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Global Real Estate – Entity Level Investing

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					Global Real Estate – Entity Level Investing

The globalization of the economy, businesses and capital markets and the            y Jonathan
ubiquitous internet are creating intense competitive pressure, while simulta-
neously redefining traditional relationships in the economy, political environ-       Short
ment and even society. The changing landscape has important implications
for institutional investors in terms of the sources of opportunities and risks.       Managing
Together with fundamental changes taking place in financial and real estate
markets across different regions, the new global marketplace creates unique           Director,
opportunities to realize higher risk-adjusted returns by investing in real estate     PRICOA
through entity level investments.                                                     Property
    Broadly speaking, the objective of entity level investment is to participate
in value creation at the entity level by selectively investing in real estate         Private
companies, private or public, where the potential exists to create significant        Equity
incremental value. There are several characteristics that distinguish the entity      Limited
level approach to real estate investment from merely acquiring or developing
real estate assets. First, entity level investing involves acquiring a significant
equity position, usually a controlling interest, in a private or public real estate   Prudential
company. Second, entity level investing often entails the active involvement
of the suppliers of capital in the strategy and sometimes even the manage-            Real Estate
ment of the company. The relationship between the entity and the investors            Investors
typically goes beyond the infusion of capital into the entity, and often in-          International
volves providing capital markets and strategic planning expertise, as well as
strategic business relationships necessary to realize the full value embedded
in the entity.
Models for Execution
The various means by which investors can participate in this value creation
can be described by two investment models: the venture capital model and
the arbitrage model. The venture capital model targets companies that have
unrealized growth potential due to inefficient or ineffective management, or
a lack of capital and financial market expertise needed to exploit a market
opportunity or niche. Investors, typically operating through funds, provide
the capital and expertise needed to take advantage of market or niche oppor-
tunities, and then harvest the gains when most value creation has been
achieved. Value can be created through growing emerging companies as well
as through restructuring and repositioning existing, mature companies.
    There are several factors that are important to the success of the venture
capital model. First, there must be a market opportunity, either a market
niche, or an expanding, preferably high growth market, in which to grow the
company. The optimal market conditions for the venture capital model are
typically found in economies that are highly dynamic–Latin America, for
Reprinted by permission from the Institute for Fiduciary Education (IFE) from papers published in conjunction with
International Investmenting for Pension Professionals, a seminar held in Florence, Italy, July 9-14.
INTERNATIONAL INVESTING FOR PENSION PROFESSIONALS

example – and/or are in major transition, like Eu-     tion of these secular forces as the world increas-
rope. Second, there must be a well defined, clear-     ingly becomes defined by economic boundaries
ly articulated strategy for taking advantage of the    rather than political boundaries. These forces are
market opportunity. Third, the entity in which         particularly evident today in Europe, which is
the investment is to be made must have the right       undergoing radical structural changes as a result
management to execute the strategy. And fourth,        of Economic and Monetary Union, or EMU. The
particularly important from the investors’ per-        introduction of a common currency, the euro, and
spective, the execution of the investment, the         the transition to a unified capital market are cre-
entrance and exit, must be timed carefully. Specif-    ating opportunities for entity level investing as
ically, the entrance should take full advantage of     businesses reorganize in response to the broader
the greatest period of growth and value creation,      playing field and more intense competition.
and the exit strategy must be clearly defined and           The more obvious source is the cyclical na-
ideally provide one or more alternative options.       ture of economies and real estate markets that
    The second investment model, the arbitrage         guarantees that at any given point in time, differ-
model, can be both a means unto itself and an          ent regions of the global economy will be in dif-
exit strategy for the venture capital model. This      ferent phases of their economic and property
approach exploits the opportunities created by         cycles. In Asia, for example, certain markets are
the interaction between the public and private         showing signs of recovery from the economic and
capital markets and sometimes the pricing ineffi-      currency crises of 1997, and their public real es-
ciencies between the two markets. Because the          tate markets, some of which are well developed,
public and private markets often price assets dif-     offer interesting opportunities to participate in
ferently for reasons relating to growth, cash flow,    the cyclical recovery by investing directly in real
management, strategy or some combination               estate companies. Any time there is a wholesale
thereof, opportunities exist to realize the “hidden”   withdraw of capital from a market, as there was in
value embedded in a company through arbitrage.         Asia in 1997 and 1998, access to capital itself
    In its simplest form, the arbitrage model in-      becomes the greatest competitive advantage. At
volves either taking a public company private          such times, entity level investments are often the
when the public market values a company at a           most efficient and effective way to acquire hard
significant discount to its net asset value, or tak-   assets. Well managed companies that have access
ing a private company public when the public           to capital are an ideal platform through which
market commands a significant premium to the           investors can benefit from both the cyclical re-
net asset value. More sophisticated approaches,        covery of the assets and from the growth of a
however, require a deeper understanding of the         company which, properly capitalized, should
public market pricing dynamics as well as the          have a competitive advantage to take advantage
behavior of investors in the property markets.         of distressed market conditions. Further, in mar-
Like the venture capital model, the successful         kets where a well established public market exists,
execution of the arbitrage model requires the          entity level investments represent a cost efficient
careful articulation and effective implementation      way to exit investments made during a cyclical
of a strategy for creating value for the entity. Not   trough by selling shares in the public market.
surprisingly, arbitrage opportunities are most              Finally, there are the dynamics of emerging
prevalent in markets that have emerging or well        market economies. While in reality these are of-
established public and private real estate markets,    ten a powerful convergence of cyclical and secu-
and particularly when either the public or private     lar forces, the unique characteristics of the
market (or both) are in transition–as they are in      emerging markets themselves warrant a separate
Europe.                                                classification and investment approach. Specific
                                                       characteristics contributing to entity level invest-
Sources of Opportunities                               ment opportunities in emerging markets include
The opportunities for entity level investments         the high demand for property resulting from the
around the globe can be classified according to        rapid growth and expansion of the economy, and
three types or sources. The most powerful source       the lack of foreign capital, expertise and under-
of opportunities is the secular forces that are        standing of international standards and business
transforming the global economy. The very pro-         practices. With the strong demand for foreign
cess of globalization itself is perhaps the culmina-   capital and opportunities to export business prac-
                                                      GLOBAL REAL ESTATE–ENTITY LEVEL INVESTING

