With the current undersupply of available joint venture equity capital, operators need to speak with the full array of potential equity investors, as well as with their existing joint venture equity partners.
The proverbial “wall of equity capital” dedicated to the commercial real estate sector is not the panacea it was once thought to be. As the economic recession, credit crunch, and commercial real estate price correction evolve, the universe of joint venture equity investors is becoming fragmented along a spectrum defined by the following two extremes: “active investor” and “active asset manager”—the latter defined as the once-active investor now absorbed in solving legacy investment problems. The fragmenting wall of equity capital will likely not be adequate to efficiently address the magnitude of required “reequitization,” given the large volume of equity investments anticipated as a result of the significant recalibration of the commercial real estate capital stack.
The fragmenting wall of equity capital is effectively reducing the availability of joint venture equity capital and, when combined with negative space market fundamentals, deteriorating credit markets, and real estate pricing is altering the investment appetite and sentiment of the active investor. This results in a risk-intolerant, highly selective, and inefficient joint venture equity capital market with higher target investment returns and less user-friendly structures.
An equity investor’s posture as an active investor or active asset manager is a function of its recent investment activities. Figure 1 outlines these activities and resultant characteristics.
The active investor is in the position to capitalize on the anticipated variety of opportunities and can afford to be highly selective while dictating cost of capital and structure. The investment appetite and sentiment of the active investor are as follows:
- target investments: distressed debt and property;
- durable in-place cash flow with growth potential and unique/ special-basis plays;
- discount to replacement cost and intrinsic value;
- all-equity plays (no, or limited, reliance on the use of leverage);
- flight-to-quality focus: property, location, and sponsorship;
- conservative underwriting;
- higher cost of capital (higher hurdle rate with lower promote);
- require more cosponsor capital;
- risk-intolerant/reward-hungry; and
- deal-starved (wants to see deals, not concepts).
The fragmenting wall of equity capital will likely not be adequate to efficiently address the magnitude of required reequitization, given the overwhelming volume of equity investments anticipated as a result of the major recalibration of the commercial real estate capital stack.
The total amount of equity capital now dedicated to the commercial real estate sector has been estimated anywhere from as low as $50 billion to as much as $300 billion, with most estimates around the $200 billion to $300 billion level. In addition, the commitment of new equity capital to the commercial real estate sector is trending downward as fundraising efforts are being downsized, delayed, or canceled in the midst of an unfavorable and difficult capital-raising environment as the system of capital flows (e.g., capital allocations, commitments, distributions, and recycling) resets to historical norms. According to the December 19, 2008, issue of PERE Magazine, put out by Private Equity Online (PEI Media), just $57 billion was raised in value-add and opportunistic real estate vehicles in 2008, a 33 percent decline from the $85 billion that was raised in 2007.
The amount of required reequitization is major, as estimated by New Jersey–based Prudential Real Estate Investors Research, at $610 billion to $825 billion. The amount of required reequitization is a result of the unhealthy combination of the unprecedented $2.8 trillion volume of loans written between 2005 and 2008 (about double the $1.5 trillion originated in the previous five years) with lenient underwriting standards and aggressive loan-to-value proceeds, which are now facing negative space market fundamentals, deteriorating credit markets, and real estate pricing. According to Real Capital Analytics, as of January 2010 the value of U.S. assets in default, foreclosure, or bankruptcy is approximately $183 billion, of which only about 15 percent has been resolved. The amount of problem assets is expected to grow significantly, therefore creating intractable problems for lenders and ample, perhaps historic, opportunities for the active investor.
Based on the aforementioned argument, equity capital currently dedicated to the commercial real estate sector is inadequate to meet the anticipated demand for the necessary “reequitization” of commercial real estate. Basic economics dictates that when demand exceeds supply, the price of the desired product—in this case, equity—will increase. The cost of joint venture equity today is far more expensive than it was during the recent market peak and arguably more expensive than at any point in the last ten years. The remainder of this article will address the rationale for the pricing and structural changes in the joint venture equity market.
Expect today’s premium pricing from many equity investors to remain elevated even after the market stabilizes and investment risk begins to moderate. For users of equity capital, it is critical to understand the challenges facing many joint venture equity investors and important to explore all available options to obtain the most attractive cost of capital.
Most real estate professionals are aware that the target returns of equity investors have been on the rise during the past 18 months. For example, opportunistic equity investors who previously sought target returns of 20 percent now seek 25 percent–plus. Moreover, to compensate for the higher perceived and real risks, investors are using more conservative underwriting standards (see Figure 2) in addition to increasing target returns.
As the economy improves, underwriting assumptions will gradually become less stringent; however, it seems unlikely that many of today’s equity investors, seeking the “current” target returns, listed in Figure 2, will be so quick to step back to “peak market” target returns. It is unlikely because there are several structural changes taking place in the industry, most notably at funds that are allocators and partner with local operators to acquire assets.
Higher internal costs are the most significant structural change. They are, in turn, putting upward pressure on the cost of equity capital to the end user (often in the form of less favorable promote structures to the operator/sponsor). These higher internal costs are a net result of changes at the investor /fund level, including lower management fees, higher hurdle rates, lower participation levels, and, in some cases, removal of the favored “catch-up” provision. Joint venture equity investors and funds also face higher external costs from either a lack of or higher cost of subscription lines used to initially fund acquisitions before formally calling capital from their investors/clients. These aforementioned higher costs mean that investors need to achieve higher real estate investment returns, all other things being equal, to maintain profitability.
In addition, well-publicized consolidation in the industry may further embolden many equity investors to maintain higher target returns as the amount of competition decreases. Real Estate Alert’s annual review of high-yield real estate funds found that the number of active or planned closed-end vehicles decreased more than 10 percent over the past year. In short, target net returns are expected to remain anchored in the near term in the 22 to 25 percent–plus and 18 percent– plus range for opportunistic and value-added investors, respectively.
Some investors less affected by the aforementioned structural changes should be well positioned to potentially capture market share by more aggressively pricing risk and sharing profits (through more favorable promote structures). Properly navigating the fragmented joint venture equity capital market requires the knowledge of the full array of joint venture investors (including family offices, sovereign wealth funds, and newly formed funds and institutions) and their various investment postures, appetites, and pricing levels. It is critical for operators to have this knowledge (or work with an adviser who has this knowledge) to select the right equity partner for a particular deal in the most cost-effective manner.