FEATURE: Stern-struck

On October 24, the law firm of Kirkland & Ellis held its sixth annual Real Estate Private Equity Symposium in New York. Attended by a select group of fund managers and investors, the half-day event offered views on the challenges of raising capital for funds in today’s markets, how macroeconomic uncertainty is slowing down transaction activity and the opportunity in distressed real estate.

The event was capped off by a keynote session with Barry Sternlicht, chief executive officer of Starwood Capital Group. In an interview with PERE senior editor Erik Kolb, Sternlicht shared his thoughts on the global economy and where he sees investment opportunities in today’s markets. Here are some select excerpts:

PERE: What is your take on the larger macroeconomic trends around the globe?

Sternlicht: In my lifetime, I can’t remember ever before having the world’s outlook rest in the hands of politicians. Everybody’s freaked out about the situation in Washington and Europe, so everybody’s sitting on their hands.

With the Western world overleveraged, we need a viable 10-year workout plan coming out of Congress, and probably out of Europe as well. The world will give us time, if we have a credible plan to work our way out of these deficits.  

PERE: How has the uncertainty over the European financial system affected US property markets in terms of pricing, deal flow and availability of debt? 

Sternlicht: I think the situation in Europe has just put everybody on hold. When the markets backed up, investors said, ‘You know, maybe the money’s not going to flow forever.’ They got much more careful about the remaining capital they had in their funds, and they wanted to make sure they were not doing anything marginal. I think that took place across the whole private equity spectrum, real estate included, because all of a sudden the gradual recovery looks like it could become a double-dip recession and nobody can figure out what Europe is doing.

I think Europe definitely has affected spreads across the entire credit complex. The banks in Europe are kind of paralysed, and US banks are nervous because Europe’s banks are nervous. Somebody told me that Lehman Brothers was the first act for the grand finale, which is the destruction of the European credit markets.  That’s a really happy thought, but the truth is that you don’t know where those credit default swaps have gone, who backed what and who guaranteed which side of what. Every day it is going to be like the Discovery Channel, and you’re going to wish that we had saved some of these institutions.

PERE: Turning a bit more to more real estate-specific topics, in which markets and property types are you seeing attractive investment opportunities?

Sternlicht:  We have been buying a lot of distressed debt, including a bunch of pools from different private sellers. Our last fund, which is almost fully invested now, is about 82 percent invested in the US. We found all the opportunities here, so why bother going anywhere else. I think the one thing this last crisis taught us is, if you have a 20 percent IRR in India versus a 17 percent IRR in the US, you are better off with the US.  

Starwood also has a mortgage REIT, which allows us to play across the rest of the debt spectrum, specifically performing loans and loan originations. With banks stepping back from lending because the CMBS market has essentially shut down, the mortgage REIT has been able to get the coupons we like on the origination side along with lower loan-to-value ratios. For example, we can make a loan at 6.25 percent or 6.5 percent and make that work.  

In a counter-cyclical bet, we also bought a lot of land. I think we bought it cheaply enough, and now we’re just going to wait for the housing market to get better, which it will someday.  More than any other market in the country, the housing market is about confidence. 

Generally speaking, if you can buy assets at cap rates higher than the cost of debt, you can achieve very attractive cash-on-cash yields relative to other asset classes. In that situation, you can be patient because you are buying assets below replacement cost. 

PERE: Coming back to Europe, are you excited about that region as a place to invest?

Sternlicht:  We’re obviously spending a lot of time in Europe, as there’s lots of distress in the market as well as many unnatural holders of debt. The hard part is underwriting what the future looks like. Even if you hedge against the euro, you better make sure you like who’s holding the hedge because you want to make sure they’re around to pay you.  

PERE: There has been some talk that fundraising, which has been progressing at a pretty good pace this year, may be slowing down a bit as LPs get worried about such issues as the global economy and the denominator effect. What is your sense of the desire of LPs to continue to invest in real estate in general and commingled funds specifically?

Sternlicht:  The market has definitely changed since the global financial crisis, essentially shutting down for most of 2009. It opened up again as the equity markets rebounded in 2010 and the write-downs came from real estate funds. 

All of a sudden, many pension plans found themselves horribly underweighted to real estate. Instead of being at a 10 percent allocation, they found themselves at 6 percent. It was ironic because, when you saw them in 2008, they said they were over-allocated to real estate. At the time, I told them, ‘Just wait, you will get those write-downs.’ Once the industry began to write its investments down, the pension plans were underweighted and they say they need to invest again. Everything was going fine until the situation in Europe unfolded. That’s when the chief investment officers, not necessarily the real estate staff, got nervous. 

Overall, it is not a GP’s market right now, and that’s true not just for real estate but private equity and venture capital as well. There are very few firms that are going to raise capital, and I don’t think you are going to see a $15 billion fund again on the private equity side for awhile. 

Some of the biggest guys have decided that fund structures can be negotiated and they’d rather just do co-investments or club deals. This too will pass because they’ll realise they’re not structured to do these club deals. Still, these firms need to put money out, so it’s an excuse for staying busy.  

PERE: Pulling it altogether, what’s your outlook for the commercial real estate markets for the next 12 to 18 months?

Sternlicht:  I don’t have a crystal ball, but I’m going with the general feeling that there’s risk in the world. Therefore, we’re investing with a big margin of safety because we need to preserve capital for a wide range of outcomes.  

This outlook has resulted in Starwood running the weirdest looking opportunity fund I’ve ever seen. This is our eleventh fund, and it’s the lowest leveraged fund we’ve ever had at 30 percent leverage. I keep asking myself if we’re missing an opportunity given that this is the lowest interest rate environment we’ve ever seen, but honestly I’m really happy to get risk-adjusted returns of 15 percent to 18 percent in this world.  I don’t need the leverage to get to 22 percent; I’d rather sleep at night.  Plus, if the world stumbles, we don’t lose all our equity.