The Trophy Chase Continues

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If any doubts remain that apartments are continuing their reign as queen of the prom, consider that the industry's biggest transaction since 2007 just occurred in that sector. Equity Residential and AvalonBay Communities will pay a combined $16 billion, including the assumption of $9.5 billion in debt, to acquire substantially all the assets of rival Archstone Inc. from Lehman Brothers Holdings Inc., the estate of the onetime investment banking giant that filed the largest bankruptcy in history four years ago.

The deal, which involves some 45,000 units across 144 complexes, mainly in coastal markets, does more than just raise Equity Residential's game, although chairman Sam Zell told Bloomberg Television earlier this month, “With this transaction, we'll be all barrier-to-entry.” Nor is it simply an illustration of the ongoing supremacy of multifamily, although it makes that point as well. It also speaks to growing investor confidence. “Sixteen-billion-dollar deals don't happen in an uncertain environment,” Dan Fasulo, managing director of Real Capital Analytics in New York City, tells Real Estate Forum.

That being said, Fasulo adds that if the Archstone sale closes before year's end, “It's probably going to make the numbers look a little better than they should, because we're kind of flat year-over-year right now. The momentum definitely has tempered. I wouldn't go so far as to say transaction activity has fallen back, but it has plateaued. It's really been apartments and CBD office that have kept the market afloat.” Nonetheless, Fasulo expects 2012 to close with about $260 billion of domestic sales volume, comparable to 2004 or 2005, if not to the market peak of a few years later.

Moreover, both Fasulo and David Rifkind, principal and managing director at Los Angeles-based George Smith Partners, cite the bifurcation between institutional-level players—and properties—and those in the lower echelons. Noting that economic fundamentals will have to show a broad-based improvement in order to support a broad-based investment sales market, Rifkind says, “Right now, we don't really have a real estate recovery. We have a chase after select assets in select markets.”

The recent Emerging Trends in Real Estate 2013 report from the Urban Land Institute and PwC sounds a similar theme. “As investors tentatively advance further along the risk spectrum in 2013 chasing yield, they suffer queasiness about the limitations of US real estate markets: there is just 'not enough product' to get the yields they want,” the report states. “Core real estate seems overpriced: plowing money into top properties at sub-5% cap rates looks unproductive, especially if and when interest rates inevitably go up. 'It's not the smartest thing to do' and 'could get ugly out there,' except for buyers and long-term holders of the best properties in the best locations.”

Yet for those buyers, commercial real estate is enticing in a low-interest-rate, low-yield environment. Calling the sector “a sweet spot” as far as investors are concerned, Starwood Capital Group's chairman and CEO, Barry Sternlicht, compared it favorably to the current expectations for vehicles such as stocks and Treasury bills. “A 4% yield looks funny to us historically,” Sternlicht told the audience at the second annual Global Real Estate Markets Conference, held Nov. 30 at the New York Stock Exchange and sponsored by the James A. Graaskamp Center for Real Estate at the Wisconsin School of Business. “But when they look at treasuries with a 1.7% yield, it's not bad.”

Fasulo notes that private equity players such as Starwood Capital and, even more prominently, the Blackstone Group, have “come back in a big way” this year. This past October, for example, Blackstone closed its Blackstone Real Estate Partners VII fund at $13.3 billion, reportedly the largest opportunistic real estate fund on record. Blackstone launched the global BREP VIII fund in April 2011 with an initial target of $10 billion; by the time it closed, about one-third had already been committed or invested across a variety of asset classes. The largest investor category in BREP VII was US public pension funds, according to Blackstone.

More recently, an affiliate of BREP VII, BRE Select Hotels Corp., bought Apple REIT Six for $1.2 billion, including the assumption of debt. BRE Select was formed expressly to acquire the Richmond, VA-based lodging REIT, which had built a portfolio of 66 hotels across 18 states. And earlier this month, a BREP VII affiliate took control of 13 lodging assets formerly owned by Eagle Hospitality Properties Trust after the Purchase, NY-based REIT failed to find a buyer for the hotels. The deals added to a Blackstone hospitality portfolio that already included the Motel 6 chain, acquired this past May for $1.9 billion, and Hilton Worldwide, which represented a $26-billion buy in 2007.

