Expectations of distress are keeping transaction volumes down and investors on the sidelines, as Stephanie Schwartz Driver reports

US fund managers are facing a dual challenge. Not only is it a tough time to raise funds, but it is also difficult to find good-quality investments at a sound price. Despite this, the market is attracting new entrants, and some existing players are broadening their presence.

Many industry players and observers acknowledge that the fundraising environment is not hospitable. "Due to all the write-downs in real estate portfolios, people are reluctant to get back into the space," says Sean Gill, partner, New England Pension Consultants (NEPC), who leads the alternative investment research group. "But we anticipate renewed interest in 2011, with investors getting back to target for both core and special situations."

Steve Renna, president of the National Association of Real Estate Investment Managers (NAREIM), says: "The slow pace of fundraising is not the only problem. Not only is it challenging to raise capital, but perhaps the greater challenge is deploying new capital."

While more than half of NAREIM's members, in a second-quarter survey this year, maintained that market conditions have started to improve, there is still an investing bottleneck: investors either cannot find the appropriate assets, or assets are being bid up because of competition. As a result, Renna says, "some members are finding that they may have to stop fundraising in some cases."

This is the case at Jamestown Investors, a real estate investment and development firm based in Atlanta, Georgia, and Cologne, Germany, which acquires US properties on behalf of German investors. "We are currently not raising capital," says Matt Bronfman, managing director and CIO. This is not because of reluctance on the part of investors, but rather due to the scarcity of investment opportunities. "Many of us raised aggressively on the notion that there would be the best buying opportunities since the savings and loans crisis of the 1980s," he says, "and now there are a lot of people in our shoes, sitting on a lot of capital."

Bronfman identifies problems with both supply and demand. "On the supply side, the banks and life companies are showing more patience than people anticipated, and on the demand side, when anything hits, the bidding is like it is still the good times," he explains. "So people like us are having a very hard time. We'll wait for the good opportunities."

The question now is whether Bronfman's patience will be rewarded by a flood of distress deals. "I certainly hope so," he says. "But I'm not as confident as I once was."

There are indications that the distress will come, and this is what is keeping money on the sidelines and transaction volumes down, as well as keeping investors focused on core. For example, real estate market analysts and forecasters Foresight Analytics has estimated that some $1.4trn (€1.1trn) of commercial real estate loans will come due between 2010-14 - and of this, around $870bn exceeds the current property value. And Fitch Ratings forecasts CMBS defaults to rise above 11% by the end of 2010, with the majority of defaults coming from the 2006-08 vintages, which amount to $445bn of issuance.

Yet even with these ominous estimates, deal volume is still quiet. "With distress, we keep hearing the buzz, but not a lot is getting done," says Gill. This year, he notes, people made some deals that could be considered "opportunistic credit", with credit opportunities, mortgage-backed securities or CMBS. "Real estate equity deals are tougher," Gill says. "People are waiting for the bottoming effect."

An NEPC report in May this year recommended that investors look at distressed and debt strategies: "Due to the severe magnitude of the downturn, there will be a multi-year opportunity for both capital structure specialists as well as real estate operators... Investors in the near term should focus on capital structure driven distressed strategies as opposed to operator-centric (single property) focused models. As the market conditions begin to improve, the investment focus will broaden to include both real estate secondary and distressed operator/turnaround strategies."

Despite the ambiguity in the marketplace, it seems that investors are remaining committed. "Our members are comfortable that the investor base has not fled the sector, but it is a new game," says Renna of NAREIM. "Investors are more risk-averse, and there are more investment parameters, more management input from investors, and there are different criteria accompanying new capital."

Kiran Patel, global head of research, strategy, and business development, AXA Real Estate Investment Managers, has noted the same trend. "Clients are more diligent now, and quite rightly so," he says. "This was perhaps lost in part in the frenzy three or four years ago, but that is what they should be doing. They are being more professional, as they should be."

The California State Teachers' Retirement System (CalSTRS), the second-largest pension fund in the US, is committed to the real estate sector, despite the dismal performance of its real estate portfolio in 2009. At the end of its 2009-10 fiscal year, 30 June 2010, its $129.8bn portfolio showed a positive return of 12.3% overall. However, within this, real estate, which accounts for just over 10% of the portfolio, showed a loss of -12.4%. Nonetheless, CalSTRS announced that it was permanently shifting 5% out of global equities and into fixed income, private equity, and real estate, to take advantage of distress in the market.

CalSTRS notes that there is a great deal of competition for core properties, leading to a scarcity premium. However, they see potential in other areas, pointing out that "there is still little available capital for assets with development or leasing challenges, creating potential opportunities in these areas."

And while fundraising in the US for some managers is challenging, for others there are opportunities. This June AXA Real Estate launched its US distribution platform, considering this as a good time to attract US capital, principally for its European opportunistic funds, but also for other separate account and product initiatives.

"Investors and pension plans and insurance companies do need to invest and they are seeking out opportunities. For a company like ours, this is a good opportunistic time," says Patel.

Patel identifies AXA's strengths. "We have the advantage of being the new kid, because there are no legacy issues," he says. "And being large helps. The fashion three or four years ago was for boutique managers, but today, investors are looking for managers with scale and depth." He believes that AXA will be more appealing to public and corporate pension plans, because endowments have traditionally favoured boutiques.

In addition, AXA is targeting the larger funds that have global mandates. "The US has been through a period of distress, and some investors can find opportunities at the higher-risk end of the spectrum in their home market," he says.

There will be a tendency for some investors to move up the risk spectrum, Patel notes. "Most investors are seeking core, which implies low returns, but you will still find investors going up the risk scale, because they have liabilities to cover," he says.

"Our advice to clients: there are opportunities, there is no need to panic and rush in, but you need to be mindful of how you spread the risk management."

While AXA is focusing on non-US core, some US investors are homing in on distressed opportunities close to home.

Toll Brothers, the largest luxury homebuilder in the country, established a subsidiary in July - Gibraltar Capital and Asset Management - that will enable it to make acquisitions and investments in deals outside its speciality. Opportunities may include the acquisition and disposition of loan and property portfolios, the development of sites for sale to other buildings, and investing in the workout of troubled real estate.

Toll Brothers' move comes on the heels of a similar move by homebuilder Lennar, which acquired a portfolio of distressed loans with a combined unpaid balance of more than $3bn from the Federal Deposit Insurance Corporation (FDIC) in February.

Looking at distress "is in our DNA," says Fred Cooper, senior vice-president, finance, at Toll Brothers. The company was active in RTC workouts in the late 1980s and early 1990s as well.

"We've been looking at distress for around two years, and in the last six months we have completed deals for both loans and land, worth around $250m," says Cooper. "We have teams of land people across the country, and more than 100 bank relationships, so we are finding good deals that may not be suitable for luxury homes." The establishment of Gibraltar allows the company to look at opportunities that may not necessarily end up as Toll Brothers communities.

Toll Brothers is not looking for coinvestment now, since the company is flush, with around $1.5bn in investible cash. "We are perhaps lucky, perhaps forward looking, but we started building our cash position in 2006," explains Cooper. "The good deals are out there," he says, "but it is not easy - you have to kiss a lot of frogs."