With an abundance of dry powder to deploy, confidence in improving real estate fundamentals and a wider net being cast in search of investment opportunities, private equity real estate fund managers may be closing in on a banner year and looking ahead to a more active 2015.
In its second-quarter 2014 survey of more than 100 private real estate fund managers, the London and New York-based research firm Preqin found that 37 percent planned to invest significantly more capital in the next 12 months than they had in the past year, while another 26 percent expected to spend slightly more.
But fund managers are looking harder to find opportunities. Preqin reported that 37 percent of fund managers were reviewing between 11 and 30 possible opportunities for each investment they made, while 20 percent were reviewing more than 50. Perhaps not surprisingly, they are casting their nets wider in terms of markets and risk profiles. Of the top 10 largest closed-end funds that closed in the second quarter, only one included “core” as a strategy (along with debt and distressed property), and that was to focus on Western Europe. The rest were aimed at debt, value-add, core-plus and opportunistic investments.
While they’re at it, fund managers are facing increasing scrutiny from their investors. A Preqin survey of 140 global institutional investors conducted earlier this year showed that “institutional investors are more focused than ever before on managers that have long track records and can point to strong performance in good and bad markets,” said Andrew Moylan, Preqin’s head of real assets products. Moreover, he said, investors “absolutely want more information,” including more frequent reports, because they are investigating their real estate portfolios more closely. There also has been an increase in separate accounts, he said, so investors have more control over where their capital is invested.
Robert O’Brien, global real estate sector head for Deloitte, which represents a number of private equity real estate clients, observed that these clients’ primary concern is the cap rate compression that has resulted from the extremely competitive acquisition climate.
The competitive climate has not discouraged fund managers from paying close-to-peak prices, however, he said, noting that pricing is not frothy and institutional investors are relatively unlevered. “The real concern around pricing is: What happens if interest rates tick up,” he remarked, adding that “there would be some correction in pricing if that happens, although it would most likely impact those with short-term holdings” (under five years) rather than intermediate or long-term investors.
O’Brien pointed out that a 30 percent increase in fundraising during the first half of this year, over 2013, has contributed to the uptick in dry powder. He reiterated Preqin’s findings that funds are focused on core and core-plus investments, seeking 8 to 9 percent returns, while opportunistic funds are targeting 18 percent and value-add investors are seeking something in between. There also has been increased interest in new development, mostly on the opportunistic side, he said.
While private equity companies have been net sellers for five years, O’Brien expects this to change within the next 12 months. “There will be some big net buyers and big net sellers, with 2007-2008 legacy portfolios,” he said.
A Top Performer’s Strategy
Preqin recently ranked 21 U.S. companies among the 26 top-performing global firms in private equity real estate that have most consistently outperformed their peers. Among the top performers, year after year, is The JBG Companies of Chevy Chase, Maryland — which also was NAIOP’s 2012 Developer of the Year and is the recipient of NAIOP’s 2014 Sustainable Development Award. (See “NAIOP Honors The JBG Companies for National Cancer Institute” on page 48.) The firm concentrates on just one geographic area: Washington, D.C., and its environs in Virginia and Maryland.
“We focus on the opportunistic space,” said James Iker, a managing partner and member of the firm’s Executive Committee. He explained that there is abundant capital available for core assets in Washington, D.C., but not for riskier or opportunistic investments in this market.
“Our strategy hasn’t changed much over the years,” he went on, noting that the strongest demand in the market is for urban walkable developments that create a distinct sense of place and are tied to transit. These kinds of high-impact, highly complex developments comprise JBG’s sweet spot.
One notable element of the company’s operating philosophy is its complete alignment with its investors, growing one opportunity fund at a time. “We don’t do anything for our own account,” Iker said. With that approach, the company has built a solid and loyal base of long-term institutional and high net worth investors.
How will JBG deploy its $680 million Fund IX? Iker expects that the region’s market will continue to experience a slow and steady recovery. Even in an environment of governmental uncertainty and double-digit vacancy, he said, there is still a need for net new ground-up office development that responds to tenants’ desire for efficient use of space, as well as for residential development that is well-served by transit.
“The rest depends on where the macroeconomic picture will be over the long term,” he said, adding that the company will be able to move between developing new income-producing properties and redeveloping/repurposing existing ones. The firm targets mid-to upper-teens in returns; its aim is always to outperform the market. As for pricing, Iker said, “it’s different than 2007. There have been a lot of aggressive acquisitions, but people understand what they’re buying. It’s less speculative and there’s less volatility. It’s all about the projections: lower growth and returns.”
One Company’s Perspective
Jim Clayton, vice president, research, at Cornerstone Real Estate Advisers, reported that on the private equity real estate side of its business, the firm is investing in core, core-plus and value-add properties. It has been investing in primary markets with an emphasis on the major gateway metros as well as growth markets in the South and West. Recent acquisitions have been made in Los Angeles, San Francisco, Dallas, Houston, Denver, South Florida and Austin, Texas.
Cornerstone is investing in all major commercial property types, including hotels. In terms of acquisitions on the core side, it has a slight underweight to apartments and overweight to industrial and retail. It also is targeting office properties in select locations.
Expected returns and holding periods depend on strategies related to the goals Cornerstone’s clients have for investing in real estate or in a particular real estate vehicle. For high-quality core property, Cornerstone expects to see high single-digit returns over the next few years as the interest rate cycle bottoms out and the economy gains momentum; it does not view the double-digit returns of the past few years as sustainable. Target returns for value-add investments depend greatly on the extent of risk being taken, but Cornerstone expects returns ranging from the low to mid-teens on a levered basis, with debt financing up to 60 percent.
“We do not think there is a correction coming in property pricing, though at the aggregate level there will be a moderation or a slowdown in appreciation as the cycle transitions from values driven by capital market forces (cap rate compression) to a stage where property income growth becomes the primary driver of value gains,” he remarked. Cornerstone is a net buyer but has taken advantage of the current environment to sell properties in sectors and markets with significant buyer interest and competitive pricing.