This past September, Bloomberg reported that Jonathan Gray, Blackstone's global head of real estate, was seeking buyers for more than 40 previous acquisitions, possibly including Hilton as well as Equity Office Properties. This would be in keeping with the private equity giant's longstanding modus operandi.

“We've had the same basic strategy for 20 years,” a time period in which the firm has averaged a 16% IRR annually, Gray told attendees at the International Council of Shopping Centers' New York National Conference earlier this month. “We call it: buy it, fix it and sell it,” whether to institutions or on the public markets.

Although his ICSC presentation focused on the firm's retail acquisitions in recent years, Gray charted Blackstone's acquisition strategy throughout the recovery more generally. He cited the macroeconomic factors that have given investors the willies since the near-collapse of the capital markets in 2008: sluggish GDP growth, even in emerging markets; high unemployment; curtailed government spending; and the health of the financial institutions at the center of it all.

“When you listen to all that, it makes you want to hide under the covers,” said Gray. “Instead, we went out and invested all this money.” And the firm is looking to spend even more: subsequent to Gray's ICSC presentation, Bloomberg reported that Blackstone was launching a Pan-Asian real estate fund, intending to raise at least $2 billion for investments in Japan, China, India and Australia.

If private equity firms such as Blackstone were in the ascendancy during 2012, their publicly traded counterparts maintained a slightly lower profile by comparison. “REITs were definitely the dominant players for most of 2010 and 2011,” Fasulo says. “Their market share fell a little in 2012, not necessarily because they had less access to capital. It had more to do with the fact that prices were getting pretty high and yields were getting low in most of the markets where they're active.”

He notes that if yields drop too low, “REITs are no longer buyers,” because they're required to pass through all their income. Many trusts have been involved in what Fasulo calls “non-traditional transactions,” such as buying debt to get access to a property or providing mezzanine financing.

A case in point is SL Green Realty Corp. The New York City-based office landlord has been active as a buyer as well as seller and as a source of rescue capital. In the past six months, the REIT has sold two assets (One Court Square in Long Island City and Procession House in London) as well as entering an agreement to sell a minority stake in a third one (521 Fifth Ave.); paid $173 million for two adjoining properties in Manhattan's Midtown South; acquired a newly built apartment building in its first Brooklyn residential investment; and bought the non-performing mortgage loan on 315 Park Ave. South for a reported $218 million. It also participated in a $746.8-million recapitalization of the so-called Cabi portfolio of West Coast office assets, although the recap concluded with Blackstone emerging as the majority owner of the joint venture.

Insurance companies, too, have been “very active” throughout the recovery, says Fasulo. MetLife, for one, started off 2012 in a $630-million joint venture with UDR to acquire a 710-unit multifamily complex on Manhattan's Upper West Side. It later entered a $548.8-million JV with Clarion Partners on 1230 Third Ave., a 1.1-million-square-foot office tower in Seattle, and on its own bought four towers in Chicago—one multifamily, the other three office—for a total of about $449 million, as well as the two-building Treat Towers office complex in Walnut Creek, CA for a reported $130.4 million. Earlier this month, it entered a JV with Loews Hotels & Resorts on ownership of the Loews Hollywood in Los Angeles; the two firms earlier had partnered on the Loews Atlanta.

In October, GlobeSt.com, sister organization to Forum, reported Prudential Real Estate Investors secured $805 million in discretionary capital for its US debt fund, and a total of $1.6 billion for its global debt strategy. Institutional investors in the US fund include pension funds, sovereign wealth funds and other prominent sources from the US, Asia and Middle East. The investors also have extensive co-investment capital to put into real estate loans.

