JANUARY 2008 Investment PUBLICATION 1849
A Reprint from Tierra Grande
PRIVATE EQUITY
DJIA 13422.77 ∇ 294.26 –2.1% NASDAQ 2652.35 ∇ 2.4%
By Cydney Donnell
NIKKEI 16044.72
∇
0.8% DJ STOXX 50 3783.36 ∇ 0.6% OIL $90.02
∇
$2.16
Transforming Institutional models to accommodate the pension
fund industry. For example, pension
Investment Strategies
funds no longer accept a flat fee on asset
value as they did in the 1980s. Under
that structure, advisors had no incen-
tive to worry about the success of the
E
investment. They were concerned only
quity capital for real estate in- Real Estate Advisory with increasing the assets under their
vestment historically came from management. Today, advisors usually
wealthy individuals, but as com- Industry Restructuring receive rewards for successful invest-
mercial real estate markets developed Investing in real estate can be a chal- ments. For example, they may be per-
after World War II, sources of equity lenge for institutional investors. Few pen- mitted to co-invest with the funds or
capital began to shift. In the 1950s and sion funds or other institutional investors they may receive incentive fees when
1960s, life insurance companies were such as endowments and foundations the investments are sold.
predominate sources. Passage of ERISA have adequate funding to staff large re- Not surprisingly, the new model for eq-
laws regulating pension funds in the search and investing departments. Conse- uity real estate mimics successful invest-
1970s encouraged these institutions to quently, they outsource these activities to ment structures private equity firms such
diversify further and add real estate to investment firms. as Kravis Kohlberg use.
their investment mix. Traditional pension real estate advisors Pension investing originally was struc-
An investment binge by pension include Prudential, RREEF, Jones Lang La- tured around sole or joint ownership
funds in the early 1980s and the real Salle and Heitman. Many companies that of fully leased property. This low-risk
estate bust later that decade opened began as brokerage firms have entered
the door for public equity in the form this market, including Cushman Wake-
of REITs. At the same time, the insur-
ance industry began to exit equity real
field and CB Richard Ellis. Some real es- Institutional Investors
tate newcomers with Wall Street roots,
estate, leaving this investment area to such as Goldman Sachs and Lehman Institutional investors are
other capital sources. Brothers, offer funds as do classic buyout entities with large amounts of
Today, major equity investors in- firms (called private equity firms) such as money to invest, such as insur-
clude individuals, REITs and pension Blackstone. More and more firms are en- ance companies, mutual funds,
funds. They have one commonal- tering this arena. pension funds, foundations or
ity: the pursuit of competitive, risk- The responsibility of identifying ap- endowments. They are led by
adjusted returns. pro-priate investments, monitoring the investment professionals and
As real estate began to offer competi- in-vestments during the holding period are considered sophisticated
tive returns with less risk than stocks, and disposing of the investments is out- investors. They have fiduciary
the industry attracted huge inflows of sourced by institutional investors to these responsibility to other smaller
investment capital. This caused yields real estate advisors. Functionally, they investors, such as the mutual
and expected returns on real estate to have investment divisions and asset man- owners of the insurance com-
decline because massive pools of inves- agement divisions. Property management pany, the shareholders of the
tors were bidding on the same assets. may be provided but often is outsourced to mutual fund, and the beneficia-
Not surprisingly, investors now seek a third party. ries of the pension fund, founda-
new investment strategies to increase Real estate investment advisory firms tions and endowments.
expected returns. have been forced to change their business
Core Investments
investing, called core investing, no lon- Core investments are characterized For small institutions, public REITs
ger provides institutional investors with by a long-term strategy (holding proper- may represent their entire allocation
high enough returns to meet their pen- ty for ten to 20 years), stable income and to real estate. As institutions increase
sion obligations, so funds have had to ex- minimal active management require- in total asset size, public REITs may be
pand the kinds of investments they will ments (management involvement and used for a portion of the core allocation,
consider. To increase returns, pension expertise is less critical because of the to temporarily manage cash await-
funds and their advisors have embraced duration of the leases). Return expecta- ing other investment opportunities or
investment structures long used by the tions historically have been 12 percent as a leading indicator of the valuation
mainstay buyout firms along with new but more recently have been in the 7 changes of private real estate.
