Private Equity's New Role

Although virtually all global economies are in a state of recovery, the majority of property markets are either flat or have improved only slightly. With the consolidation and disappearance of many Investment banks, the elimination of many of the commercial and savings banks, the difficulties encountered by owners and developers and the issues facing many other real estate players, two questions remain:

First, , does the current investment climate mirror that of the 1990s, which spawned the boom of CMBS and vulture funds? And second, what will create the next new influx of capital?

Growth of the property markets has been restrained by an absence of willing, able players, especially in the secondary markets, as banks, CMBS lenders and REITs continue to be burdened by distressed or defaulted loans. As these players have suffered with legacy assets, private equity has begun to provide the liquidity required to drive up property prices and resolve bad loans, replacing the capital markets.

Only some commercial banks are currently looking for new business while most remain burdened by nonperforming land and construction loans. In fact, more than 800 banks are currently on the FDIC bank watch list. Since the beginning of the year, at least 125 banks have been closed.

Similarly, CMBS lenders have experienced drastic declines. In the first three quarters of this year, the CMBS market saw only $4.8 billion of issuance. Nonetheless, CMBS issuance has recently been increasing and at the current rate could reach $11 billion by the end of 2010 and $24 billion in 2011. Compare that to the $13 7 billion that was issued in 2007. However, the improvement in the CMBS market is not as promising as it may appear, and 67.8% of all CMBS loans coming to maturity in the past 12 months have defaulted. Finally, despite tumbling prices in May, the REIT market has been steadily improving since March of2009. Nonetheless, over the next two years, more REITs are expected to make strategic defaults to renegotiate, refinance or to hand over the keys and walk away.

So private equity is poised to take a leading role in the real capital markets. In the absence of the predicted deluge of foreclosures, various sources estimate that private equity funds are sitting on more than $100 billion of capital. However, despite the large amount of money on the sidelines, only $34.2 billion of transactions were completed in the US through the end of this June, up 67% from a year ago but still nearly 90% below 2007 transaction figures.

Despite this relatively modest growth, recent reports indicate that 51 % of institutional investors plan on committing new capital to real estate over the next 12 months, with 63% of those planning to invest only in core and value-added strategies. In an environment where lenders are hyper-sensitive to risk, these strategies are the norm. Private equity generally reaches out to the real estate market following one of three strategies. Core plays focus on building a long-term, low to moderate risk portfolio of expensive, durable assets, usually comprised of class A properties. In the moderate-risk value- added strategy, trophy assets comprise the portfolio foundation, while riskier assets target higher returns, for example properties that require redevelopment or other improvements. An opportunistic strategy focuses on the highest available returns, including assets with broken capital structures, but features high-risk and little diversification.

Not surprisingly, there is intense competition for class A assets, driven by the surplus of private equity. When something does come to market, there is a frenzy because funds are eager to put capital to work. This supply-and demand disconnect, which will likely continue through 2012, creates an illusion of broad-based recovery, but most commentators agree that these transactions do not paint a good picture of what is happening for a substantial segment of the industry, since the quick rebound of class A values comes at the expense of Band C assets. Possibly, as private equity realizes that it needs to put more of its capital to work, it will look to Band C properties for opportunities before other lenders, injecting liquidity throughout all classes of property. Private equity has the potential to flush the markets with liquidity and, to an extent, has already begun to do so. However, the market still does not seem to have enough attractive supply for the private equity surplus .

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