and Stanley Ross may have stirred a sleeping giant—the $100-billion world of real estate private equity funds. Their innocuously titled paper, “Real Estate Private Equity Funds,” is forcing real estate companies to take a hard look at greater transparency and standardization in their disclosures and also to work towards establishing performance benchmarks. Linneman is a real estate professor at Wharton, and Ross is chairman of the board of the USC Lusk Center for Real Estate.
After studying numerous such funds, which often guard their finances from public scrutiny, Linneman and Ross make several suggestions to move towards standardized and more transparent reporting formats. While acknowledging the role that these funds play in creating a developed market for real estate entrepreneurs looking for equity capital, the paper also points out structural shortcomings in the real estate finance industry. After analyzing these and the investment strategies of such funds, the paper examines the complications involved in benchmarking returns and devising valuation models.
In setting the context for the paper’s recommendations, it might be helpful to examine the origin and evolution of real estate private equity funds. These funds, which raise money from institutional and high net worth individual investors, had their predecessors in the private equity investment funds of the late 1970s. These funds provided equity for leveraged buyouts (LBOs) of companies with solid but modestly growing cash flows. Led by firms like Kohlberg Kravis Roberts (KKR) and Forstmann Little, the funds offered investors high returns in exchange for high risk, the paper recalls. Back then, such equity funds had little role to play in real estate, where debt financing deals typically ran up to nearly 100%.
The recession of the late 1980s and early 1990s changed all that. In the aftermath of the savings & loan industry’s collapse, the federal government was accumulating vast pools of non-performing real estate loans and lesser quality properties through the Resolution Trust Corporation (RTC). Traditional real estate owners and developers lacked the equity to invest in these properties. Real estate investor Samuel Zell (a major supporter of the Zell-Lurie Real Estate Center at Wharton) sensed an opportunity in 1988, and the Zell-Merrill I real estate opportunity fund raised $409 million using a private equity fund partnership structure. “The Zell-Merrill I fund was often the only potential buyer for high-quality properties,” the paper says.
Goldman Sachs was another big player. The Wall Street investment firm identified an opportunity in creating funds that would buy wholesale loan pools from the RTC and either re-sell the underlying properties or restructure the non-performing loans to turn a profit. Several rivals soon followed, and companies like Angelo Gordon, Apollo, Blackstone and Soros as well as investment banks like CSFB, Lehman Brothers and Morgan Stanley joined the game. Linneman and Ross estimate that since Zell first rolled the dice, real estate private equity funds have raised about $100 billion.
The paper highlights two important ways in which real estate private equity funds—also called opportunity funds—have changed financing patterns in the real estate industry. First, they brought about structural improvements in the way investors approached the industry. Before these funds came along, institutional investors had specialized real estate managers who were compensated by transaction fees and a percentage of the property’s value. That model suffered from a serious flaw. “These real estate management firms had a strong incentive to mark up the value of their properties in order to increase their fee income (and no incentive to mark down),” the paper says. “Further, managers did not invest alongside their institutional investors, so they were rewarded even when their clients lost money.”
That system “blew up in the early 1990s,” Linneman and Ross explain, making way for real estate private equity funds where the sponsors are compensated by a 1%-2% fee on committed capital and an interest that is subordinated to the returns on investors’ money. The sponsors don’t gain if the value of their properties rise. They get the bulk of their compensation in the form of their “subordinated interest” (generally 20% of profits). If their funds fail to generate the promised returns, their subordinated interest is worthless paper.
The other important change real estate private equity funds brought about was that along with their investors, the fund sponsors invested anywhere between 2% and 25% in the properties. This, along with the change in the compensation structure, opened up a more mature market for real estate entrepreneurs looking for capital. Instead of relying only on their local networks of high networth individuals, real estate entrepreneurs could shift their focus to these private equity funds that offered a well-developed market structure.
To be sure, nothing is seriously wrong with the private equity funds that invest in real estate. The industry is dominated by big, mature players like Morgan Stanley and Goldman Sachs, among others. “With the exception of a couple of funds, there’s a fair amount of disclosure, and pretty good transparency,” says Linneman. “But the way your fund reports and gives that transparency is different from the way my fund does it. And that makes it hard for people to compare us. That’s where the real work has to be done — consistency in standardizing formats, standardizing definitions.”
Most real estate private equity funds have also produced handsome returns for their investors, which include large financial institutions and pension funds. Linneman says that although he doesn’t have access to detailed data, his research reveals that barring a couple of exceptions, most of the funds that raised money in 1996 or earlier brought home returns of more than 20%. Although they didn’t realize it when they made their investments, hindsight showed that they were able to pick up properties at bargain prices in an economy preparing to boom. Of the funds that raised money between 1997 and 1999, almost all posted returns of around 20% except some that had invested heavily in hotel properties and assisted living centers.
