Equity: Wall of money or begging bowl?
Substantial amounts of equity are piling up for commercial property. But the price needs to be right and the difficulty of accessing leverage is a serious impediment to mobilizing funds. Phil Moore reports.
As in the debt market, there is no shortage of demand for real estate equity investment. A war chest of equity worth more than €50 billion has been amassed by a range of institutions and third-party money managers, earmarked for investment in commercial real estate. If some of those funds start flowing into Europe’s beleaguered real estate markets, the collapses in value of up to 40% in some markets might be decelerated and even reversed. At least, that was the conclusion reached by Jones Lang LaSalle in its report on the outlook for European capital markets published in January.
Tony Horrell, head of European capital markets at JLL in London, says that the figure of €50 billion is a conservative estimate. Some of the 400-odd investors polled by JLL were third-party money managers whose end-investors might still be waiting for further expected falls before giving their managers the green light to commit fresh funds to the real estate market. Nevertheless, €50 billion is an impressive tally and, Horrell says, is made up of a diverse range of players with different return profiles. According to him, opportunity funds account for about 20% of the total equity raised, international wealth entities (principally family offices) for 10%, German open-ended and closed-ended funds for about 18%, third-party money managers for just over 20%, institutions from around Europe for a little under 20% and private investors for about 5%.
When that money will start to make its presence felt in underlying real estate markets is anybody’s guess. "Our aim was to identify how much capital has been made available to participate in European real estate markets over the next year," says Horrell. "Whether those investors choose to commit some or all of those funds or to delay their investments, who knows? There are certainly some markets where investors will continue to sit on the sidelines and wait for more pain to come out of the banking sector, but conversely there are some markets where investors are beginning to tread as they perceive fair value emerging."
Market participants, however, remain cautious about surveys such as JLL’s. First, they say that in many cases the significant discounts to net asset value in the quoted sector might not be as compelling as they seem.
"When you’re looking at discounts to NAV the key is the ‘v’," says Bill Hancock, head of European acquisitions at JER Partners. "A lot of the UK companies are reporting that their NAVs have fallen by 15% or 20% or even 30%. But given that direct real estate values fell by 30% in 2008 according to IPD, a company with 50% leverage would have seen its NAV fall by around 60%, all other things being equal. So although I’m sure there are opportunities in the listed space, I’m not certain that the apparent pricing arbitrage in the listed sector is as clear cut as it would seem."
Another reason for caution is that while there is certainly plenty of money on the sidelines, some insist that the lion’s share of that war chest tends to be much more highly concentrated than a number of surveys suggest. "A lot of the equity we’re talking about is in very few hands," says a market participant. "For example, Blackstone has €10 billion to invest and Morgan Stanley has €6 billion, so you don’t have to add up too many of the leading players to get to half of the €50 billion. But if you talk to these guys they can’t do anything in scale because they can’t access debt."
This feeds into perhaps a more important reason for caution, which is that there is general agreement that no matter how plentiful it might seem to be, equity provides only part of the ammunition that is needed if it is to deliver on its potential to re-energize the European commercial real estate market. That is especially important for opportunistic funds, says JER’s Hancock. "Although the market may look attractive, the key questions for an opportunistic investor like JER are, do we need leverage? And can we get leverage?" he explains. "Because if you are looking to buy on an unleveraged basis you have to believe that you’re going to achieve a very significant value uplift over the next five years, or you need to be confident that you will be able to releverage significantly within that time frame. So availability of debt is a big constraint for some investors, although it is also a competitive advantage for those who are able to access as well as to restructure debt."
The arithmetic appears to be straightforward. A recent presentation delivered at the Drivers Jonas UK investment seminar 2009 – appropriately subtitled An opportunity for some – asked if for real estate investors internal rates of return of 15% should be the new benchmark in an era when leverage remains scarce. In the bull market, this presentation noted, an asset value of £100,000 generating net income of £10,000 with £80,000 of leverage and a cost of debt of 7% would have generated a return on equity of 22%. In today’s straitened environment, the same asset value generating the same net income, but with 60% leverage at the same cost of debt, would produce an ROE of 15%.
For analysts and investors assessing the immediate outlook for the key drivers of the market, such as real estate investment trusts, this would seem to suggest that one of two things needs to happen if the wall of equity on the sidelines is to inject fresh life into the real estate market. The first is for banks to suddenly rediscover their appetite for lending. That is as true in continental Europe as it is in the UK.