tices and real estate concepts to local real estate    Even national governments, now held to new
companies, investors can participate in value cre-     standards of fiscal policy and economic manage-
ation at the entity level. But the risks–currency,     ment by the European Central Bank, are being
inflation, political, for example–can be consider-     challenged by the new environment to improve
ably higher in emerging markets. Hence, the abil-      efficiency.
ity of the fund sponsor to identify companies that         These long term trends are already manifest
possess the management, strategy and market            in the corporate restructuring, consolidation and
position required to take advantage of the rapid       privatization taking place across Europe. Histori-
economic growth is especially critical.                cally, European companies, and financial institu-
                                                       tions in particular, have been major owners of
Secular Opportunities                                  corporate facilities. By substantially reducing bar-
The new dynamics in the global economy and             riers to market entry, EMU is forcing corpora-
the opportunities for entity level real estate in-     tions and financial institutions to restructure and
vestments are readily apparent in Europe. The          improve economic efficiency in response to com-
most important factors contributing to these op-       petition. Today, the single market and deregula-
portunities are the secular changes occurring as a     tion issues are forcing companies to focus on core
result of the transition to a unified European         activities and divest under-managed real estate
economy. Rarely does an historical occurrence          holdings. This pressure is creating both a signifi-
lead to profound, seminal change in a single           cant pipeline of quality assets and demand for
country, let alone a region of 15 nations and 300      well-managed, professional real estate operating
million inhabitants. But today, extraordinary and      companies.
fundamental changes are being wrought in the               The restructuring is not, however, limited to
European Union (EU) by the implementation of           the corporate sector. EMU is also fostering a
Economic and Monetary Union.                           “competitive” environment among governments
     Two forces in particular will drive the pan-      as countries are being required to comply with
European market in the future and make the Eu-         new standards of fiscal policy and management.
ropean economy fundamentally different from            Governments throughout Europe are seeking to
the past. The introduction of a single currency        transfer ownership of under-managed assets to
and consequent creation of a unified capital mar-      the private sector at bulk sale prices to fund bud-
ket has transformed former national “seas” of capi-    geting requirements, again creating a substantial
tal into a single “ocean” where the scale and cost     pipeline of institutional quality assets that have
of debt and equity has been substantially reduced.     generally never been accessible to the private
The harmonization of the financial, accounting         sector.
and regulatory environment and further integra-            The ongoing corporate restructuring is also a
tion of the economy have been removing many            driver of the consolidation trend underway across
of the barriers that once separated markets, lead-     nearly all industries in Europe, including real es-
ing to the development and refinement of higher        tate. Many companies, previously protected by
standards for goods, services and professional         domestic legislation and inadequate transparency,
practice–a natural result of a more competitive        are now having to respond to the opportunities
environment.                                           and challenges brought about by EMU. The re-
     The principal long term effects of the conver-    moval of currency risk and the creation of a single
gence of the currency, interest rates and econom-      common currency within the 11 members of the
ic policy should be greater stability and a higher     Euro-zone has dramatically increased the scale
trend growth rate as markets become larger and         and incidence of European Union (EU) cross-
more efficient. The potent combination of the          border investment. For example, mergers and
euro currency, financial deregulation and single       acquisitions this year are expected to exceed, in
market legislation has also created a more com-        US dollar terms, total transactions in the US.
petitive business environment in which compa-              The impacts of these secular changes on the
nies are no longer constrained by national bound-      real estate industry are numerous, but overwhelm-
aries. Increased competition and greater               ingly positive. Among the trends creating oppor-
transparency are already challenging European          tunities for entity level investment are the enor-
business and commerce to improve profitability,        mous potential for the expansion of the public
returns on equity invested, and shareholder value.     debt and equity markets, the need for and pro-
INTERNATIONAL INVESTING FOR PENSION PROFESSIONALS

