Real estate money managers stanch the bleeding

Total assets — excluding real estate investment trusts — of the 100 real estate managers in sister publication Pensions & Investments' annual survey dipped 5% to $677 billion during the 12-month period ended June 30. Over the comparable period last year, total assets plummeted 30%. During the survey period, the NCREIF Property Index lost 1.48%. And for all the talk about the rising popularity of real estate debt strategies, only one of three debt classifications went up in value this year. Hybrid debt rose 6.5% to $2.2 billion, while mezzanine dropped 31% to $3 billion, and mortgages fell 10% to $53.5 billion. U.S. institutional tax-exempt assets of the top 50 managers fell 7.4% to $294 billion. And 45% of the U.S. institutional tax-exempt real estate assets were managed by the top 10 managers, down from 56% in last year's survey. The institutional real estate story this year “was hot competition for core real estate, Class A properties,” said Gary Koster, global leader for real estate fund services at Ernst & Young. But “outside the major markets, real estate fundamentals continued to erode,” he said. Those fundamentals, including tenant occupancy and property values, continue to deteriorate, Mr. Koster said. Institutional investors also are looking closer at real estate managers before they invest, he said. In the rankings, TIAA-CREF managed to hold on to the top spot for managers of U.S. tax-exempt assets, even though its assets under management fell 12% to $30.9 billion. It ranked fourth in worldwide assets. The firm's real estate equity assets dropped by 11% to $13 billion. “It was not a pretty time in the industry in general,” said Tom Garbutt, senior managing director and head of global real estate at TIAA-CREF. The company spent a great deal of time keeping occupancy up, he said. “There was a lot of hand-holding,” Mr. Garbutt said. “It paid off,” he said. “Today our properties are more than 90% occupied.” An added complication was that the real estate market during the survey period was “a very illiquid time,” Mr. Garbutt said. “Capital became uncomfortable with the asset class in 2008, and it continued to 2009.” Uncertainty in the market drove valuations down, Mr. Garbutt said. He said that he saw a big change in investor attitudes toward real estate, starting at the end of the second quarter. “You could feel the difference,” Mr. Garbutt said. Investors now want stable, high-quality properties in highly valued locations, Mr. Garbutt said. “We are bouncing along the bottom now. While it is still a tough place to be, there is increasing predictability,” he said. Allen Smith, chief executive of Prudential Real Estate Investors, also is seeing increased global demand for core properties. “Clearly, yield is what people are pursuing,” he said. PREI retained its second-place spot on the list of top managers of U.S. tax-exempt assets and its No. 1 ranking in worldwide assets; assets dipped only 3.6% in the 12-month period ended June 30. And values have risen significantly since the second quarter of 2009, when the real estate market hit bottom, Mr. Smith said. “The tenor of the environment is much different, and the sentiment is more positive than a year ago,” Mr. Smith said. PREI executives have seen inflows from investors for select strategies and global regions, he said. Far from those bright spots is the other end of what is being called the “trophy versus trauma” spectrum — real estate debt and assets that were taken over by the Federal Deposit Insurance Corp. as part of the Legacy Securities Public-Private Investment Program. Those investments, mainly commercial- and residential-mortgage-backed securities and properties, are considered opportunistic, Mr. Smith said. J.P. Morgan Asset Management remains in third position, with tax-exempt assets down 6% to $25 billion. It ranked seventh in worldwide assets. Kevin Faxon, managing director and head of real estate for the Americas, attributed the drop to a “dramatic decline in values of real estate portfolios.” “We set about to do the hard work of reflecting market conditions,” he said. But there is good news for the firm. In the past six months, J.P. Morgan has had $2 billion in capital commitments. Most real estate offerings are open-end funds. Investors first directed new commitments to the firm's core real estate funds, and in the past three months, more capital has been invested in its value-added funds. “In around January and in the last eight months, we saw a shift in client sentiment,” Mr. Faxon said. “In mid-2009, we had substantial exit queues,” he said. “That has turned around dramatically, and we have contribution queues.” Tax-exempt assets at Invesco Ltd.'s real estate arm fell 18% during the survey period to $9 billion, dropping it to 11th, from seventh. “In 2009, new fund flows into private real estate [at Invesco] were minimal. Growth on the private side of our business came mostly from direct property asset transfers,” said managing director Max Swango. “That has changed in 2010, with significant interest in core real estate today through both the private and public markets,” he said. At the same time, Invesco has managed to snag business from competitors hit hard by the financial crisis, Mr. Swango said.

