PE Funds Hit Targets by Finding Niches

NEW YORK CITY—Terming the amount of global capital earmarked for real estate investment “extraordinary,” EY notes that the ravenous investor appetite bodes well for the industry at the macro level. However, it does create challenges for private equity players trying to allocate funds or hit return targets, EY says in its new “Global Market Outlook” report on real estate private equity.

“With few exceptions, institutional investors are competing for core assets in global gateway cities,” according to EY's report. “Whether they are Canadian pension funds, sovereign wealth funds, or Asian and Middle Eastern high-net worth investors, all are looking for long-term assets in these markets.”

A notable absence from bidding wars in the two top gateway markets, New York City and London, is the PE community. “More can be found searching for yields in markets and asset types that fall farther along the risk curve,” says EY.

Domestically, says EY, the uptick in interest outside of gateway markets has begun to create heat in some well-known secondary cities, among them Atlanta, Seattle and parts of South Florida. “Investors engaging in these parts of the country are betting on increasing demand for high-quality assets and have pegged their chances for a high-yield exit,' EY says.

Private equity interest in development has also picked up in US markets, with EY citing funds that have backed new hotel and distribution space construction in particular. On the industrial and distribution side, the global advisory firm points to “a surge in new construction” underway in Florida as a direct result of the ongoing Panama Canal expansion.

However, EY says that “new development in any asset category outside of multifamily has not yet reemerged significantly in secondary markets,” due to the level of risk. “Equity requirements on new projects remain between 50% and 65% on average, and most lenders require some form of construction guarantee.”

EY also looks at other markets globally and pinpoints where PE funds have managed to find niches. In Europe, for instance, a proliferation of foreign investors—including those that have begun considering core-plus deals—means that “for opportunistic private equity players, returns are becoming narrower and narrower in Europe's northern markets. As a result, they are migrating south, to Spain and Italy, where price discovery is underway through increasing transaction activity.” PE players continuing to look at opportunistic plays in the continent's northern markets are becoming involved in “larger, more complicated transactions,” such as ground-up construction.

The B in BRIC, Brazil, has faltered lately in terms of economic performance, and this has dimmed investor enthusiasm in the country's real estate. Two areas where EY says PE funds have found near- to long-term investment opportunity in Brazil, though, are logistics and retail.

“The logistics market is currently in growth mode with a spate of redevelopment projects converting single-owner warehouses into modern, professional-grade properties,” EY says. As for retail, growth has slowed considerably, even as Brazil is generally perceived as underbuilt in terms of retail, especially shopping malls.

Fund activity in the Asia-Pacific region has centered on Australia lately. “Historically an institutionally owned market, Australia is beginning to open up to new sources of capital with a need for recapitalizations, redevelopment and new construction in its aging real estate stock,” according to EY. “A key source of the new money coming into Australian cities is Asian funds, which see Australia as a core market.” The funds have shown themselves willing to explore higher risk opportunities there thanks to Australia's comparative stability.

In short, EY says, PE funds are finding that “there is no shortage of deal opportunities that will meet or exceed their return targets, regardless of their geographic focus.” But given the tremendous appetite for core assets in gateway cities, finding the opportunities means “continuing to identify new holes in the market to fill or accepting a greater appetite for risk. 2008 should continue to serve as a reminder, however, that the market can only be pushed so far.”