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Casualties of the gold rush

By Paul Fried


As hedge funds increasingly look to property investment, one real estate investment banker discusses five common mistakes – and how to avoid them. 

Finding office space and setting up trading floors used to be the limit of hedge funds’ interest in real estate.  This changed dramatically over the last five years as the funds saw real estate as a terrific vehicle for diversifying their portfolios and capitalizing on booming markets.
For hedge funds real estate is relatively safe, requiring miniscule resources compared to a traditional investment play.  But many hedge funds are finding that even “cash flowing” real estate has unforeseen risks and costs they never expected.  Real estate should be able to earn its keep in a fund’s portfolio – and it has a better chance of doing this if practitioners can learn from the five most common mistakes these investors make when investing in real estate.

Focusing on cash flow instead of the asset

 

It has long been said that real estate is entirely different than any other asset.  Some funds don’t believe the adage.  They should.
Experienced real estate investors are generally asset-focused.  In contrast, hedge fund analysts focus on the cash flows and financial models.  But cash flow modeling – which serves these investors so well in all their core acquisitions – fails to capture the asset’s competitive position in a changing market.

Cash flow modeling doesn’t account for unquantifiable factors, such as the approval process required for new construction or redevelopment projects­­­­­­ – and the inevitable delays that dramatically impact costs.  Traditional financial analysis also doesn’t factor in the almost certain, yet unpredictable, hiccups that come with any real estate deal: A simple change in local government or zoning is a potential death knell for any project.

Funds also apply standard lease-up assumptions about office tenant retention costs and market average rents that fail to account for how a specific asset will perform in a post-bust climate.  Funds are learning the hard way that many assets don’t achieve the average.  Less competitive properties suck wind if they have tired exteriors and interiors; dated technology and systems (such as air conditioning and small, slow elevators); or are “parking-challenged.”  Add larger than anticipated rent concessions to compensate, and what was believed to be a “good buy” quickly becomes a loser.

Believing that the rent rolls never change

Applying standard lease analysis can lead to a false sense of security: The conclusion that the rent roll will not materially change since it’s been thoroughly scrubbed, stressed and subjected to “market” assumptions.  But real estate analysts know the truth; Rent rolls can-and do-change, no matter the history of a property or the quality of the tenant.

            Recently we arranged capital for the acquisition of a vacant office tower in Austin.  The tower previously had been fully occupied by government agencies.  Certain issues were obvious:  The interiors looked, well, like they’d been occupied by government agencies and the building also required extensive exterior improvements as part of a “branding” plan to reintroduce the property to brokers and tenants.  This was the cornerstone, and really the key part of the business plan for this asset – an element that couldn’t be discovered from rent roll analysis and wouldn’t be properly budgeted for by using standard leasing and improvement assumptions.

Assuming all real estate risk is the same

 

One property sector that has attracted plenty of fund attention is land development – the process of acquiring raw land and obtaining “entitlements,” or the right to build on it.    The strategy can offer high returns, especially when the developer has a good track record.  But as every experienced real estate investor knows, when a developer promises to deliver the necessary zoning approvals, one can’t count on them always coming through – even if the mayor is an investor.

            In one recent scenario, a hedge fund made a $10 million investment in the development of a fully approved, master-planned community with single-family homes.  The plan had been to sell the lots to different builders for development and sale to homebuyers.  Weakening market conditions forced the developer to do the build-out and sales directly to the end-users.  While the project was no less viable, the entire budget changed.  More importantly, the project’s timeline was greatly extended and, by taking on vertical construction and end-user sales, the developer would be taking on far greater risk than originally intended.

            While risk is greatest in new development, each asset class has its own risk profile.  The solution that we’ve found in many cases has stemmed from a “back-to-basics” approach, working with each fund to develop their particular “risk-and-reward” view and then tailor the structure accordingly.

            For instance, in a recent residential condominium development, the hedge fund’s overriding concern was construction cost overruns.  Given the developer’s financial capability, we advised the fund to consider giving up some of the upside potential for some downside risk protection – this lead to a structure in which the developer provided construction cost guarantees well above the norm.  The fund received these enhancements plus a preferred – albeit lower – return and the developer received a greater share of the back-end profits.

Thinking the work is done when the deal closes

 

Some large hedge funds have created real estate investment divisions staffed with experienced professionals.  These companies are the exception, not the rule.

            Traditionally, hedge funds are lean machines.  It’s not unusual to find an investment platform run by three people with a five person staff.  Their experience has been that once a trade closes, the heavy lifting is over.  Nothing in the non-distressed bond or public equity markets has prepared them for managing an active real estate investment.

            Real estate investments require ongoing time, energy, focus and resources.  The potential re-flagging of a hotel property mandates days or weeks of due diligence, paperwork and approvals.  A straightforward investment in an office building can lead to hours spent approving leases- continuing for months after the acquisition is completed.  New construction generally involves innumerable redesigns, revised budgets and contractor agreements.  As a result there is an immeasurable cost associated with ongoing real estate asset management with which hedge fund executives can find themselves saddled.

            We can’t tell our funds that they’re understaffed for an investment that they want to do, but we can zero in on the issues that will likely create drag on the fund – and ultimately the sponsor.

            One of our recent hotel transitions involved a sponsor group which hadn’t worked with institutional partners before and a fund which had never invested in this asset class.  We spent considerable time working with the sponsor to get their systems in order, making sure they understood the “major decisions” and discussing likely scenarios, such as approval of large construction contracts, draw requests and changes to room rates, personnel and food and beverage services.

Having the wrong alignment of interest with the owner

 

Unlike bond or equity traders or the CEO and CFOs with whom funds generally work, real estate owners are a breed apart.  They are used to establishing their own rules for success asset by asset.  Their decisions are based on a simple question: Are they making money?  When developers and their investors bring different perspectives and motivations to deals, there can almost never be a true alignment of interest.

            Alignment of interest would appear straightforward.  The owner/operator and hedge fund invest in a deal; they improve and hold the property for a period of time; and finally they sell it and share in the proceeds.  But deals are never that straightforward.  After all, the owner/operator receives income from the leasing, management and operation of the property using the capital to grow its portfolio by keeping the property on its books and pay for a number of its employees through the building’s budget.  Even if a hedge fund can force a sale, the owner/operator still controls the process and still has no incentive to sell.

            In order to have alignment of interests, the hedge fund has to incentivize its partner and resist the temptation to force a financial mindset into the relationship with the real estate partner.

            The relationship can be managed successfully through careful deal engineering.  In a recent transaction where the fund provided equity to drive a construction pipeline of short-term residential properties, the key was to plot the natural points in the business cycle where the properties could be refinanced – the fund agreed to a capped return if the sponsor was able to refinance the assets along the agreed timeframe, thereby providing the sponsor with a built-in mechanism for buying back the fund’s equity and achieving long-term ownership.  The fund’s capped preferred return eliminated the pure “alignment of interests” structure in favor of “economic incentive” structure.

            Even with the collapse of the subprime mortgage market and setbacks in the CMBS and CDO markets, hedge fund and private equity dollars will continue to chase real estate deals, as long as they continue to provide the prospect of outsized returns.  Funds looking at property have the benefit of smart financial analytics; they just need to make sure they incorporate the wisdom of real estate investment experience into their due diligence, which will provide a much clearer understanding of the risks, as well as the rewards.

Paul Fried is a principal of AFC Realty Capital.