NEW COMMITMENTS

“Over the last couple of years, we have seen allocations from investors making new commitments to real estate, and assets from investors who are changing managers. The global financial crisis created issues and opportunities for real estate managers,” Mr. Swango said. Last year, Invesco Real Estate took in $1 billion of net new capital from investors, and those flows have continued in 2010. Invesco's international assets managed for U.S. clients also declined 64%, the result of a shift of one client's portfolio in-house. “We built a large pan-European portfolio for a U.S.-based client with the understanding that they would eventually take the assets in-house, and that's what happened last year,” Mr. Swango said. Last year, Invesco Real Estate raised a $1.5 billion fund to invest in FDIC assets. It is being jointly managed by Invesco's real estate, fixed-income and private-equity units, Mr. Swango said. Many of the banks closed by the FDIC are community banks that carried loans not usually in institutional portfolios, he said. “They are buying at cents on the dollar, but it's typically not institutional-quality property — carwashes and land development, for example, that are viewed as higher-risk. We will see more of this opportunity as more loans mature and banks fail,” Mr. Swango said. Going global — either to invest in real estate or to acquire clients — didn't appear to boost managers' assets, according to the survey. International assets managed for U.S. clients dropped by 8% to $24.6 billion. Non-U.S. assets managed for clients worldwide dropped 13.3% to $203 billion, and U.S. assets managed for foreign clients declined by 11% to $28.6 billion. “There's still a lot of attention being paid to emerging markets,” Mr. Koster said. “China [is one] because of its growth characteristics, although some are worried about [that market] overheating. Brazil is attracting decent attention,” he said. “Europe is having a tougher time of it,” Mr. Koster said. A great deal of capital was invested in central London in the last year or so, but opportunity has diminished, and the bargains are gone. London's property markets, which fell in value before U.S. markets did, are recovering, Mr. Koster said. TIAA-CREF is seeing net inflows, with the capital evenly split between U.S. and non-U.S. investors, Mr. Garbutt said. Some non-U.S. investors find that it is a “unique time” because U.S. property values are down. “Investor interest was very low for U.S. and foreign investors alike, but that all picked up in the second quarter,” Mr. Garbutt said. And with the exception of London, investors showed little interest in either U.S. or European real estate until the second quarter, he said. However, while there has been an increased interest by non-U.S. investors in core U.S. real estate, those investors have had little success spending the capital, Mr. Smith said. “Transactions are low, and competition for institutional-quality assets is very high,” he said. This could be a pivotal moment for many real estate managers, Mr. Koster said. The universe has changed, and not all are expected to survive, he said. “Investors are taking greater steps. They are performing their own due diligence and not taking a manager's word for it,” Mr. Koster said. “Managers that treated investors well have built up brand loyalty, and investors are narrowing their manager choices to a very controllable few. As a result, managers are in reputation-grooming mode.” At the same time, investors have become disenchanted with the closed-end real estate funds that had been associated with higher returns, Mr. Smith said. Instead, investors are seeking more separately managed accounts and, in some instances, club deals, he said. “Investors want more control, transparency, more-favorable governance, an alignment of interests and more-favorable structure of fees,” Mr. Smith said. Investors were frustrated with the process of working through the problems of large commingled funds that have many limited partners with a wide range of sizes and sophistication, he said. Now that investors are deploying capital again, they want to make sure that they don't get into the same position, Mr. Smith said. Arlene Jacobius is a reporter at sister publication Pensions & Investments.