EUROPEAN ROUNDTABLE: Intellectual honesty amid economic woes

With approximately £100 billion of UK real estate that cannot be refinanced under current conditions, there are plenty of opportunities for the country’s private equity real estate players. However, as the roundtable participants reveal, the UK market isn’t as simple as that. PERE Magazine, June 2012 issue.

PERE’s roundtable series is intended to provide a platform for firms participating in the private equity real estate space to showcase and explore their market strategies and experiences for the benefit of a global audience. A conference panel held behind closed doors would be an appropriate analogy.

Therefore, it comes as something of a surprise that Stuart Jenkin, director of fund management at London fund manager Frogmore; Julian Stocks, managing director and head of the UK at developer-cum-fund manager Tishman Speyer; Michael Zerda, director of special situations and debt investments at LaSalle Investment Management; and Matt Maltz, real estate partner at global advisory titan Ernst & Young, spend an unusual amount of time at this year’s roundtable asking questions.

Undeniably, the fact that there’s a mix of sector professionals – a private equity fund manager, a banker-turned-debt specialist, an agent-turned-fund manager/developer and a tax specialist –sitting around the table is playing its part. However, as the nearly two-hour session in the private dining room atop the world-famous Gherkin at 30 St Mary Axe in the City of London progresses, it becomes apparent that each man wants to get as much from the occasion as they give. 

That is not to say the original roundtable thesis is marginalised – far from it. In answering one another’s queries, the table is benefitting. “Is equity the new debt?”, “Does buying core actually mean less risk?”, “Will deal-flow from the partly-nationalised UK banks increase?” and “Will double-taxation stop foreign capital from entering the UK?” are some of the broader questions posed. “Are you doing due diligence on other lenders?”, “What’s your LTV target?”, “Are you more of a venture capital firm than a private equity firm?” and “Are you building much in London?” are some of the more direct ones.

Like pieces of a jigsaw puzzle, the answers from the four roundtable participants help to paint a picture of how the UK market is looking for private equity real estate these days. And, like the panorama about us, that picture requires snapshots from the four vantage points present to be fully appreciated.

Make no bones about it: the UK real estate market currently is facing multiple headwinds. Years from the start of the credit crunch, institutional investors eyeing the country are still reluctant to take much risk, the gap between prime and secondary property markets appears more like a gulf, credit from traditional lenders is scarce and the occupational outlook is harder than ever to forecast. 

Unsurprisingly, the UK economy isn’t helping matters. Flat gross domestic product growth has been succeeded by two consecutives quarters of negative growth. Indeed, recession is back, just as the Eurozone crisis flairs up once again. The roundtable participants appreciate the need for intellectual honesty if they are going to enhance their businesses against such a backdrop. Asking more questions is a by-product of the times.

Glass half-full

“You asked me what keeps me awake at night?” posits Jenkin. “I wouldn’t say there’s anything that gives me concern, but I do get excited by the opportunity. There is so much distressed real estate that needs to be tackled, turned around and made fit for purpose, and that is very exciting. Perhaps not for those who own it, but certainly for those looking at it.” 

Frogmore is coming to the end of the investment period of its second opportunity fund, Frogmore Real Estate Partners II. The firm’s long-serving funds man – 38 years in the industry and counting – will soon find himself in front of LPs, making the case for the UK once again, and no doubt that message will be in his opening gambit. 

According to the roundtable participants, approximately £31 billion of real estate changed hands in the UK in 2011. Still, when you consider that approximately £200 billion of debt is outstanding on these shores and that about £100 billion of that cannot be refinanced under current conditions, it becomes abundantly clear there remains plenty of scope for the firms participating in this roundtable to entangle themselves in deal-flow, whether in equity situations, debt situations or both.

“We’re coming across a lot of opportunities presented by people who cannot borrow,” Jenkin says, presenting a hypothetical company whose original investment thesis – for whatever reasons – doesn’t work today and further money is needed to move it on. “Traditionally, they rang the bank, but now they are told ‘no’ and so we are receiving the phone calls.” 

The issue for property investors is that many of Europe’s banks, which account for the vast majority of existing debt in the UK, have either retrenched or departed altogether. Property services firm DTZ’s well-respected Money into Property report says private debt in real estate declined 3 percent in 2011 after declining 5 percent in 2010. Naturally, this receding debt availability is provoking other types of money providers to look to bridge the gap – often at an opportunistic profit – and that concept is not lost on the roundtable participants.

“Are you becoming more of a venture capital firm than a private equity firm then?” asks Tishman’s Stocks. “I wouldn’t call it venture capitalism,” Jenkin responds, “but we have equity that can make things happen.” Selling stakes to groups like Frogmore is one option. Furthermore, he notes that Frogmore’s banking relationships are robust and, as such, supplementary debt can be arranged through the firm as well.

