The real estate opportunity

Historically, private equity's relationship with real estate (or if you prefer, property) investment hasn't exactly been intimate. In the United States, it took the banking crisis of the early 1990s and the promise of some $500bn of underpriced property assets on the books of distressed sellers to convince general partners that there was indeed a major opportunity up for grabs. It then took several years more for private equity investors to start looking at real estate in Europe, and although a European market place has started to evolve in recent years, most practitioners will tell you that it is still at an early stage of development.

Flick through the member directories of the European private equity associations, and you won't find many firms that reference any particular appetite for real estate. (Quite a few of them exclude it actually.) Nor are there any numbers available as to how much private equity capital has been raised for, and invested in, European property assets to date. General partners specialising in real estate use the same organisational structures as their more ?conventional? private equity colleagues, use leverage in the same way, service the same clients, aim for similar returns and are remunerated in the same way – and yet they don't attend industry gatherings and rarely feature in private equity publications or indeed the mainstream financial press.

Property is of course a huge and long-established asset class in its own right, which may be one reason why its private equity specialists have largely kept to themselves and their publicly listed colleagues. But it is striking that, with the exception of a few leading LBO houses such as Blackstone, Carlyle and Doughty Hanson, mainstream private equity firms have not attempted to make significant inroads into European real estate. That those heavyweight buyout firms have, offers some clue as to why real estate provides a distinct new dimension to a private equity portfolio.

Understanding the asset class
There are several reasons for the sector's historical lack of appeal to the private equity industry. To begin with, liquidity has been an issue. And property investing is a highly specialised field, populated by career professionals who have gained a deep understanding of how value creation works in the asset class. Part of this understanding relates to a high level of comfort with real estate's inherent cyclicality, which outsiders tend to fear.

?When property markets correct, they correct very quickly and tend to overshoot,? says David Brush, managing director and global head of Deutsche Bank's Real Estate Private Equity Group in London. This phenomenon creates the kind of asset dislocation and false pricing that value investors seek to exploit, thus providing so-called opportunity funds with a significant part of their deal flow. Understanding the real estate cycle correctly in different geographies and within different sub-sectors requires a set of skills that straight private equity investors have thus far often lacked.

?For private equity houses, moving into the real estate sector is the next logical step,? says Charles Graham of Europa Capital Partners, which manages a pan-European real estate opportunity fund. ?But the main question is, where is the property expertise? Real estate investors get far more involved in understanding the property and working the assets. And their investors expect that.?

Valuing these assets properly can also be difficult unless there is the kind of property-specific expertise that agencies for instance such DTZ and Jones Lang Lasalle, or the property divisions inside investment banks, possess in abundance. Marc Mogull, managing director of Doughty Hanson & Co. Real Estate Fund: ?Private equity houses have a hard time understanding what drives valuations in the sector. Say you're buying assets that yield between six and nine per cent. If you flip that over and look at it as an implied EBITDA level, the multiple looks high and, by private equity standards, the sector looks expensive.?

But such knowledge can be acquired, and qualified professionals can be brought in. Perhaps the most important reason for private equity's apparent apathy towards property in the past is a motivational issue: until recently, the returns on offer didn't, by comparison, seem attractive enough. Early-vintage US real estate opportunity funds, who in the mid- to late 1990s began to arrive in Europe, have performed well, but even at the best of times only ever aimed to return between 18 and 25 per cent annually. (Lower risk core investments in stable, cash flow generative property assets fall into the six to nine per cent range. Medium-risk investments, sometimes referred to as core-plus or value added, are generally expected to generate between 12 and 18 per cent.) So when mainstream private equity and venture capital funds were succeeding in delivering returns far in excess of these numbers there just wasn't much to excite about property.

European Private PropertyMarket Correlations

European Market Correlations

Europeans proceed with caution
Part of European institutions' reservation stems from the fact that many of them continue to operate large-scale in-house property teams that invest directly in the asset class. Says Mansley: ?For investors like us with a large direct exposure, we need to get a clear indication of where the added value is going to come from. We have issues with the fee structures in opportunity funds, particularly with low thresholds for carried interest or performance fees which are easy to beat without the managers adding significant value.? Such comments confirm that investors in real estate funds are confronting GPs with the same issues over compensation that mainstream private equity managers currently have to address as well.

Meanwhile real estate general partners are well aware of the European buy side's lack of enthusiasm for their product. One GP commented that he had ?nothing positive to say about UK institutions? as a potential source of capital for real estate private equity.

In continental Europe, limited partner hesitation derives in part from a lack of familiarity with the general partnership investment methodology that US and UK institutions have been dealing with for a lot longer. ?Discretionary or blind-pool investing in opportunistic vehicles is a relatively new product in Europe and many of the German pension funds and insurance companies are reluctant to jump in?, says Seth Martin of Apollo Real Estate Advisors' European arm in London.

