Meeting in the middle
In redefining themselves, many opportunity funds find themselves encroaching on the value-added space, writes Maha Khan Phillips
Institutional investors’ appetite for risk is growing for the first time since the financial crisis, according to a January report from INREV, the association for non-listed real estate vehicles. It revealed that 43% of investors surveyed had a preference for value-add strategies, almost double (21.9%) what was recorded last year.
But unfortunately for opportunistic managers, investors’ risk appetites have not stretched as far up the spectrum as making opportunistic plays. The research revealed that for the next two years, the net balance of expected allocations to opportunity funds would actually be a net fall of 23.6%.
This is in contrast to some high-profile fund developments. In October last year, Blackstone raised $13.3bn for its latest comingled fund, Blackstone Real Estate Partners VII. The fund raised the capital with the support of 250 investors on a global basis. Investors aim to achieve a leveraged gross internal rate of return (IRR) of 20%, and Blackstone estimated a 65% loan-to-value ratio on the comingled fund’s portfolio.
But there are few launches of a similar size occurring in the market. Although there have been some opportunistic investment activity, fund managers say it is a difficult fundraising climate. One fund manager, who declined to be named, explained that his firm had struggled for two years to build institutional interest for its latest opportunistic product. Data from research provider Preqin reveals that value-added strategies made up the largest amount of closed-ended private real estate funds holding a final close in the fourth quarter of 2012, with core and core-plus following a close second, and opportunistic funds tailing.
“The old idea of opportunistic, which is speculative development, isn’t really happening much at all in Europe and the UK,” says Paul Richards, head of European and Latin American real estate at Mercer. “Even if you wanted to do that kind of activity, there isn’t much of it going on.”
It is understandable, then, that many opportunistic players are finding themselves encroaching on the traditional value-added arena in a bid to raise capital. Some industry participants say it is simply a matter of semantics, while others argue that the nature of opportunistic investing is changing to meet investor needs regarding risk.
“We think of opportunistic investing as ‘going anywhere investing’, where you are backing skilled management teams,” says Paul Jayasingha, senior investment consultant at Towers Watson. “In that sense, we might think of opportunistic or value-add in a similar bucket. We do see less demand for opportunistic than we did five years ago, but we do see [some] demand.”
He explains how the market has changed, particularly as managers are not producing the 20% returns of the past. “Managers have become more humble. The fee structures have changed. Return expectations have been reduced and become more realistic to the current environment.”
It means that the definitions of what is core, core-plus, value-added, and opportunistic are becoming blurred.
“Investors are used to looking at guidelines for core, value-added and opportunistic strategies, but these have become outdated,” says Simon Durkin, head of European research at RREEF. “There is capital that’s chasing core returns down to below 5%, which in some cases is justified by low sovereign rates. So the fact that core is being redefined more narrowly must mean that the definitions of value-add and opportunistic have also changed.”
Durkin believes that the industry needs a more dynamic definition of risk and return, one that pays reference to the current economic cycle. “Investors are far more mindful now that if a particular strategy is targeting 15%-20%, then they need to understand how much, and the nature of risk they are really exposed to in order to generate that rate of return. I think that to achieve 15% the nature of risks are different risks than in the previous cycle and hence need to be priced differently.”
Getting hung up on semantics
In addition to encroaching on the value-added space, managers are increasingly investing in distressed assets, using lower levels of leverage than those found before the crisis. In January, a report from Andrew Baum, professor at Reading University, found that opportunistic funds performed worse than core or value-added strategies because of their use of leverage on a risk-adjusted basis from 2001 to 2011. A 60% levered opportunistic fund could expect to underperform annually by as much as 13.2%. It is perhaps one of the reasons why investors have shunned funds that are too leveraged. Managers have responded accordingly.
“How are you going to get opportunistic returns without leverage available in the market? The key is that often leverage is available but it is embedded in transactions,” says Russell Jewell, head of private equity funds at AEW Europe. “Our focus is on buying deals that have sub-performing debt attached to them.”
In December last year, Tristan Capital Partners raised over €170m for a first closing of its real estate private equity fund, European Property Investors Special Opportunities 3, which was launched to target investment opportunities being created by economic restructuring in the distressed European markets where equity and debt capital are in short supply.
