Too much money creates its own problems

Funds and REITs may be hauling huge sums of cash, but are struggling to find investments with big upsides

In the years following the 2008 crash, Barry Sternlicht was dubbed “the real estate bargain hunter” by the New York Times for buying up loan portfolios and properties at depressed prices and turning them into cash cows.

And the returns racked up by private funds managed by his company, Starwood Capital Group, were indeed impressive. Between March 2013 and June 2014, for example, Starwood Distressed Opportunity Fund IX racked up an annualized yield of 36.9 percent.

But recently, Sternlicht has had difficulty living up to that moniker, at least in New York City.

In the past three years, the company bought just one major property here — the Herald Square Old Navy Building on West 34th Street — that it picked up in 2014 and promptly flipped. It’s not for a lack of capital: Sternlicht recently raised another $5.5 billion fund, explaining at NYU’s hospitality conference in June that he “raised large funds from investors that have kind of tossed in the towel” on fixed-income assets and are instead turning to real estate.

But Sternlicht and many of his peers in the high-level real estate investment world face a dilemma. While raising capital has almost never been easier for private funds and REITs, it is increasingly difficult to find profitable investment opportunities in major markets like New York City.

Scott Robinson, director of the REIT Center at NYU’s Schack Institute of Real Estate, noted that capital is always easiest to raise when “you are on the significant side of the upside of a cycle.”

“But when you are near the top, yields are getting compressed and it becomes tougher to meet yield requirements,” he said.

Hunting, no gathering

The what-to-do-with-all-this-capital dilemma is a pervasive one in the industry these days.

Private real estate funds have more money to spend than ever, according to new data by Preqin, a research firm that covers the private equity industry.

In addition to Starwood, plenty of other mega funds are sitting on piles of cash. For example, the Blackstone Group, the behemoth private equity firm, raised $14.5 billion from institutions for a new global real estate fund this spring, and the global real estate investment management firm Westbrook Partners raised nearly $700 million for its 10th real estate fund in January.

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A flood of capital coupled with limited investment opportunities could be a recipe for a bubble, prompting funds to overpay for properties just so they can deploy their capital.


However, fund managers are finding it harder to secure good deals, according to a survey by Preqin in late 2014. A full 74 percent of fund managers surveyed said the competition for core assets increased between late 2013 and late 2014, and 55 percent said finding investment opportunities was harder than in the past.

Much of this growth in competition — and resulting decline in returns — is the result of an influx of foreign investors, said Greg MacKinnon, head of research at Pension Real Estate Association, a trade group representing the global institutional real estate investment industry.

“Whereas a U.S. investor may look at current prices of core properties in major markets as overpriced, some Asian investors might look at exactly the same properties and see them as fairly priced,” he wrote in a recent report published by Preqin.

Like private funds, REITs are facing a similar problem when it comes to finding deals with serious upside potential. 

On aggregate, REITs have seen their balance sheets swell over the past several quarters. But the companies are also having a harder time justifying purchases in gateway cities. For example, Anthony Malkin of Empire State Realty Trust, which owns the Empire State Building, said he’s no longer bidding on open-market deals in Manhattan because prices are too high.

And American Realty Capital’s New York REIT, one of the most aggressive investors in Manhattan over the past two years, recently came under fire from some of its shareholders urging it to sell some New York assets.

“The New York City commercial real estate market will not stay hot forever,” shareholder Gregory Cohen wrote in a letter to the REIT’s management.

New game plan

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So what is a private fund or REIT to do without attractive investments to plow capital into?

Observers say they have three main choices: stop fundraising, lower their investors’ return expectations, or venture into new types of deals or markets. Most funds go with the latter two options.

Andrew Moylan, Preqin’s head of real estate asset products, said funds are starting to look outside of primary markets, both within the U.S. and abroad.

For example, Blackstone invested heavily in real estate in Southern Europe, where prices are still depressed in the wake of the euro crisis, buying 40,000 home mortgages in Spain. And given Blackstone’s stature as an industry trailblazer, others are likely to follow its lead.

Meanwhile, when REITs and funds invest in major markets like New York, they now have to work harder to find deals that make financial sense, said Steven Moore, head of the U.S. real estate corporate finance practice at the mega auditing and tax firm KPMG. 

“People have become increasingly creative in their origination efforts,” he said, explaining that some firms are now retaining advisors to hunt for off-market opportunities and are often closing deals faster than they did in the past.

The real estate private fund manager Savanna is one firm churning out profits by what it claims is a less-traveled path. “The market is competitive, but the competition is mainly chasing cash-flowing stabilized properties,” said managing partner Nick Bienstock.

“We buy more complex transactions,” he said. “There is always competition for the kinds of deals we buy, but we typically compete only against a small field of two or three similar firms that have the capacity to execute a complex repositioning in New York City, not 50 bidders that receive an investment sales memorandum from a brokerage firm on a fully occupied cash-flowing asset.”

Both REITs and major funds are also showing increased interest in the outer boroughs and in new development deals, Moore said.

“My view is that there has been a recalibration of expectations,” he said, adding that these investors are also looking at more creative ways to structure deals by, say, pursuing joint ventures.

Of course, not pleasing investors takes a financial toll on these funds and REITs.

While fund managers charge fees based on the assets they manage, they also typically get a share of profits once certain benchmarks are met — meaning poor performance affects their bottom line. More importantly, it makes it harder to raise future funds. REITs, meanwhile, are always under pressure from shareholders to ensure strong returns.

No running scared

The fact that investment funds and REITS are still able to make record fundraising hauls despite scarcer opportunities highlights just how attractive real estate has become as an investment vehicle amid global economic turmoil and low bond yields, experts say.

That’s despite the fact that returns are not continuing their vertical trajectory.

For example, Blackstone’s Real Estate Partners Fund VII, which it closed in 2012, delivered annualized returns of 27.4 percent. Its most recent real estate fund, however, is targeting a slightly lower 20 percent.

And others are dealing with the same.

Preqin’s Moylan said the research company has already seen a “slight drop” in target returns among private equity firms.

But while real estate companies still have reason to be happy about continued interest from investors, there is real reason for concern.

After all, a flood of capital coupled with limited investment opportunities could be a recipe for an asset bubble, prompting funds to overpay for properties just so they can deploy their capital.

But according to observers, private funds and REITs today are still generally prudent investors — in part because of lessons learned during the last crash.

“I think that fund managers are arguably more responsible today than ever before, in terms of having a pretty clear view of what they’re looking to invest in before they go out and raise capital,” said Mitch Roschelle, the national practice leader of the real estate advisory division at the tax and auditing firm PwC.

Roschelle explained that regulations and disclosure requirements are stricter today than in 2007, and that institutional investors are scrutinizing the funds and REITs they invest in more closely.

“The level of sophistication of investors and the level of transparency has improved greatly over time,” Roschelle added. “And that’s a good thing.”