“In the US, we expect significant demand for creative debt financing as approximately $1.8 trillion in mortgage loans come due over the next several years, leading property owners to search for reliable and trusted sources of capital,” Jack Taylor, who heads PREI's global real estate finance group, told GlobeSt.com.

Pension funds, too, continue to be “a good source of capital for the industry,” Fasulo says, although the funds don't always act alone. “If the downturn has taught the pension funds anything, it's that they need to be as sophisticated as possible when dealing with their direct real estate investments,” he says. “Sometimes that means hiring some of the best managers in the world.”

For instance, Los Angeles-based CommonWealth Partners LLC spent close to $1 billion on behalf of the California Public Employees Retirement System on core office assets over a three-month period earlier this year. The deals included the $480-million buy of Russell Investments' Seattle headquarters from Northwestern Mutual Life Insurance Co. in April and Hamilton Square in Washington, DC from San Francisco-based Shorenstein Properties for $200 million in June. On its own, CalPERS paid $500 million in October to take the 50% ownership it didn't already have in Woodfield Mall, a 1.1-million-square-foot regional mall in the Chicago suburb of Schaumburg, IL. The seller was another pension fund, of General Motors Corp.

Fasulo also notes an increase in so-called sidecar investments involving pension funds. “You give money to one fund and you can also co-invest with that fund on certain investments,” he explains. “The macro is that for pension funds, commercial real estate looks attractive right now versus the other assets.”

That appeal shows no sign of fading as we head into 2013, with the Texas Municipal Retirement System providing a case in point. At its board meeting earlier this month, the $19.3-billion fund committed up to $600 million to real estate investments for the coming year, with half going to core strategies including core investments and commercial mortgages. 

As you'll see in a News Front story on page 10 of this issue, a wave of distressed properties that was expected to roll in following the 2008 financial crisis may never arrive. That has left a number of would-be investors waiting on shore. “A lot of funds that were formed for purchasing large amounts of distressed assets didn't get to buy very much,” says Rifkind. “What we've seen in the past year is a reimagining of these funds that raised money with the distressed thesis. They realized that there isn't enough flow to be able to place those funds and they're retooling.”

The result, he says, has been “somewhat of a slack in institutional money, trying to figure out what it wants to be when it grows up. We're going to see more of those funds getting committed in 2013.”

Broadly speaking, Rifkind says investment decisions at present are driven more by “placing money and not making mistakes than by making broad entrepreneurial plays. The money that is out there now is careful and it wants to book some solid wins. The institutional pension funds and dedicated real estate funds are being careful. Their yield expectation is lower, and they're creating a lot of competition for a very small pool of investment grade properties in core markets. That's how the big investment funds are playing and will continue to do so into the new year. The bold investment plays are being made by the middle-market entrepreneurs.”

Although there are still relatively few transactions outside of gateway cities, Rifkind says that's changing. “As institutions start to reach for more yield, they're going to need to reach out of these safe markets and start buying in secondary markets,” he says. Fasulo sees it happening already: “We have definitely seen capital move from the primary markets to secondary markets,” he says.

However, Fasulo cautions against making blanket statements about secondary markets per se. “It's as though we've gone one notch below the primary markets, but there are some secondary and certainly tertiary markets that are being left out of the party,” he says. Among the second-tier markets that are generating investor interest, he says, are Seattle, Denver, the major Texas cities, and “even places like South Florida and Phoenix.”

The low-interest-rate and low-cap-rate environment that has sustained investor activity for at least the past two years is likely to be with us through next year and probably into 2014, says Rifkind. “But real estate's a bet on long-term store value, and what you're really buying is a multiple on future revenue,” he says. “At some point you have to bet that rents are going to go up and occupancies are going to improve. Interest rates have been the fuel up to now; that fuel is starting to run dry, so we've got to look to jobs and improved fundamentals to be the next driver of investment.”