Will private equity and opportunity funds be frozen out as the banks begin to unlock credit and become more choosy about who they chose to team up? Dean Hodcroft reports

Twelve months ago the real estate investing world was divided into two types of people - they were either depressed by the banking sector turmoil or excited by the opportunities it created, or at least by the opportunities that seemed to be created.

Real estate private equity funds and opportunity funds were licking their lips at the prospect of acquiring assets on the cheap from the major European real estate lenders, most notably RBS, HBOS and Hypo. In fact, in the UK, the banking turmoil alone appeared to have the power to bring investment capital back to the UK from its extended holidays chasing racier yields in Russia, India and Vietnam among other countries.

There was an expectation that the Resolution Trust Corps' (RTC) much bigger brother might be just around the corner getting ready to trade its prized assets. It was all so clear: RTC 2 would happen and the funds would ride to the banks' rescue and disappear into the sunset declaring everyone a winner - government, banks, industry at large, funds, fund investors. No more big bad private equity (PE) - bring on big good PE.

What a difference a year makes. There is no doubt that the banks need external help but it needs to be the right kind of help. The major banks have held funds back while they have developed their strategies, assembled their teams and, most importantly, considered whose flirtatious advances to accept. And all the signs are that they will be very choosy about who they team up with.

Only six months ago fund managers would privately say that they were waiting for the banks to self-manage their real estate work-out programmes, "screw it up then move in to show them how it's done". This was not an isolated view.

Maybe it is this mind-set and the potential adverse PR associated with PE, no doubt a combination of factors, but the current probability is that PE might not get an invitation to the party. Banks are keenly aware of their new capital structures, which introduce a new layer of politics and management on top of traditional business-based decision-making processes. With six months at most until a UK general election the paranoia is evident and the last thing the government needs is the perception (regardless of reality) that taxpayer assets are being sold cheaply to PE.

Rumours abound - from PE being blocked out of joint venture (JV) arrangements outright, to lists of preferred counterparties. All of this raises the obvious question. Are the banks sure that this is a good thing to do? The real estate problems the banks have are enormous. Lloyds TSB and RBS have loans in excess of £180bn. This is more than the value of the FTSE top 10 and around 30 times bigger than the market capabilities of Land Securities, Europe's biggest property company.

So let us stress-test the idea of blocking out PE by replacing sentiment with cold hard logic. Let us assume a well structured JV arrangement between a bank and a UK REIT, consisting, broadly, of the following features:

Establishment of JV vehicle between bank and REIT; Equity from JV partner into JV; Transfer of assets by bank into JV at an agreed price to avoid further write-downs; A loan from bank to JV to fund the acquisition; JV profit sharing arrangement.

Assume now that an asset (more likely a bundle of assets) worth £1bn at par (loans or foreclosed assets) is already marked down by the bank to £800k. Bank transfers the asset to JV at £800k and there is £200k of value up for grabs. With debt funding from the bank at, say, 60%, this, still leaves £320k of equity needed just to fund the JV's purchase price. Multiply this £1bn deal by 180 and you get the picture.

It seems churlish to add an extra layer of complexity to the overwhelming scale of this challenge but it should not be forgotten that some of the preferred JV parties will be REITs. Loan portfolios are not good income for UK REITs. Foreclosures would, presumably, be necessary, adding further time and costs just to get to the starting blocks of a JV.

Short of some window-dressing and PE funds sitting behind JV partners as financiers, it is impossible to see how the banks and their ‘preferred' JV partners can pull this off, unless the institutions can step in and perform the financing role? This would be a huge step for institutions and one that seems very far-fetched. It seems unlikely that the case can comfortably be made for the real estate sector to live without the PE and opportunity funds.

The next six months will be an extremely interesting time as the banks finally begin to implement their strategic plans in a market that is becoming surprisingly vibrant. The next 12 months even more so - given that May 2010 provides ample opportunity for pre-election stalling and post-election U-turns.

Dean Hodcroft is partner and head of real estate for EMEIA, Ernst & Young