edges, that need something doing to them to add value,” said Europa's Graham: “That could mean an old factory in Warsaw, a golf and residential complex in Greece, or a retail development in northern England.”

Despite the fact that there has been such a surge in fundraising for real estate funds, Gabriel says that there are still relatively few opportunistic funds genuinely seeking to apply a private equity-style approach to property.

“Competition to invest in property has increased, but the number of funds taking our approach is still relatively limited,” he said.

Davide Proverbio, a partner at law firm DLA Piper in Milan, says that the market is shifting away from portfolio acquisitions to single assets.

“In markets like Italy, in recent years a lot of portfolio deals have been done, partly triggered by large corporates divesting their property assts, but there is less scope today for those kinds of transactions,” he said.

Funds are also looking beyond the more traditional geographical boundaries. “In general, the London property market is probably at or close to its peak, so people are increasingly looking to places like eastern Europe,” said Travers Smith's Roberts, although he adds that in the UK there is still interest in house building because of a lack of starter homes.

“We may see a move away from commercial property to house building and activities that support the property industry."

A number of private equity/real estate funds are targeting eastern Europe, and particularly the Warsaw area.

“We see great opportunities for starter homes in greater Warsaw because Poland is going through a similar experience to Spain a decade ago, with people having more disposable income and not wanting to live with their families so much, but aiming to get on to the property ladder,” said Europa Capital's Graham.

He adds that the development Europa Capital is investing in will probably eventually list on the Warsaw stock exchange.

One of the questions to be answered in the future will be to what extent the global property funds can succeed. Graham notes that a number of large global funds are now active and that real estate has emerged as a global asset class. In the past, he said, you had to buy shares in a Hong Kong or an Australian property company to get exposure to different markets, but now you can buy into one of these global funds.

“But I think it’s difficult to have the necessary expertise on a global basis and to know how to invest in markets as diverse as Japan and Brazil.”

The sheer weight of capital going to real estate funds could be stoking up problems, however.

“The impact of the huge sums being raised could be problematic for pricing if it gets out of kilter with risk, but the market has a tendency to bring equilibrium,” said Graham. He adds that despite the fact that there is currently a superfluity of capital, there are still deals to be done.

“The fund we raised in 2005 is now 60% committed, and by the summer of 2007 almost all of it will be committed.”

Doughty Hanson's Gabriel says that there is so much money in real estate chasing some yield that prices are increasing and yields falling.

“Nearly everything is being auctioned, and in some cases assets are going for more than they’re really worth.”

Because of this, Doughty Hanson’s approach is to try and get below the radar, and deal directly with companies that are considering selling property assets.

But Gabriel is positive on the continued potential for real estate, particularly if private equity techniques of creating new value are applied and if assets can be acquired outside a competitive auction process.

“There is still an awful lot of real estate in Europe in the hands of companies who are not traditional real estate owners and who perhaps are not getting the best out of those assets.”

But like Europa Capital's Graham, Gabriel believes that successful property investment depends on local expertise.

“We have offices in seven European countries and having local teams means we can source deals under the radar,” he said, adding that big US funds can sometimes underestimate the fact that Europe is not a single market in the same that the US is.

“They can arrive in Europe with a few people in their team and expect to do deals but then realise it’s difficult because they lack the local knowledge."