gression toward pan-European real estate compa-        corporate users for professional real estate com-
nies, and the introduction of new real estate con-     panies to manage their increasingly pan-European
cepts including financing innovations and non-         property needs is increasing the importance of
traditional property types.                            scale and breadth. Together, these forces create
    A critical element of these opportunities is the   opportunities to grow real estate companies of
creation of pan-European public equity and debt        scale by providing the requisite capital, expertise
markets. Prior to Economic and Monetary Union,         and strategic planning. Further, growth of these
the public equity markets were generally con-          companies and investors’ opportunities for exiting
fined to single countries or even cities, and the      investments in them will be facilitated by the
public debt markets were very immature. Europe-        expanding public equity and debt markets.
an real estate markets, public and private, were            The fragmented tradition of the real estate
also relatively immature, having been confined         industry, broader economic playing field and
for the most part to their domestic boundaries.        more competitive environment are also encourag-
With the creation of a unified capital market,         ing innovations in the development of new prop-
however, the public debt and equity markets are        erty types. Formats like outlet shopping centers,
changing very quickly. The market for securitized      senior assisted living, and self-storage facilities, all
debt has become much broader, more sophisticat-        of which are quite familiar in the United States,
ed and more innovative. Twenty-nine debt securi-       are relatively new in Europe and are being intro-
tization transactions were completed in the first      duced on a relatively small scale with success.
quarter of 2000 for a total of US$14.5 billion,        There are even opportunities among the more
including US$3.8 billion worth of commercial           traditional property types due to the diversity
mortgage-backed securities. In the equity mar-         that still persists across different European prop-
kets, individual exchanges are seeking alliances       erty markets. The supply of retail space, for ex-
with one another to take full advantage of the         ample, varies significantly from country to coun-
unified capital market. With the recent announce-      try, with Germany, Italy and Belgium having less
ment of mergers between the bourses of Amster-         than half the shopping center densities of the
dam, Paris and Brussels, now known as Euronext,        UK, Sweden and France. These market dynamics
and the London Stock Exchange and Frankfurt            offer opportunities to create and rapidly grow
bourse, which merged in May to create “iX,” com-       companies that can take advantage of new or un-
panies now have unprecedented access to capital,       der-served markets.
while investors have unprecedented access to a
broader array of opportunities.                        Cyclical Opportunities
    The new dynamics significantly change the          While secular events are the dominant force creat-
opportunities for real estate operators and inves-     ing entity level investment opportunities in Eu-
tors. The elimination of exchange rate volatility,     rope, cyclical factors can also be an important
for example, provides further incentives for finan-    source. In the case of Europe, most obvious today
cial institutions to make cross-border loans, while    is the disparity in the value of the euro against the
the emergence of the commercial mortgage-              US dollar, which gives many non-European inves-
backed securities market creates opportunities for     tors significant buying power. Additionally, much
pan-European CMBS transactions, the first of           of the region is experiencing an economic recov-
which was introduced in March of this year. The        ery and the accompanying resurgence of tenant
broader and more liquid public markets will pro-       demand and rental growth. While these favorable
vide attractive exit opportunities for real estate     market conditions make a compelling case for in-
investments, particularly entity level investments     vesting in real property, public real estate compa-
via initial public offerings, mergers and consolida-   nies in Europe continue to trade at significant dis-
tion.                                                  counts to net asset value. This public market
    The forces driving consolidation in the real       discount affords investors opportunities to both
estate industry come both from within the indus-       acquire assets at significant discounts and partici-
try and from outside the industry. Internally, the     pate in the dynamic corporate environment by
competitive environment together with more             investing directly in real estate companies.
efficient capital markets is forcing consolidation          The entity level investment opportunities
of ownership among traditionally fragmented and        created by cyclical factors are not confined to
passive property owners. Externally, the needs of      Europe, of course. In Asia, these factors are even
                                                       GLOBAL REAL ESTATE–ENTITY LEVEL INVESTING

