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.

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

“The pension community has stepped back, and the private side is really starting to see some bargains and come in,” says John Fenoglio, a senior vice president focused on the equity market for Charlotte, N.C.-based Grandbridge Real Estate Capital. “And the active sellers we’re seeing in the marketplace have, for the most part, been some type of financial institution.”

Searching for Gold

Today’s buyers are overwhelmingly targeting cash-on-cash returns. In the past, most 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. “Today, they’re looking for cash-on-cash yields going in so that they’ve got a 10 percent to 12 percent [return] day one,” Fenoglio says. “They’re not banking on the residual sale of the property.”

Most of the equity funds being raised are targeting 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 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,” Fenoglio says. “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.”

A Second Look

Like construction debt, joint venture equity for new construction is very hard 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 a possibility for vertically integrated companies.

Since institutional equity providers prefer larger deals, developers looking for $3 million in equity, for example, have a hard time getting their attention. But if an organization has the capacity to do seven deals a year, for instance, “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,” says Dennis Walsh, a senior director of Boston-based Tremont Realty Capital, which provides preferred equity and also acts an advisor to those looking for common or joint venture equity.

Key to these types of deals is an organizational structure that includes some pretty 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 bring it somewhere else. Tremont has arranged several joint ventures between regional developers and institutional equity providers, and the company believes that model will become more popular as access to equity continues to be constrained.

“It tied a lot of people’s hands, but given where we are today, smaller developers might have to go back into that type of agreement in order to get the attention of a fund,” Walsh says.