"Bank refinancing clearly remains the bottleneck in Germany," says Lutz Behrendt, managing director and head of German investment at DTZ Zadelhoff Tie Leung in Frankfurt. "The equity waiting on the sidelines equates to 50% of the overall investment required, which means you need a 50% loan. Pure equity only takes us halfway, which is why everybody is looking to the banks and hoping and praying that they will open up their lending books again soon."
The dispiriting consensus is that it is highly unlikely that commercial real estate lending will reappear anywhere near the top of bank’s to-do lists within the foreseeable future. As JLL commented in its Capital markets outlook for 2009, published in January: "We fully expect that it will take three to five years for banks to repair their balance sheets and that they will only begin to address this problem in 2009. They will most likely be ultra-cautious and conservative in the handling of their outstanding real estate exposure and highly selective in their lending criteria. This all points to a year of limited real estate debt finance, low loan-to-values at around 60% and high margins until that time when inter-bank lending is more free-flowing and at traditional margin levels."
Reits are not going to die wondering about the prospects for a deus ex machina in the form of bank lending that would allow them to start reinvesting. Instead, market participants say they will have to move quickly to reduce the debt that is weighing so heavily on their balance sheets. One way of doing so would be to engage in an aggressive round of asset sales, which is the medicine prescribed in a recent note published by Goldman Sachs. The note argues that in order to bring loan-to-value ratios to more manageable levels, UK Reits need to offload some 27% of their assets, worth an estimated £16 billion ($22.75 billion).
A second option, which some UK Reits have already started to explore, would be for the property companies to pass their hats around among their existing shareholders.
"Because capital values have almost halved in the space of two years, even those Reits that were very conservatively financed at the top of the cycle at LTVs of 30% or 35% risk coming under covenant pressure," says Alex Ross, manager of the Premier Pan European Property Share Fund. "So I expect we will see some fairly widespread equity issuance in the UK Reits sector. In the short term, that will create further volatility, but ultimately it will act as the catalyst we need to spark some sort of stabilization in the underlying property market. Re-equitization of the market will allow Reits to refinance their balance sheets at LTVs below 50% and to start reinvesting in assets at attractive yields of 8% or 8.5%. So although we are cautious in the short term, we believe that recapitalization of the sector will create a once-in-a-generation opportunity for the Reits sector."
Certainly, for those companies with soundly structured balance sheets and with access to debt, there would appear to be an increasingly attractive range of investment opportunities in the commercial real estate sector. "UK commercial property is now yielding well over 7% and heading towards 8%, while base rates, swap rates and Libor are all coming down," says Ross. "Even with high margins of 250bp to 300bp on top of those lending rates, bringing the all-in costs of borrowing up to almost 6%, the risk-return equation is starting to make more sense for investors."
As one example of a transaction that may turn out to have been completed at a turning point for the UK investment market, a number of observers point to the recent £74 million acquisition by London & Stamford Property of One Fleet Place. The office building near Victoria Station in London, which was bought by Legal & General from British Land for £119 million in 2005, is leased to law firm Denton Wilde Sapte until 2025 for £36 per square foot.
"London & Stamford’s rationale is that it can generate an annual ROE of 13% compared with 1.5% or 2% on cash," says Ross. "So even if capital values continue to fall and yields go out to 8.5%, for investors with cash the opportunities are looking increasingly attractive."
AEW Capital Management is one such investor poised to take advantage of these market conditions. It raised €800 million last year for a new fund targeting investment opportunities from growing dislocations in European real estate markets.
"With €800 million of equity capital and a large revolving credit facility of €500 million we feel that we are pretty well armed to take advantages of opportunities as they arise," says AEW’s chief investment officer, Ric Lewis. "We are still fairly cautious, but I am comfortable that the assets the fund has acquired so far, which are mainly in the UK, represent real value with significant downside protection."
Assessing that value, however, is a much more difficult exercise than it was some years ago.
"Over the last three to five years it was pretty easy to buy up assets assuming that yields would carry on compressing," says Lewis. "Now I think we’ve had to go back to basics. We can no longer afford to be the fancy guys at hedge fund conferences; instead we need to be looking carefully at the bricks and mortar and building the finance around it. It’s more difficult than it used to be, but if you have the right financial structure and the right perspective, it’s not impossible."