What's the New Model?

Continuing on thoughts about the $300 billion said to be sitting on the sidelines, waiting to cushion the coming downslide in values, these fund sponsors who raised all this cash over the past few years must be struggling figuring out how to deliver the returns they promised investors. Their investment model was largely based on leveraging up performance in a sky's-the-limit pricing frenzy, providing 20% plus returns. It worked splendidly for more than five years in an almost free-money lending environment that suddenly evaporated 12 months ago. But without the leverage, the investment model no longer works and the sponsors can no longer make the promotes which drives their business bottom lines.

Given the depths of the credit morass, free-flowing debt will not be coming back any time soon. When lenders finally sort out all their issues and regulators finish with implementing stricter guidelines, borrowers will pay more for less. We're in a deleveraging environment for some time to come.

So what's the new model--filling the void in the debt markets, offering distressed owners loans that could provide equity like returns or loan to own features? Maybe. Or buying core-like properties in all or mostly cash transactions once the value floor looks like it's taking hold? That's a possibility. There are always homebuilder lots, going for cents on the dollar today.

But then investors will need fundamentals to improve quickly to push up rents and net operating incomes, and/or homebuyers who can obtain ready financing. Neither the economy nor the credit markets offer much hope for any sort of rapid recovery.

So either that $300 million accepts potentially lower returns than advertized in different investing schemes or maybe it goes elsewhere. That also goes for the investment bankers and advisors, sponsoring these funds. 

         

Comments

[Chris T]

The very same topic of conversation has been raised over the last several weeks while we conducted a fairly unscientific survey of some institutional and private investors. After considerable discussion with these investors we have concluded investors have moved to the sidelines for one of two primary reasons. The first is they cannot see clearly over the current horizon and can't tell if they are stepping into the valley or over a cliff. The investor in this first category is typically an all cash buyer but through disciplined fundamentals has essentially removed themselves from the market for new purchases or if they are making a purchase it is of a quality class "A" main on main type of asset. And the second is investors cannot buy with any leverage, as you indicated in your article. This dramatically impacts an investments Irr removing many "good value" purchases from consideration. Investors in this second category are the buyers who need to use leverage in their purchase to maximize Irr's.

When you can buy a property at a decent CAP rate, but can't sell it because buyers can't achieve a certain Irr to make it work because of their sponsorship platform then you have what we have now which is a stalled investment market. In the case of the all cash buyer they will need to reach a point of no return (CD's) before venturing back into the investment market. The investment market needs some momentum to help these cash buyers return to the market. Seller carry may help us achieve this momentum. The money market is just as competitive as the brokerage business and money clients will flow to the investors who can post returns whether through core or value add/opportunistic investments. This competition will force the all cash buyer to get back in the game.

The answer for the short term is debt provided by sellers in the form of seller financing. We had that question posed to us by one institution who cannot sell several assets which in a different market would not even make it to market before offers hit their inbox. Sellers will need to start carrying back a portion of a sale if they want to sell their assets. Particularly if they are selling to a sponsor more sensitive to Irr.

Leverage will need to come from somewhere. I have a hard time seeing sponsors giving back funds to their investors.

As for where the money goes? Well its safe to MAKE ASSUMPTION its not the stock markets.

[Charlie]

The idea that assets can not be sold in this environment is incorrect. Sellers are electing not to sell because of the ask/bid gap. Managers typically have quarterly "market valuations" done to report financial performance to their investors. There is a hugh amount of purposefully misleading "valuations" being reported, and the more astute investors remain quiet but they know it. What the astute investor is unsure of is what actually is the truer underlying value of their real estate portfolios. What do they own? In the case of the multi-billion pension fund investor, the appraisal vs true market value gap may result in write downs akin to what has happened to Wall Street. Right now it's mostly a case of the three monkeys for the fund manager, their investor and the financial reports- see no evil, hear no evil and speak no evil