investment strategies that may not be fa- to 10 percent range. Core investments Core investments may also include
miliar to most real estate developers and include: strategies of investing in senior secured
investors. • publicly traded REITs, mortgages. These mortgages are viewed
Real estate entrepreneurs are increas- as low risk because they are senior to
• tenant sale/leasebacks,
ingly forced to turn to various institu- all other claims to the property, often
tional investors, including pension funds • substantially leased multitenant have a loan-to-value ratio less than 70
and their advisors, for capital. Under- commercial properties with long- percent and may have an investment
standing the goals and investment strate- term lease maturity schedules grade rating of BBB or better. A mort-
gies of the various types of funds is one and gage investment may be a single asset
key to sorting through the myriad invest- • senior secured mortgage lend- or “pooled” — several mortgages com-
ment products in the marketplace. ing. bined into a single security.
Value-Added Equity investment in commercial
Investments real estate seeks properties in need Collateralized Debt
C
onceptually, this strategy seeks
of redevelopment, repositioning or Obligations
recapitalization to improve operating
a higher return than a core income and value. Properties may be Collateralized Debt Obliga-
strategy. It usually involves acquired as sole ownership or joint tions (CDOs) are asset-backed
investing capital and management time ventures with experienced operat- securities. The CDO invests in a
subsequent to the initial investment. ing partners. Leverage ranges from pool of cash-flowing assets such
The investment horizon is generally me- 50 to 75 percent loan-to-value ratio. as car loans or real estate. Cash
dium term (three to five years). A value- Geographically limited to the United flows are then paid out to inves-
added strategy generally produces an in- States, these funds will sometimes tors based on a priority schedule.
come over the life of the investment but venture beyond major metropolitan These schedules are known as
expects a portion of the overall return areas to secondary markets. traunches. The traunch that re-
to come from the successful sale of the Structured real estate financial in- ceives cash flow before any other
investment. Targeted returns typically vestments are often subordinated loans is usually investment grade rated
range from 12 to 15 percent with 6 to 8 created from real estate debt portfolios AA or AAA. Subsequent traunch-
percent derived from income. such as commercial mortgage-backed es receive lower priorities and rat-
Management capability and exper- securities (CMBS), REIT debt and real ings with the lowest classified as
tise is critical in a value-added strategy. estate collateralized debt obligations junk or equity rating. Conversely,
Examples of value-added investments (CDOs). Fund managers seek to invest losses are applied first to the low-
include equity investments in com- in complex, “mispriced” securities est ratings. The term “commer-
mercial real estate, structured real es- that the investing public may not fully cial real estate CDO” usually re-
tate financial products and mezzanine understand. They may use financial le- fers to a security backed by REIT
financing. verage to achieve their assets.
return objectives. For example, they leverage is employed, thus increasing Redevelopment projects may involve
may seek to match fund securities by both risk and potential returns. Man- assets that have been neglected by an
issuing a CDO with the fund retaining agement must be talented in finding in- owner because of poor capitalization or
the CDO equity. These investments vestment opportunities because proper- lack of expertise. Value enhancement
typically require greater real estate ties acquired through auctions typically may be achieved by upgrading the as-
knowledge and analysis capability than conducted by real estate brokers are set quality or changing its use or design,
traditional fixed-income portfolio man- competitive and often will not produce which ultimately improves the proper-
agers may possess because the debt may required returns. ty’s financial performance. This process
be unrated, underperforming or both. Opportunistic fund investments are may be more difficult if desired changes
Mezzanine financing, a hybrid of debt more complicated because of financial, include obtaining entitlements.
and equity, uses a strategy of investing regulatory or tax requirements. They re- Development projects require iden-
in debt or preferred equity with equity quire expertise in structuring complex tifying shortages in a market and ac-
participation or conversion rights. The transactions and in asset/property man- cepting the inherent risk of creating a
typical investment horizon is short agement. Funds in this category gener- new project. While new development
term — less than three years. Mezza- ally target returns exceeding 15 percent. opportunities may be somewhat lim-
nine interests typically are subordinate Some strategies employed are: ited in the United States, many other
to first mortgages and senior to tradi- • asset and portfolio acquisitions, countries lack modern facilities. Typi-
tional equity. If the mezzanine loan is • redevelopment projects, cally, funds enter into joint ventures
not repaid, the lender usually converts • development projects and with partners who have local knowl-
the investment into an ownership po- • real estate operating company edge and experience.