However, many of those interviewed for this article suggested that there are signs in different parts of Europe of a change of perception among investors that opportunity funds are likely to benefit from going forward. It is also very much the case that the universe of institutional investors based in Europe who have allocated a portion of their capital to alternative assets is growing. Just as some are making tentative first steps, so others are progressing to more sophisticated, and diversified, alternative portfolio strategies. And that's where real estate fits in.

Jonathan Short, whose investment approach at PRICOA does not fall into the opportunistic category as he is pursuing a more ?strictly private equity? strategy investing in the equity capital of small- to medium size property companies (entity-level investment), says that many institutions today are looking to outsource large parts of their real estate investment activities. ?The large Dutch houses such as ABP and PGGM were first to go in this direction and are now doing most of their real estate investment through funds and securities. Danish and Swedish investors are taking a similar route, and there is some interest in the UK now as well. And there are internal organisational changes: often the buy side decision in real estate private equity is no longer made by a real estate unit but by a larger alternative assets team.?

Peter Cluff, finance director at Europa which raised its €250m fund in 2000 mainly from North American and Middle Eastern investors, also notes that sentiment among institutions is beginning to change: ?Today, post-Myners, there is a move towards indirect private equity investment within which real estate is an increasingly favoured subset. In the early days, we had to convince people of the opportunistic returns that could be generated from real estate. Now there is much greater awareness among LPs, and new investors are entering the market. What we would like to see most is for UK investors to play a greater role in European real estate through indirect investment in the way Dutch institutions do already.?

Christophe Tanghe is a managing director and co-head of Lehman Brothers' $1.6bn Real Estate Merchant Banking Fund that closed in September 2001 to invest in North America and across Western and Central Europe. ?We had both institutions and high net worth individuals invest in the fund, alongside a cornerstone investment from the bank. In Europe, we mainly used existing relationships to market the fund as opposed to a full marketing effort, and the response was very positive? he comments.

The fact that institutional investors are now struggling with allocation models that have lost their balance following the collapse of the public equity markets doesn't help when it comes to making capital available to general partners, even where commitments have already been made. But whether practitioners like Tanghe will rely on Europe as a source of capital more in the future depends largely on the ability of general partners to generate meaningful returns. The necessary resources are in place: established funds are cash rich, and debt is readily available (in the UK, real estate loans are currently at their highest percentage of total commercial lending since 1992, according to DTZ). So one priority going forward is to demonstrate to investors that the opportunistic real estate investment proposition can be as successful in Europe as it became in the US.

Delivering results
Europe certainly at present provides an environment that is becoming more conducive to building a track record for the opportunistic property investor. Yields may be lower than in the US market, but European property also has some attractive characteristics such as lower tenant mobility, a more restrained asset supply and lease terms that tend to be more favourable to the owner and more onerous on the tenant. Real estate assets across Europe are obviously as diverse as the respective regulatory, accounting, tax and valuation frameworks in each country. But the introduction of the Euro has meant that practitioners now enjoy an unprecedented degree of fiscal and pricing transparency. In fact, the single currency is already being credited with a marked increase in multijurisdictional investment. ?If you look at cross-border real estate investment in Europe five years ago, the total amount of equity invested was probably smaller than one mega private equity deal today. The single currency has changed that,? says Mogull at Doughty Hanson. DTZ Research estimate that total European cross-border investment in property has increased from €9.7bn in 1997 to €26.7bn in 2000 and €26.6bn in 2001. Privatisation of government owned property assets is another important catalyst of deal flow. More powerful still, European corporations continue to own an estimated 70 to 80 per cent of the real estate they occupy, whereas in the US the equivalent figure is closer to 30 per cent. European companies that are under pressure to generate a greater return on equity are now offering the prospect of large-scale disposals that give GPs the chance to apply their real estate savvy combined with financial engineering skills. The trend has also prompted efforts to finesse sale and lease-back technology as a means to move such assets off corporate balance sheets.

Another trend in recent years that has grown interest in alternative real estate investing has been the disenchantment amongst investors with publicly owned real estate companies. In June of this year, quoted Irish operator Green Property became the latest such entity to be taken private, having spent years trading at a large discount to net asset value and choking from increasingly elusive liquidity as the market punished its perceived poor management. Alignment of interest between management and shareholders in publicly listed property companies is often seen as poor, as currently evidenced by the negative sentiments expressed by shareholders in UK property giant British Land. General partners are likely to benefit from a lasting impression from investors that, as far as aligning interests is concerned, limited partnerships in which the GP is invested personally has intrinsic advantages over public market ownership.