Debt de jour

LaSalle’s Zerda has something different to offer. Through the firm’s special situations platform, the former vice president at Merrill Lynch’s Global Principal Investments can offer two types of bridge financing: core mezzanine and value-added mezzanine. The core mezzanine costs borrowers between 8 percent and 12 percent and is secured against “high-quality, income-producing real estate,” while the value-added mezzanine costs between 12 percent and 15 percent and is for situations when LaSalle must undertake more residual risk. He likens the latter to “pseudo-equity,” which slots into the capital stack of an investment somewhere around the 80 percent mark. “We also can lend against select secondary assets with this,” Zerda says nodding to Jenkin’s hypothetical situation. 

Mezzanine finance, however, is not something Tishman Speyer or Frogmore currently entertain. “What’s your loan-to-value target?” asks Zerda of Stocks. “Between 40 percent and 50 percent,” the former Jones Lang LaSalle agent replies. “We have not needed mezzanine financing recently because our funds mostly don’t gear that heavily,” he points out. That is hardly surprising given Tishman Speyer’s current UK portfolio consists of a handful of office assets in central London. 

“We haven’t needed it either,” injects Jenkin, who maintains that the firm still secures senior debt at “sensible levels.” He says Frogmore’s investors expect the firm to keep moderate gearing levels, and the firm, for its part, is equally as keen to ensure it has absorbed the sector’s “lessons of the past” by not gearing up too heavily.

LaSalle is one of a number of firms in the UK offering mezzanine capital. Others include The Blackstone Group, Goldman Sachs’ Real Estate Principal Investment Area, Pramerica Real Estate Investors and DRC Capital. Although the roundtable participants believe that, given the debt funding gap in the UK at present, there’s plenty of scope for more, there are indicators to suggest an increasingly competitive marketplace. According to research last year by property services firm CBRE, for example, increasing competition has precipitated average returns of about 16 percent – whittled down from between 20 percent and 25 percent at the turn of the credit crunch in 2007 and 2008. 

Zerda is adamant that there remains copious appetite from institutions to back mezzanine financing strategies. “Investors are attracted to the space both for from the high income component as well as for downside protection inherent in such investments,” he explains. 

Although Zerda admits that the backing of real estate debt funds is considered “satellite” to the firm’s core real estate portfolios, he says: “They look at the types of returns they can generate being in a subordinate debt position with equity downside protection and high-quality sponsorship, and that is a compelling place to be.” He recites the findings of a recent INREV survey, which found that 41 percent of investors were “likely” or “very likely” to commit to a debt funding vehicle in the foreseeable future.

Senior first

One potential obstacle for bridge finance providers, however, is the evaporating amount of new senior debt currently being issued for UK investments. In March, property agent Savills said it had identified just 21 lenders in the UK that had issued more than £75 million in senior debt in the prior six months, while a survey by rival Cushman & Wakefield revealed there were 78 senior lenders in Europe, of which less than half would issue loans to new customers. 

Zerda thinks the lending universe is even tighter. “If every lender active in UK property in 2006 was here now, the room wouldn’t be able to cope,” he says. “But if every lender active in UK property today was here, they’d probably only fill half the room. If you then asked that group who could lend anything more than £50 million at a time, there would be 10 guys. And if you asked them who wants to lend to someone new, there probably would be just two guys.”

While the appetite from banks is diminishing, other groups are marketing products aimed at filling the void. Stepping up are fund managers such as Henderson Global Investors, Fortress Investment Group and Starwood Capital Group, to name a few. 

Insurance companies also are engaging. Last month, Legal & General and Prudential issued (via its M&G Investment Management arm) two of the largest individual senior loans this year – at £121 million and £266 million, respectively. These groups evidently have an appetite for fixed income-style products that offer low-risk, steady returns and, crucially, an attractive arbitrage between the cost of getting the capital and the interest rates on making those loans.

Sovereign wealth funds also are contemplating the senior financing opportunity. At the Reading Real Estate Foundation annual lecture last month, Chris Morrish, the head of real estate in Europe for the Government of Singapore Investment Corporation, told the audience how the state fund was “finding the right home for it” and that it would invest “in due course.”

E&Y’s Maltz submits that, while instances like these are welcome, they are still relatively few and far between. “Yes, it’s a trend,” he says, “but something like 91 percent of new loans secured by real estate funds still come from banks.” Insurance companies, for example, accounted for no more than 2 percent of the lending taken on by real estate funds, he notes.

According to Zerda’s various inter-creditor dialogues with other lenders, senior finance for prime property currently costs anywhere between 200 and 300 basis points. While margins have increased of late, the typical loan-to-value ratio that active banks are willing to lend against prime property has dropped from 65 percent to 60 percent in the first quarter of the year as Eurozone fears precipitate an even more cautious approach to real estate.