If the going is so good, why the fuss? The paper argues that while investors may be happy with their funds — especially these days, when stocks are so volatile – it is important to be able to compare apples with apples. Linneman recalls the genesis of their research at a conference a year ago that he and Ross attended, where the feasibility of comparing one fund’s performance with others dominated the discussions. Linneman recalls managers of pension funds who invest in real estate private equity funds saying, “Well, this fund’s doing great but it reports very differently from that fund, and that fund reports very differently from those other funds, and it’s very hard for us to sort it out.” But the managers hadn’t gone as far as to complain to their funds’ sponsors because they were happy with the returns they were getting. “It was an undercurrent,” says Linneman. That’s when he and Ross decided to write a paper that “summarizes what’s going on and make some big suggestions.”
Their checklist of suggestions for these funds includes:
• Detail quarterly and annual overviews of investment activity and fund performance in terms of progress on the particular properties and changes in status from period to period, including commentary on major actions or conditions that have changed, such as changes in market conditions, status of construction progress, lease-up status, zoning and entitlement, and regulatory issues.
• In quarterly and annual narratives, describe the activity and performance of each fund investment compared with the strategy and the underwritten internal rate of return (IRR).
• Prepare a special events report—similar to an 8K for public companies—reporting unusual events when they occur.
• Publish quarterly and annual summaries of cash inflows and outflows. Investment vital statistics should include condensed financial information for each fund investment.
• Fully detail and update all activity related to debt or leveraged components of the investment, including underlying ventures in partnerships and compliance with underlying loan provisions and covenants.
• Group quarterly reports on the performance of fund assets according to the following categories: assets sold; stabilized assets that are ahead of acquisition underwriting; stabilized assets on target with acquisition underwriting; stabilized assets that are below acquisition underwriting; and nonstabilized assets.
• For each of these groupings, at a minimum, the sponsors should report: the asset name; date purchased; cost; equity invested; reserves; debt level; ownership percentage; net operating income (when relevant); current value (when relevant); IRR (when relevant); and equity multiple (when relevant).
• For nontraditional types of investments, include details about changes in market conditions, regulatory bodies, restrictions, or limitations.
The authors also make recommendations for measuring property values. These include:
• Perform calculations on an individual asset basis as well as on a fully rolled-up consolidated basis.
• With IRR calculations, use the projected residual value methodology where stabilization has occurred.
• Carry non-stabilized investments at cost and test for impairment on a quarterly basis.
• Perform all calculations on a gross IRR basis as well as a net IRR basis after taking into consideration the fund expenses, including management fees and net carried interest of the fund sponsor.
• Perform all calculations applying GAAP (Generally Accepted Accounting Practices) accounting rules and with respect to consolidation of partnerships, joint ventures, and non-wholly owned corporations, and essentially consolidating where effective control exists.
• Provide multiple performance calculations including: cash on cash returns from inception to reporting date; cash on cash returns from inception to date of exit; IRR using the projected residual value methodology; and equity multiples.
• Assess whether each fund investment is tracking on, below, or above the underwritten IRR, and why.
• For the same time period, the time weighted return analysis should be an optional reporting method, if the investor desires it. Because it is not an accounting methodology, it should be based on existing standards of the AIMR (Association of Investment Management and Research) or the NCREIF (National Council of Real Estate Investment Fiduciaries, an association of institutional real estate professionals).
• Whatever methodologies are used — and more than one may be appropriate — they should be applied consistently across all funds and sponsors.
The authors don’t want any leeway for unyielding sponsors. “If the sponsor is unwilling to state the current value of stabilized assets, then investors should seriously question investing in their funds,” they say in their paper.
Linneman says the ultimate objective of these recommendations is to deepen the market for real estate private equity funds and make it more resilient. But while that might take some time to happen, the near-term outlook is not entirely disheartening. Going forward from this year, he expects “another good generation, [although] not as good as the early 1990s—around 20% returns.” However, there will be casualties among those who exposed themselves in the years immediately before the current slowdown gathered momentum. “The worst performing funds are going to be those that were investing in late 1999, 2000 and early 2001,” says Linneman, expecting them to manage returns of between 14% and 16%. “Why? Because the economy slowed in the first year or two of their investments.”
The timing of the paper is sheer coincidence. A year ago when they started working on it, the researchers hadn’t the faintest idea that their report would appear at a time when companies like Enron and WorldCom have collapsed because of financial shenanigans and the government is pushing hard for greater corporate accountability. “There is increased pressure on everybody, on every company of every type, to improve reporting and increase transparency,” says Linneman. This research and these recommendations could push real estate equity funds in the same direction.
In late May, Linneman and Ross went to a meeting in New York City with 15 private equity funds. “They are torn,” says Linneman, who found each fund claiming to have kept its own investors happy, but faulted others in its tribe. “It’s the other guy’s investors who aren’t happy.” Even so, fund managers are circulating copies of the paper and asking for comments. Linneman thinks he has an inkling of the outcome they want: “I think they’re hoping that everybody will say, ‘Everything is wonderful, we don’t need to make any changes.’ But we’ll see.”