Time For Private Equity and CRE To Get Serious
The speed dating between real estate operating companies and institutional private equity investors is ready to move to the commitment phase—formal program investing. This involves a real estate operating company and an institutional investor agreeing to and executing on a partnership that describes how the two will invest, operate, and own a series of real estate assets in a conditional, exclusive relationship.
Such a programmatic partnership is the next step beyond what’s been the market practice over the past few years: one-off operating partnerships with either a very loose right to continue to do business or silence regarding the next asset opportunity.
Investors Are Seeking Change
A combination of forces is responsible for this shift to a more formalized approach. For one thing, private equity relationships are busier than ever. And for another, there’s an abundance of asset opportunities in everyone’s in-box. This is the good news.
The challenge is to efficiently process the variety of deals that require individual underwriting with different operating partners. Having to establish a brand-new investing relationship all the time is difficult for everyone. It requires sourcing, initial operator meetings, track-record diligence, tours, relationship building, process communications and familiarity, asset underwriting, deal negotiations, due diligence, document preparation, lawyering throughout, investment committee by prep, and eventual closing.
Now do this from scratch with a new party on a continuous basis. Now add the natural differences from different asset types in different geographic submarkets. Then consider investor relations and the continuous raising of new capital.
This is a lot of work. And while we continue to be impressed with the organizational leverage of the best and the brightest in institutional real estate, it’s important to remember that, despite the growing scale and complexity of assets under management, these assets are controlled by relatively small teams.
RTC 2.0 Didn’t Happen
Once we all left the paralysis stage of the Great Recession, programs were the rage as investors anticipated a massive level of asset selling from the financials. We all thought RTC 2.0 was in front of us. Both investors and operators spent time and money to put program agreements in place. Unfortunately, the early-’90s tempo of asset shedding and ownership changes that really launched the modern real estate opportunity funds didn't happen.
The regulatory pressure that once forced the financials to mark to market—which resulted in write-downs and then asset sales at the new basis—was what we all expected. It just didn’t occur. As such, the newly formed programs didn't activate.
It looked like wasted effort and expense. The market turned toward one-off, single-asset, single-entity investing. Programs were taken off the table early in every discussion,even when the intent was to partner on multiple deals over time.
Many things have changed. The business cycle is moving too slowly, but it’s at least moving. The uncertainties are shifting from the downside to the upside. Multifamily has led real estate into recovery, and commercial asset values have rebounded faster than justified by the economy. Interest rates and the dearth of investment alternatives have everything to do with real estate’s shift to positive territory.
Here are a few other factors:
- Housing is stabilizing thanks to private investment in foreclosed homes that are converted to rentals. Can anyone say he or she isn't surprised by the recovery of the Phoenix housing market?
- Pension funds have been pressured in numerous ways,including a surge in the need for liquidity for their pensioners. As state, county, and municipal layoffs have washed over the country, laid-off workers with vesting rights have started to draw their pension benefits.
- Real estate investing has turned voraciously to opportunities that have going-in yields above the low-cost debt and can obtain higher operating yields within a year or two of the acquisitions.
- Multifamily values have corrected so quickly that operating yields from perfect pricing are hard to find.
- We’re all uncomfortable guessing exit cap rates given the consensus view of higher rates within a five-to-10-year investment hold.
The shift to real programmatic deals is under way in some leading-edge sectors, offering a road map for other firms, big and small, public and private.
In conventional multifamily partnering, Rockwood Capital and Mill Creek Residential Trust entered into a partnership agreement last year to invest in multifamily property acquisitions, construction, and development across the United States. An earlier seminal arrangement now actively investing is KBS Legacy Partners Apartment REIT, a private-REIT tie-up between Legacy Partners and KBS Capital Advisors.
More recently, programmatic arrangements are fueling the REO homes-to-rental space. In January, Colony Capital launched Colony American Homes with a goal of acquiring 5,000 homes this year, and Oaktree Capital joint-ventured with Carrington Homes to buy up to $450 million in troubled single-family homes for rent. Last year GI Partners announced an investment to acquire more than $250 million in single-family rental homes by investor-operator Waypoint Homes. And in June 2012, investor-operator Landsmith announced a national platform, investing $100 million from private investment sources.
Operators Are Standing By
As we shift from the low-hanging fruit of acquiring all the profit on the buy, operator competency grows in importance. When the most important part of the underwriting cash flow projection is the period between the acquisition and the exit, the operator is the key to everyone's profit.
In general, today's middle-market real estate operators are poised and eager to grow. There’s a core team, the legacy assets have been resolved one way or another, and underwriting, leasing, construction management, property management, and tenant retention skills are present. Local-market access to opportunities is also active, withmultiple sources bringing deals to these operators to gain favor and become part of their team on the way back up.
The Time Is Now
Simply put, it's time for formal program investing. Plan sponsors hunger for yield, and operator skills will drive it. The sooner capital locks up quality operators, the more time will be available for profitable investing among true partners investing across multiple deals together.
Gone is the negative selection and the à la carte operator–capital partner shopping. If pension funds want to rationalize the number of managers in a given product type, geography, and investing style, why should the operator selection and execution part of the process be any different in the same macro environment?
In hindsight the 2010 programs between private equity and real estate operators were premature. As we head into Q4 of 2012, the time is right to take a second look at program investing. If you believe Europe, the election, the fiscal cliff, and so on will work themselves out soon, the time in the cycle for solidifying the operating execution solution is now.
Stephen J. Duffy is Managing Director-Real Estate at Moss Adams Capital (www.mossadamscapital.com) and can be reached at (949) 623-4178.
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