Thursday, April 8, 2010

Private Equity Money Seeing Opportunities in CRE Again

While Major Action May Not Occur til 2011, Some Anxious To Get in Now

By Mark Heschmeyer,

April 7, 2010

Fund managers and others involved in the real estate private equity sector expect further deterioration in commercial real estate this year as unemployment leads to lower commercial occupancies and declining rents. And that could be a good thing.

With the sector still in recession, many fund managers are preparing for the beginning of a "generational buying opportunity" that could manifest as early as the first quarter of 2011, according to a survey by Ernst & Young's Real Estate Fund Services.

The survey, Market Outlook: Trends in the real estate private equity industry 2010, reveals that most market participants polled expect a gradual opening of debt and equity markets to occur by the end of this year as investors shift their strategy away from preservation of capital and begin to search for higher returns on investment.

But while many have noted the investment opportunity expected as a result of the deep recession, few seem to agree when investors should expect to see those opportunities.

For example, in its 2010 Private Equity Outlook, asset management firm Neuberger Berman said it expects a "a potentially large and sustained period of opportunity," and noted that that distressed real estate is "in" as an investment.

"Lower valuations in the U.S. commercial real estate sector are likely to continue to make debt refinancing more difficult and the distressed investing opportunity for that asset class more robust. The maturity schedule of commercial mortgages may exacerbate this stress, precipitating a need for more equity to be provided to leveraged real estate and, as a result, the potential for change in control. Given the size of the U.S. commercial mortgage market, these circumstances provide a potentially large and sustained period of opportunity," Neuberger Berman reported.

In Ernst & Young's survey, almost nine out 10 U.S. respondents (87%) also said they believe that the availability of debt and equity capital will increase by the end of 2010. However, few respondents see the U.S. real estate leveling out before then. Most expect 2011 to be the year in which investment opportunities start to appear in some abundance.

"Significant amounts of opportunistic capital have been accumulated to invest in distressed real estate, but simply stated, there is not enough distress to go around," said Gary Koster, Ernst & Young's global leader of Real Estate Fund Services. "Real estate lenders are not forcing the issue with respect to maturing debt which is under-collateralized. If the banks won't take action and instead choose to just extend loan maturities, there is little incentive for real estate owners to trade at current valuations. Given the impact that alternatives - such as foreclosure - will have on bank earnings and capital, it's not difficult to see why lenders' 'extend and pretend' strategy is still being widely deployed for maturing loans."

A majority of respondents to the survey clearly said they believe the commercial real estate crisis among U.S. banks is still only in the "middle innings" - 70% expect that banks will feel increasing pressure to trade troubled loans at reduced valuations or move to foreclose on problem assets by the end of this year.

"The consensus, at least in the US, seems to be that 2011 will be the year in which transaction velocity in the real estate private equity market returns in earnest," Koster said. "However, before fund sponsors can take advantage of the returning market opportunity, they must address any existing problems in their legacy investment portfolios and generally set their houses in order."

The report also points to a central dichotomy in the mindset of U.S. real estate private equity managers.

"The banking community's strategy of deferring the impact of distress is a double-edged sword for the real estate fund sector," Koster said. "The lending community's reliance is a lifeline for investors short on capital and holding problem assets, but it's a challenge for investors long on capital yet to be invested and anxious to put that capital to work at current valuations. Whatever the eventual outcome, one side of the market will ultimately be disappointed."

At least one investment manager Mark Taborsky, executive vice president and product manager at Pimco, said in a March Viewpoint that the reluctance to jump in now also presents its own opportunities.

"We also may see many kinds of opportunities in natural resources, real estate (mindful of the refinancing that will take place on a large scale in the coming years) and in other spaces. But each situation will be different, and most such opportunities are likely to have longer-term horizons," Taborsky said. "After the crisis, there isn’t as much willingness for investors to embrace illiquidity. So while liquid markets have rallied a lot, illiquid assets will lag as their liquidity premium gets re-rated. It’s going to take time for capital to return to less liquid and longer duration strategies. This itself is an opportunity - the fewer the bidders there are for long-term cash flows, the higher the expected return an investor may be able to command."

It appears Taborsky is not be alone in that thinking. According to an analysis of first quarter investment activity by CoStar Group, private equity funds have returned to commercial real estate office market as buyers. Private equity investors were net sellers last year reducing their holdings by a net of about $100 million. This year, though private equity investors have upped their holdings by a net gain of about $300 million.