CASH IS KING, BUT THE KING has left the building.

The equity market has grown more constrained this year, as pension funds, life insurance companies, and other institutions stay on the sidelines waiting for a bigger volume of distressed assets to hit the streets.

Most of the equity funds being raised are focused on distressed properties and distressed debt note acquisitions, also called “loan to own” acquisitions. While many older opportunity funds are increasingly seeing investors pulling their commitments, new institutional equity funds anticipating distressed acquisitions are closing every week.

“The reason they're not more active is that there just aren't the opportunities that yield the kind of returns that they're looking for at this stage,” says John Fenoglio, a senior vice president focused on the equity market for Charlotte, N.C.-based Grandbridge Real Estate Capital. “But there's a mountain of money being created on the sidelines. The distress is building, and the number of loans going into special servicing is rapidly escalating, so the product will be there eventually.”

Return expectations from institutional equity providers now run from the mid-teens to 25 percent, an increase of 300 to 500 basis points (bps) since mid-2008. But the most active buyers today are private, regional players scooping up assets from larger institutions.

New Targets

Today's buyers are overwhelmingly targeting cash-on-cash returns. In the past, buyers assumed that at least half of their internal rate of return would come when the asset was sold five years down the road. But buyers are now expecting to make hefty returns on cash flow.

Underwriting on equity deals has also grown more conservative, especially concerning rent growth assumptions. And exit cap rate assumptions—or where cap rates will be when the buyer becomes a seller— are increasingly being scrutinized.

Those pension funds, hedge funds, and opportunity funds that are active are looking for a hold period of around three to five years. “If something takes more than a few years to get done, it's too hard to handicap whether it's ever going to get done, and it starts to dilute the returns the longer you hold it,” says Dennis Walsh, a senior director of Boston-based Tremont Realty Capital, which provides preferred equity and advises on common or joint venture equity. “If you can't realize that value over a three- to five-year window, it's a deal that won't pencil for them.”


Month (2009)









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Source: Real Capital Analytics

A Second Look

Much like trying to find debt for transitional deals (such as new construction or substantial rehabilitation), joint venture equity, particularly for development work, is increasingly harder to find. Smaller developers working on one-off deals will still find their best success in raising “friends and family” equity. But striking a relationship with an equity provider on a series of deals is possible for vertically integrated companies.

Since institutional equity providers prefer larger deals, developers looking for less than $3 million in equity, for example, have a hard time getting their attention. But if a firm can handle seven deals a year “then the amount of equity inches up in the aggregate of $20 million to $30 million over 12 months, and it hits the threshold where it makes sense,” Walsh says.

Key to these types of deals is a structure that includes fairly big overhead costs, such as in-house construction, leasing, inspection, and engineering expertise. A single developer hiring several third-party providers is not as attractive to equity providers.

These “first look” agreements, which were popular in the 1990s, may be coming back in style. Such agreements require the developer to give the equity provider first dibs on any of its deals, and if the equity provider says no, the developer is free to get it elsewhere. Tremont has arranged several joint ventures between regional developers and institutional equity providers, and the company believes that model will become increasingly popular as access to equity continues to be constrained.

Currency Exchange

Industry watchers also expect foreign equity sources to be more active in the fourth quarter and throughout the first half of 2010. A mid-year survey by the Association of Foreign Investors in Real Estate found that 75 percent of its membership sat out the first half of 2009, but about 66 percent expected to be active investors in the second half.

Consider that Highlands Ranch, Colo.- based UDR recently announced a joint venture with Kuwait Finance House to invest up to $450 million in multifamily assets. The company said it had actively been exploring joint venture opportunities for the last two years, but that return expectations were too high to pencil out.

But the pendulum is swinging back, according to Warren Troupe, a senior executive vice president at UDR who said investors are now starting to lower their expectations to a more realistic realm. “In the past four months, we started to get a lot of traction from institutional investors who had been in the multifamily market and exited in 2006 or early 2007.”

China Investment Corp. (CIC), a $300 billion sovereign wealth fund, is also looking to make a big splash in the U.S. commercial real estate markets. CIC met with private equity managers such as BlackRock and Invesco in late summer 2009 about opportunities in distressed mortgage notes as well as physical assets. Last year, CIC invested just $4.8 billion in global financial markets, but this year, it has invested as much in a single month.

—Additional reporting by Les Shaver