Groups still able to borrow also are finding that the due diligence process is far lengthier than before.  M&G’s financing of Round Hill Capital’s £415 million purchase of Nido Student Living from The Blackstone Group took more than six months to conclude – and that was for prime assets in a real estate sub-sector arguably at its most popular. 

Stocks says even Tishman Speyer, one of the world’s most-respected property companies with $35 billion in assets under management and an enviable track record in the UK, took four months to secure senior lending and close its latest investment – the £170 million acquisition of London’s Eland House in January from UK REIT Land Securities. 

“That’s the dynamic,” Jenkin interjects. “All deals are taking a long time. The heady days of ‘bids in Friday, sign next week’ are gone.”

Slowly does it

This time last year, roundtable participants discussed the deal-flow that would come from the UK’s partly nationalised banks, Royal Bank of Scotland and Lloyds Banking Group, and even Ireland’s National Asset Management Agency (NAMA). Two loan books – code-named Isobel (RBS) and Royal (Lloyds) – were the talk of the market as they, perhaps wishfully, were widely slated to precipitate the unlocking of large parts of their respective banks’ £40 billion and £26 billion loan books. Both loan portfolios ultimately did end up under the stewardship of private equity real estate firms – Blackstone and Lone Star Funds. 

Despite talk of further Project Royals to come, little more has been relinquished in the months since. Ernst & Young advises both Lloyds and RBS on their property exposures, and Maltz says it has become abundantly clear that bargain hunters were always going to be disappointed. “The crystallising of distress – with these banks enforcing more and investors achieving ‘bargain’ pricing levels – was never going to happen.” 

Maltz continues: “We still see situations that are not quite at the point where the banks want to take back the keys because it’s not a pleasant or easy process.” But he admits that, on an asset-by-asset basis, many properties currently on banks’ books should be moved on. “The economic fundamentals are one thing, and what people actually do is another,” he says.

According to DTZ’s Money into Property report, UK investment fell to £30 billion in 2011 from $34 billion in 2010. The roundtable participants, while not prolifically putting capital to work, have nonetheless been deploying their resources steadily. Stocks points to two separate acquisitions of approximately £170 million each by Tishman Speyer; Frogmore has amassed seven deals for its second fund across a spectrum of sectors, including data centres, care homes and residential; and LaSalle has deployed more than £200 million of the discretionary capital it amassed for its special situations platform since 2010. 

Of course, successful investors require carefully constructed exit strategies, and there’s a new elephant in the room – changes 

to the UK’s rules about capital gains taxes. This keeps Maltz up at night with worry, he admits in reference to PERE’s opening question. Today, the UK is one of few jurisdictions where capital gains made by foreign groups are not taxed, but this may no longer apply to residential properties under the latest government budget proposal. 

“You can see the concern that it could move across to commercial and that it will be a big blow to investment in the UK,” Maltz says. “I assume the government thinks it will raise revenue, but I think it’ll discourage a lot of investment that will then go to other jurisdictions.” He notes that 59 percent of investment in London last year was cross-border, providing an indication of how important foreign money is to the UK’s most important property market.

Indeed, if a recent breakfast meeting between Zerda and one Asian investor is anything to go by, there are warning signs these investors might remove some of their capital from the table. “His group is viewing this with meticulous eyes,” he recounts, telling Maltz, “I definitely share your fear.”

Nonetheless, Asian investment into London offices grew 150 percent in 2011 – last month saw Korea’s Public Officials Benefit Association park its first £165 million in the City of London in one instance – and by 10 percent in terms of the capital city’s total office investment. In other words, these buyers are, today at least, still here.

In the meantime, there’s £100 billion of real estate that cannot be refinanced under current conditions, and that is keeping private equity real estate firms like Jenkin’s Frogmore up at night with excitement. Whether investors can temper their macroeconomic fears to share in that excitement remains to be seen. 


Julian Stocks
Managing director and head of the UK
Tishman Speyer

Stocks leads Tishman Speyer’s UK acquisitions, sales, development and asset management activities. Previously serving as head of capital markets for the UK at global property services heavyweight Jones Lang LaSalle, he switched from advisor to principal when he joined Tishman Speyer in 2010. 
Stocks currently is putting his ‘on the ground’ property knowledge to work helping the New York-based property giant add to its approximately $35 billion in assets under management, with a current focus on either core or value-added investments in London. By his own admission, the firm’s exposure to the UK is “not much now,” owing to its decision to exit about £1 billion in London investments between 2005 and 2006, immediately prior to the start of the global financial crisis. Today, Tishman Speyer manages £550 million of properties in the UK, all of which are offices in London.