Clarity of purpose required
To raise their profile among investors further, GPs active in Europe will have to keep articulating investment strategies that are well-defined and sufficiently diversified. Sceptics allege that opportunistic investing is arbitrary in its pursuit of value, and investors demand specific propositions that provide comfort. As Nick Mansley at Morley Fund Management puts it: ?We believe investors will increasingly favour funds that either have specific investment themes such as investing in corporate outsourcing or are focussed on a particular sector of the market.?

Limited partners acknowledge that funds have been heeding this demand already. Graham Senst at OMERS points out that things have already changed significantly since the early 1990s, when US opportunity funds were basically vultures buying distressed assets from pressurised sellers. ?Today opportunity funds are used as vehicles with very different profiles, designed to execute different real estate strategies.?

Strategic differentiation may involve developing an appetite for specific types of asset. It may also be about specialising in different types of transaction, ranging from distressed loan purchases and property repositioning to asset-pricing arbitrage to development funding. In Europe, the need to diversify has already put some innovative players on the map. Patron Capital Partners is an example for a private equity house taking a novel approach to real estate investment, concentrating on what it describes as entity-level investing in companies where it is the assets, not the underlying business, that support the purchase price.

For those with an appetite to do business on a pan-European basis, it is also necessary to determine how to best equip a fund with the skill-set needed to deal with the idiosyncrasies of individual European markets. And real estate is another of those asset classes where networks deliver significant amounts of business. ?The old saying ?capital is global, property is local' is very true indeed,? says Graham at Europa. His firm operates a system of local partners who are based in European target countries to ensure it has access to the right deals as well as the ability to execute them. The alternative to this model is to set up a network of local offices, which is what Doughty Hansen has opted for. According to Marc Mogull, a pan-European strategy ?is impossible to execute from London. That's why we have seven offices across Europe. It's a pretty high barrier to entry for newcomers.?

Variations of either structure already exist. Practitioners who feel that there are markets in Europe that are too big for individuals but too small for a big fund like to work with local joint venture partners. This, say critics, can leave the GP with the difficulty of assuring a partner in one country that a deal they originate will be given sufficient attention at headquarters, even though they may be distracted by ongoing business with other partners.

An arguably even more important issue facing general partners is a growing need to evidence an ability to exit. Opportunistic real estate investing has not been in Europe for long enough for funds to be able to point to a track record of building and subsequently exiting a portfolio that in sum has more value than its individual parts. Says Mogull: ?The question of exits is one that the real estate opportunity fund industry is coming to face much later than other private equity sectors, perhaps because rising valuations left people happy to just report unrealised IRRs.?

Acquiring a successful exit track record will be vital both for individual firms as well as the industry as a whole. Few practitioners are under any illusion as to where the proof of the pudding is ultimately going to come from. As Martin at Apollo puts it: ?We're hoping that the funds that are in the market today are going to do well, which will open the doors to domestic institutions.? Although still early days, European real estate investing could well become a significant subset of private equity: most of the ingredients are already in place.

The environment in real estate
Dr Marcel Steward

One of the key considerations for any real estate private equity investor is the ever-changing landscape of environmental issues and legislation. Environmental legislation and liability is typically assumed to have originated from America. However, a commonly overlooked fact is the historical relevance of Europe's role as the epicentre of the industrial revolution. In short, Europe has less land, has been polluting it for longer and continues to carry on using it. This does not mean that environmental risk should act as a deterrent to real estate investment in Europe. Certainly there are specialist skills required to turn an apparent risk into an opportunity to create value, but those skills are available, as are the tools to achieve it in the forms of physical environmental risk management, finance and insurance.

In a market where opportunities for portfolio improvement are very much required, private equity investors should view environmental risk as an opportunity to assist them in reaching their required return on investment. Contrary to popular belief, environmental risks are only infrequently addressed with expensive site clean-ups or the removal and relocation of contaminated waste. Today, there is an array of innovative financial and insurance capital solutions, which are specifically designed to address such risks.

However, it is the perception of risk that has the potential to materially affect a private equity portfolio. Perceived risks have the potential to blight whole tracts of land and real estate portfolios, turning what should be a positively valued asset into negative equity.

There are areas where physical environmental risk management is the correct response to some risks, but those are relatively rare in relation to real estate. It is also possible to contractually leave environmental risk with the seller, but that comes at a price. Then there are other areas however, related for instance to ground and ground water where contamination can probably be left to attenuate naturally, but the risk that earlier intervention may be required can only be treated using financial risk management, such as specialist environmental insurance, or other forms of Alternative Risk Finance (ARF).

Even where risks cannot be removed, the fact that their potential impact on profit can be adequately limited or transferred away usually goes a long way to alleviating stakeholder's fears, changing perception and significantly affecting portfolio valuation and return on investment.

Dr Marcel Steward is head of environment at Marsh Private Equity and M&A Practice.