“People are, in a way, hung up on names,” says Cameron Spry, partner and head of investments at Tristan Capital. “What is value-added and what is opportunistic is more about how much return you are getting for the risk you are taking. ”
Joe Froud, managing partner of Columbus Capital, part of Schroders’ real estate investment arm, says that true opportunity funds – those with 20% IRRs – have tended to move to more unusual sectors, such as residential development in London. “If you look at what a lot of them are doing, they are doing things that are outside the main retail, industrial, core sectors. And a lot of them have turned to development, because they can’t get leverage on the standard sectors.”
He says there is a difference between having an opportunistic strategy and being an opportunistic fund. “Our fund is really a value-add fund but we have an opportunistic strategy. We aren’t linked to any sector or region, we cover the whole of the UK and we are targeting 17-18% growth, so we are targeting 15% net in hand for the investor.”
There are also still plenty of opportunities in the distressed markets in Europe, according to fund managers. “The financial crisis is different from the last time we had a major real estate crisis,” says David Boyle, chief investment officer and co-head of Morgan Stanley Alternative Investment Partners Real Estate Group. “There are distressed assets but there are also local, hands-on groups that can buy those assets and turn them around, reposition them, put money in them, and execute. That’s the opportunity.”
Boyle believes there are opportunities if you know where to look for them. “If you have a core, prime, well-leased asset in a major market then you’re more likely to get near pre-crisis prices. Investors will price it like a bond. An investment that might result in higher returns would be to buy the building that is next door but has problems. Maybe it needs capital to go back into it, or the lobby is old.”
Richards says there is very little other types of opportunity in the market. “The debt funds and long-term income funds are below the old core funds in terms of risk and return. It used to be that core was low risk and you’d go value-added and opportunistic. Now there are things that are below core. Going above core, the only thing that is attractive, other than distressed, is under-priced properties, and you really have to be good at your stock picking for that.”
In December, Peakside Capital, the specialist European real estate private equity firm spun out of Bank of America, sold the Warsaw Distribution Centre, a 34,000sqm logistics and office business park, to CBRE Global Investors. Peakside founding partner Roger Barris says the market is often misunderstood. “Typically you see distressed sellers, rather than the assets themselves being distressed. We are finding the biggest opportunities where properties are financially or managerially in the wrong hands, particularly when the property starts developing some vacancy or needs some capital invested in it to return it to its core function.”
The fund invests in Germany and Central and Eastern Europe. “We think the economy is in reasonably good shape in those markets,” Barris says. “Germany and Poland are two of the stronger performing economies in Europe. We like the fact that there are no significant debt problems in that region. We were quite cautious about the Anglo-Saxon part of the world before the crisis; the problem is that these economies are still over-leveraged.”
Peakside categorises itself as opportunistic, although it has bought real estate on an unlevered basis. “And we are still generating high teens. We are able to demonstrate that there are opportunities in the ‘brave new world’ even though there’s little leverage available.”
Markus Meijer, CEO of Meyer Bergman, the specialist retail private equity firm which operates in the opportunistic and value-add sector, says the firm has been focused primarily on Germany and the UK, but also sees Poland and Turkey as growth markets.
“When things start to move over the next 12 months we’ll spend more time on Spain and Italy as well. Our return expectations are more opportunistic than value-add. We are targeting about 18-20% gross return. But the assets that we are buying are potentially core quality assets, such as the Burlington Arcade [in London] and the Westfield deal in Bradford. Those are core quality retail assets but obviously there is a value-add element because we are working very hard to improve them.”
Managers say that the majority of investors in opportunistic assets come from North America, partly because of tradition but also because of market concerns. “European investors are more cautious about the macro-economic situation in Europe, whereas US investors have tended to be more comfortable with opportunistic investing in Europe,” says Jewell.
But new investors have come to the market. In September last year, Patron Capital, (which had lost about 30% of its US capital base when investors wanted to change strategies or, worried about uncertainty in the Europe, wanted to minimise their exposure to the region) was able to raise €880m for its fourth opportunistic fund, much of it from corporate pension funds in Europe and investors in the Middle East.
“There is enormous interest from Europe, the US, and Asia,” says Keith Breslauer, managing director.
Jewell believes that investors are interested in opportunities, not labels. “We don’t really find that investors want to know if a transaction is value-add or opportunistic. They like to look at the specifics of the deal and they like to get an adequate return for the risk they are taking.”