more pronounced, and are the dominant source            tries can both trade freely with one another and
of investment opportunities in most markets. The        collectively participate in international trade.
collapse of the economy, currencies and real es-            Because of this new economic and political
tate markets in the latter half of the 1990s had a      environment, the economies of Latin America
severe impact on property values, financial mar-        may very well be on the verge of fully realizing
kets and real estate companies. Many markets,           their growth potential. Like in Europe and Asia,
however, began to recover in 1999. All of the           Latin American real estate companies tend to be
Asian economies, with the exception of Indone-          local, under-capitalized entities. Opportunities
sia, experienced positive GDP growth in 1999,           exist to provide the much needed capital and ex-
and the growth rates of several economies were          pertise to companies that can exploit inefficien-
far higher than had been expected at the begin-         cies in the local markets to meet the growing de-
ning of the year.                                       mand for housing and commercial property as the
     Although Asia is not undergoing the type of        economies grow wealthier and attract more for-
secular transformation being brought about by           eign direct investment.
EMU in Europe, the economies are highly dy-
namic and heterogeneous, and the recovering             Conclusion
markets are creating opportunities to recapitalize      The highly competitive business environment
existing companies and to form partnerships with        created by the secular and cyclical changes taking
local operators. Like in Europe, there are numer-       place across different regions is providing compa-
ous opportunities to create value at the entity         nies with greater incentive to deliver value to
level by introducing new concepts and property          shareholders by maximizing efficiency and return
types, as well as by providing the capital neces-       on equity invested. This environment and the
sary to grow new and under-capitalized compa-           expanding economy are also increasing produc-
nies that have strong management and a strategy         tivity–a positive trend for all investors–and, in the
for exploiting market opportunities.                    process, creating more wealth and demand for
                                                        services and goods of all kinds, including real
Emerging Opportunities                                  estate.
Few investors will deny the enormous potential of            Beneath all companies and across all markets
the emerging market economies in different re-          there is one constant, real estate. Hence, the forc-
gions of the world, from Eastern Europe, to Asia        es that are creating investment opportunities
and Latin America. The dynamics of emerging             across all other industries ultimately, in one form
markets provide ample, albeit riskier opportuni-        or another, influence the use of and demand for
ties for entity level investments. In many respects,    real estate. While these forces can be a source of
these opportunities are created by the conver-          risk, particularly for passive investors, they are
gence of the secular and cyclical factors as the        overwhelmingly a source of opportunities. Inves-
economies become more integrated into the glo-          tors can access these opportunities through a
bal capital market.                                     number of different strategies which fall along the
     In Latin America, for example, economic and        risk/return spectrum from relatively low risk, di-
political reform based on free enterprise, free         rect private investment in core properties to high
trade and the democratic form of government has         risk, opportunistic strategies involving complex
largely taken hold. In startling contrast to its im-    financial engineering.
age in the 1980s, when Latin America was                     Investments in real estate companies are con-
plagued with economic and political crises, the         siderably more risky than a core strategy, and
region today has become a politically and socially      therefore require higher rates of return to com-
mature, highly dynamic economic bloc. The               pensate for the incremental risk. But the strategy,
changes taking place across Latin America are           executed through the venture capital and arbi-
both fostering and being facilitated by a spirit of     trage investment models, offers investors the op-
regional cooperation. Regional trade agreements,        portunity to earn higher risk-adjusted returns by
such as MERCOSUR, are working to establish a            participating in both the favorable conditions in
common market among all South American coun-            the property markets created by the expanding
tries over the next five years. Taken as a whole,       economy and the value creation at the entity level
the region would represent a formidable econom-         created by secular and cyclical changes, and the
ic bloc through which individual member coun-           dynamics of emerging economies.
Notes

				
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Description: The globalization of the economy, businesses and capital markets and the ubiquitous internet are creating intense competitive pressure, while simultaneously redefining traditional relationships in the economy, political environment and even society. The changing landscape has important implications for institutional investors in terms of the sources of opportunities and risks. Together with fundamental changes taking place in financial and real estate markets across different regions, the new global marketplace creates unique opportunities to realize higher risk-adjusted returns by investing in real estate through entity level investments. Broadly speaking, the objective of entity level investment is to participate in value creation at the entity level by selectively investing in real estate companies, private or public, where the potential exists to create significant incremental value. There are several characteristics that distinguish the entity level approach to real estate investment from merely acquiring or developing real estate assets. First, entity level investing involves acquiring a significant equity position, usually a controlling interest, in a private or public real estate company. Second, entity level investing often entails the active involvement of the suppliers of capital in the strategy and sometimes even the management of the company. The relationship between the entity and the investors typically goes beyond the infusion of capital into the entity, and often involves providing capital markets and strategic planning expertise, as well as strategic business relationships necessary to realize the full value embedded in the entity....