Addressing several people’s concerns about the state of private equity and the possible assertion that private equity could be the next fallout candidate, I thought I would look into this situation a bit more. For those of you who think that this discussion will be outside of the scope of commercial real estate investing, read on and I am sure you will be pleasantly surprised.
At the 8th Annual US Real Estate Opportunity & Private Fund Investing Forum several very important items of note were mentioned. The most significant item is the increase in fundraising efforts, which has moved up from $35 billion in 2005 to $60 billion in 2006. On the heels of that announcement, Morgan Stately Real Estate has just announced it has raised an $8 Billion fund designed to invest in Real Estate in established and emerging markets.
Before I discuss how these numbers will affect the common investor, I want to take a step back and clearly outline what a Private Equity Real Estate Fund or Opportunity Fund does. First, these funds begin by raising investment capital. The larger funds typically bring in money from pension funds, hyper wealthy individuals and governments all over the world. Then, they take these funds and make leveraged investments. An $8 Billion fund will probably invest in about $30 Billion worth of real estate. Investors typically expect returns of 12-20% based on the investment strategy and they expect to exit the fund within the span of 7-10 years.
These funds make a variety of investments. First, they typically invest in all major commercial property types (hotel, industrial, office, retail, and apartments) and minor ones as well (storage units, trailer parks, malls, etc.). Additionally, they may purchase Real Estate Investment Trusts, Mortgage Companies, Real Estate Services firms, etc. With $30 Billion to invest, any and all real estate investments are fair game.
Over the past 20 years the private equity industry has grown tremendously. While the major players (Blackstone, KKR, etc.) get all the headlines, many smaller private equity firms operate in lower tier investment categories. If KKR looks for Billion dollar deals, these firms will be looking for deals in the tens of millions of dollars.
Commercial investors (like me) have typically operated in the lowest tier, doing deals of $20 million or less. The problem occurring today is that there is more money than ever in private equity. As Billion dollar deals dry up, the KKR’s and Blackstone’s start taking the hundred million dollar deals. This forces a cascade affect, resulting in a lot more competition for the $20 million and below deals. Many firms that would never touch deals under $10 million are now scooping them up as fast as they can.
Additionally, remember that most of these funds must have an exit strategy in the next 7-10 years. This creates an interesting situation in the commercial real estate area because these funds have to sell. In the past this has dovetailed nicely with private equity firms that had to invest. Remember, if a fund takes $8 Billion, it has to find a way to put all that money to work. This begs the question at what point will this game of musical chairs end? And, when the game does end what will be the state of the real estate industry and the banking industry, which provided the leverage for these funds.
While I don’t have a dooms day theory suggesting when this will all come crashing down, I do want to point out that until it does smaller commercial investors will continue to get squeezed out. Places like New York City and Los Angeles are already seeing record low cap rates for major office buildings. Expect even more competition to come in these markets and competition to expand to other upper and mid-tier markets.
Russ says:
Michael;
Interesting assessment. You are correct about the top tier shops moving down the line to smaller deals. Also, there are more and more middle market players popping up as well. In fact, from what I am seeing from my clients who work in this space (many of which are your peer business school cohorts) are mostly going to middle market shops.
This is very much like the dotcom boom when there was simply too much liquidity and everybody and their grandma with a few bucks in the bank thought they could be a venture capitalist. Now everyone and their grandma thinks they can be a private equity investor.
Much like the dotcom implosion (and even current housing market with residential specuvestors), the music will stop when the returns stop ultimately seperating the amateurs from the professionals. The KKRs of the world will probably walk unscathed, while the newer funds will get some battle scars. The smaller investors who are prudent and experienced are probably going to get squeezed out temporarily, but if they stick to the fundamentals, I am sure they will be ok.
June 21, 2007 — 10:39 am