Matthew Maltz
Ernst & Young

Maltz has a background in tax consultancy and works predominantly with private equity real estate funds. Among his clients are The Blackstone Group, Benson Elliot Capital Management, Morgan Stanley Real Estate Investing, Pramerica Real Estate Investors and Brockton Capital, as well as various sovereign wealth funds. 

Ernst & Young has the largest exposure to real estate of all the ‘Big Four’ accounting firms, with approximately 7,500 people worldwide including about 1,500 people in Europe. The firm offers a wide array of services to its real estate clients, including audit, tax, transaction support, corporate finance and other advisory functions.

Stuart Jenkin
Director of fund management

Jenkin is a self-confessed ‘property person’, despite his remit as Frogmore’s director of fund management. Nonetheless, the 38-year industry veteran is the point man for the London-based firm’s institutional investors. He joined Frogmore from Siemens Properties, where he spent 18 months as managing director for its 6 million-square-foot portfolio of properties. He also previously worked for Provident Mutual Life Assurance and Abbey Life Assurance. 

During his tenure at Frogmore, Jenkin has witnessed the firm de-list from the London Stock Exchange in 2001, become a private investor and, from 2006, become a private equity real estate fund manager. The 40-staff firm raised £330 million and £200 million for its first two funds, the second of which is nearing the end of its investment period.

Michael Zerda
Director of special situations and debt investments
LaSalle Investment Management 

Zerda is a real estate debt specialist through and through. He joined LaSalle Investment Management’s special situations group in 2009 from Merrill Lynch’s Global Principal Investments division, where he was a vice president and spent significant time focused on debt investment opportunities in Europe and the UK. Before that he worked for Archon Group, the real estate loan workout group of Goldman Sachs, where he was focused on securitised nonperforming loan portfolios and mezzanine debt investments in Europe and the US. 

At LaSalle, Zerda is responsible for the origination and evaluation of structured European real estate investments in mezzanine debt, stretched senior loans, structured equity and loan acquisitions on behalf of two discretionary investment vehicles comprising £400 million in commitments.


All work, no fund
As the roundtable participants thumb their way through PERE’s Capital Watch, it quickly dawns on them how little equity has been raised for European funds

Stocks: We are finding that the traditional commingled model still works in some regions of the world. Indeed, we are successfully raising funds for the US and Brazil right now. Europe, however, is more challenging as our larger investors in particular don’t want to go down the commingled fund route at the moment.  They are much happier with more control via direct deals, joint ventures or clubs. Will the pendulum swing back in due course? I think it will in time.

Maltz: We structured a fund for Tristan Capital Partners, which just raised €420 million. Apart from that, there’s been the Niam fund, but those are pretty much the only major new funds closing this year. AEW Europe is raising a debt fund and an opportunity fund, and others are out raising capital, such as Perella Weinberg and MGPA. People are more confident about the capital-raising environment this year, even though INREV says fundraising has fallen by 70 percent since the peak. 

I think the commingled fund works for firms with a good track record with investors, but it is mistrusted by others who, for various reasons are now looking to the club or segregated mandate model. LPs know they have the power now and are making strong demands across the board – on structure, alignment of interest, management fees and even the size of the fund.

Stocks: Looking at the table, there has been a noticeable lack of successful fundraising for Europe. It’s funny when you think that most of the distress in the world’s markets is in Europe, which should mean lots of opportunities, but investors are still very cautious. 

Jenkin: The US is looking at volatility. If they felt there was some sort of bottom reached, things might be better, but every day or week there is some kind of currency or bond issue in Europe. That is the problem.

Stocks: By the time it has stabilised, don’t you think it might be too late to invest?

Jenkin: That’s why local players recognise there is an opportunity today.


London versus the rest
Frogmore’s Jenkin sees significant ‘arbitrage’ opportunities in the UK ex-London, but his view was not shared by Tishman Speyer’s Stocks, who feels the regional occupational situation does not support the prime-secondary gap thesis

Jenkin: I think London has opportunity, but I also think you have to ask where the value is now. We’ve always looked around the UK for significant arbitrage opportunity to create value or produce reasonably attractive returns, and there’s a fascinating graph produced by CBRE (see below) that shows the correlation between prime and secondary yields. If you go back to 2000, there’s probably a 150 basis points correlation between the two. Then, go forward to the global financial crisis and that explodes. Now, we’re looking at 400 basis points difference. In the last six to nine months, we’ve seen another big change in the pricing of secondary or regional properties, and I don’t think you can ignore that.

Stocks: I have to disagree. I can sense an increasing interest in the regions, but I don’t think the occupational market yet supports buying into the secondary gap you touched upon. London is growing and its GDP is strong – that has been well documented. While rents are flat today, there isn’t any new development finance available and therefore we see 2014/2015 rents growing again. While I agree that prime yields have moved too far from their long-term average – by about 75 basis points – I’d prefer to focus on secondary assets in and around London than in the regions.