Having a theoretical debate about performance is fine, but what LPs and GPs want to know is when will the good times return?
By common assumption, 2006 and 2007 will likely be looked upon as among the poorest years in terms of performance. After all, opportunity funds were competing so hard for assets in those two years that people simply paid too much for the real estate. Those buyers should of course be divesting those assets now, but they are facing the opposite problem: values are falling. They have a stark choice of either selling and taking a hit, or holding and watching their IRRs fall into single digits. Either way, 2006 and 2007 will not be kind.
Most argue that the bulk of opportunities to buy distressed assets will emerge in 2009 and 2010, for both equity and debt investments.
2001, was though, the best of all times for opportunity funds, according to research by Partners Group. The median IRR for funds as a whole was 30.2 percent, higher than in any other year since 1996 when data was first collected. The findings match that of the new NCREIF/Townsend Group opportunity fund index, which also says 2001 was the best vintage. It found the median net IRR to be 25 percent.
That 2001 was the best year on record shouldn't come as a great shock. Pamela Alsterlind, partner and co-head of the private real estate team at Partners Group, says property assets, particularly in the US, were seeing “quite a bit of distress” with buyers able to snap up office buildings at “very low prices”. Those with such assets on their balance sheets were getting “hit hard by write downs”, she added.
The downturn in 2001 followed on the back of the bursting of the tech bubble and the 11 September terror attacks. The year had already begun with a round of sharp interest rate cuts at the behest of the then-Federal Reserve chairman Alan Greenspan in order to prevent recession. However, between 2001 and 2004, interest rates were slashed to a low of one percent. Banks were beginning to loosen terms for commercial real estate loans and by 2004 a study revealed ever-growing demand for commercial real estate loans.
In 2001 then, opportunity funds flourished by acquiring distressed assets at a time of low interest rates and an improving lending environment. Of course, there are a different set of circumstances at play today, notably the lack of easily available credit.
Given that leverage can pump up returns, performance in a low-debt environment would hurt returns. David Michelson, general partner of US firm Three Arch Investments, said his firm's Californian Distressed Land Fund reviewed 17 past projects from the early 1990s which typically used 75 percent leverage for homebuilding projects. The 17 partnerships yielded an annual IRR of 26.2 percent over an average holding period of two years and seven months. But when they calculated IRRs with the leverage removed, the IRRs were lowered to 13.5 percent.
Seeing as the present crisis began with weaknesses in the US residential sector, it is worth taking note of what lessons Michelson learned from the last great economic downtown of the early 1990s, and how long it took the market to recover. He argues the normal recovery cycle is L-shaped, meaning that it will take several years for recovery to take place once the US housing market stabilises.
Our conclusion is that all cash real estate transactions will reduce the IRR from the 20 percent range down to low teens. We believe leverage cannot be deployed until the marketplace has clear evidence of reduced inventories, stabilisation of the financial markets, improvement in the jobs market and public homebuilders starting new communities again. This in our opinion will not be likely until 2011-2012.
In his market, the important sign to watch for is inventories reducing in terms of single family homes in Western parts of the US. Michelson says that based on the S&P Case-Shiller Home Price Indices, once the market reached stability in 1995 it took another 22 months before inventories reduced and demand began rising.
He said: “Our conclusion is that all cash real estate transactions will reduce the IRR from the 20 percent range down to low teens. We believe leverage cannot be deployed until the marketplace has clear evidence of reduced inventories, stabilisation of the financial markets, improvement in the jobs market and public homebuilders starting new communities again. This in our opinion will not be likely until 2011-2012.”
However, there are those GPs focused on other parts of the US market who expect things to turn around a little quicker. Anecdotally, they are telling LPs they are prepared to buy assets with equity now in the expectation that debt will be around to refinance acquisitions in the following one or two years.
The hope is that debt will become accessible again, though perhaps from different sources and on different terms. And when combined with what is actually happening – a rerun of 2001 when the US government slashed interest rates and property owners became distressed – there is cause for optimism.
On this last point of distress, Alsterlind says, “Where there is a lot of distress you would assume the good opportunistic GPs are going to take advantage of it and produce strong returns.”
Claude Angéloz, fellow co-head of the private real estate at Partners Group, draws a different lesson from the Partners Group data. He notes that there is a wide disparity between the performance of the top quartile and bottom quartile in 2001. Choosing the right fund manager is imperative, he says. “The dispersion of returns between the good managers and the below-average managers is very significant. Picking the top managers makes a real difference.”