sition. Management must be talented investments. Real estate operating company in-
in structured finance and extremely Asset and portfolio acquisitions involve vestments are those that finance or
knowledgeable regarding tax law. buying single assets and entire portfolios recapitalize businesses providing real
Opportunistic of real estate. Portfolios may have dispa-
rate product holdings located all over the
estate–related services or companies
that own real estate assets. Examples
Investments globe and may include fee simple hold- of service providers include hotel op-
These are the most intricate invest- ings, partial interests in real estate or erating companies, specialized mort-
ment strategies. A high portion of varying mortgage ownerships including gage lenders or property management
expected return comes from the sale subordinated loans. In many cases, this companies. Buyouts of publicly traded
of the property and may or may not strategy includes re-selling individual as- companies such as REITs fit into this
include any current return. Higher sets in the portfolio to other investors. category as well.
Real Estate Fund of Funds
T
he strategies discussed previ- fund managers to build an interesting raise capital in the institutional
ously are suitable only for the mix of investment strategies. An asset marketplace.
largest of institutional inves- management fee is added to compen-
Dr. Donnell (cdonnell@cgsb.tamu.edu) is
tors because a minimum investment sate the fund manager in addition to the
executive professor of finance and director
of $5 million to $10 million per inves- underlying fund fees. At this time, few
of real estate programs in the Mays Business
tor is required. A real estate fund of opportunities exist to invest in fund of
School at Texas A&M University.
funds (FOF) assists smaller institu- funds. However, interest in this product
tions (those with $25 million or less has been growing.
allocated to real estate) in diversifying The challenge for today’s institu- THE TAKEAWAY
their investment strategies. tional real estate investor is deter-
An FOF pools investor funds and Private equity firms have trans-
mining the investment strategy that
invests in real estate opportunities formed the ways institutional in-
meets its desired risk and return tar-
representing multiple strategies. For vestors invest in real estate. Core,
gets. Real estate firms hoping to be-
example, ten small institutions might value-added, opportunistic and
come investment managers for these
combine their money to meet the fund of funds investments use dif-
institutional investors must under-
minimum investment required by the ferent strategies to produce com-
stand these needs, the competition
FOF. The FOF then contacts existing petitive, risk-adjusted returns.
and the fund structures to successfully
MAYS BUSINESS SCHOOL
Texas A&M University http://recenter.tamu.edu
2115 TAMU 979-845-2031
College Station, TX 77843-2115
Director, Gary W. Maler; Chief Economist, Dr. Mark G. Dotzour; Communications Director, David S. Jones; Associate Editor, Nancy McQuistion; Associate Editor,
Bryan Pope; Assistant Editor, Kammy Baumann; Art Director, Robert P. Beals II; Graphic Designer, JP Beato III; Circulation Manager, Mark Baumann; Typography,
Real Estate Center.
Advisory Committee
David E. Dalzell, Abilene, chairman; D. Marc McDougal, Lubbock, vice chairman; James Michael Boyd, Houston; Catarina Gonzales Cron, Houston; Tom H. Gann,
Lufkin; Jacquelyn K. Hawkins, Austin; Barbara A. Russell, Denton; Douglas A. Schwartz, El Paso; Ronald C. Wakefield, San Antonio;
and John D. Eckstrum, Conroe, ex-officio representing the Texas Real Estate Commission.
Tierra Grande (ISSN 1070-0234) is published quarterly by the Real Estate Center at Texas A&M University, College Station, Texas 77843-2115. Subscriptions
are free to Texas real estate licensees. Other subscribers, $20 per year. Views expressed are those of the authors and do not imply endorsement by the
Real Estate Center, Mays Business School or Texas A&M University. The Texas A&M University System serves people of all ages, regardless of
socioeconomic level, race, color, sex, religion, disability or national origin.