Capital Raising & Investor Relations Council Meeting Report
A Year of New Changes, New Rules and New Realities (Click here for a print version) ¬†The economic recovery seems to be well under way. 2012¬†continued to be challenging for real estate investment managers,¬†but there were positive developments none-the-less. Larger,¬†established managers successfully raised capital for a number¬†of funds, while smaller, more entrepreneurial groups managed¬†to work through various alternative capital raising strategies.¬†But what next? With new regulations, new demands and a slowly¬†improving economy, what will real estate managers have to face¬†from their investors, from government and from the markets? In December of 2012, NAREIM capital raisers and investor relations professionals gathered in Chicago to discuss our industry‚Äôs future direction. And though there were few absolute conclusions, there seemed to be a genuine consensus that our environment will not remain the same, and that alert participants in this market must be able to change along with it. The changing economy: Trends to watch In a discussion of the macro-economy, Joe Pagliari, Clinical Professor of Real Estate at¬†the University of Chicago and Jim Costello, Managing Director and Head of Investment¬†Consulting and Strategy, CBRE, discussed areas of worry on the horizon.¬†Costello pointed to three trends to watch: 1. The health of the housing market, 2. The condition of a region‚Äôs state and local finances, 3. Quantitative easing and inflation. Pagliari affirmed the importance of housing. ‚ÄúThe data shows that the health of the housing market is a leading indicator of the health of the commercial real estate market. As the single family housing market picks up, that should serve to pull the entire economy forward.‚Äù Housing has always been a significant part of the economy ‚Äì comprising 4%-9% of¬†GDP. Prior to WWII home ownership rates hovered around 40%. Public policy changes instituted after the war including the creation of Freddie and Fannie, interstate highway construction and the mortgage interest tax deduction were responsible for the rise in¬†home ownership rates to a recent high of 70%. Since the housing bubble burst five years¬†ago, home ownership rates have stabilized at 65%. Demographics are still very positive¬†for housing. Based on population growth trends and family formations, there is a need for about 1,000,000 new units per year. The key challenge for investors is: what form those new units should take. Single family? Multi-family? What size? It is very likely that the answers to those questions will not be the same as they were ten years ago, but there is definitely a positive force for growth coming from the simple growth and demographics¬†of the general population. The market also seems to have settled into a more reasonable band of pricing. There¬†may be distress, but much of the distress discount is now more difficult to find. Pagliari observed, ‚ÄúIf you look at Case Schiller data, today‚Äôs housing prices are about where¬†they were ten years ago. I took a look at home prices since 1890 and then added a long¬†term trend line to estimate where home prices should be today..are they still overpriced¬†or have they fallen¬†dis proportionally¬†below long term trend pricing? ‚ÄúAt this point, I don‚Äôt¬†think prices are terribly over or undervalued.‚Äù Of course, the health of specific residential markets is very different at closer inspection. Pagliari developed a fascinating chart that showed the boom/bust price appreciation¬†and depreciation of key markets. The middle curved line indicates all of the different combinations of price appreciation¬†and depreciation that resulted in a net annual price appreciation of 2.4%, the annual¬†rate of inflation. This would include housing in Denver, Portland, Seattle and Tampa.¬†Any market below the middle curve experienced negative real appreciation.¬†The top line indicates net annual price appreciation of at least 4% and includes the global¬†gateway cities of New York, Boston, Washington and Los Angeles. ‚ÄúIn general it is more¬†difficult to build in coastal areas,‚Äù said Pagliari, ‚Äúwhich might begin to explain why those¬†markets experienced the greatest appreciation. There are implications for commercial¬†real estate as there tends to be more volatility for suburban office tenant demand in the¬†most volatile housing markets.‚Äù The financial health of state and local municipalities is likely to have even greater impact¬†on the success of various investments, and Jim and Joe strongly encouraged the group¬†to incorporate a deeper analysis of government finances in any risk assessment. What¬†is the tax stream of the state? What percentage of state revenues come from income¬†taxes? For example, in California, that number is 45% and the top 1% pay 45% of all¬†income taxes. The numbers are similar in New York and New Jersey. An over-reliance¬†on a small portion of the tax base is ‚Äúa recipe for potential financial disaster‚Äù if the¬†wealthiest residents move to low tax states, leaving even bigger gaps in state budgets.¬†The challenge for local governments, of course, is not just revenue. Grossly underfunded¬†pension systems in states like Illinois will challenge any governments efforts to balance¬†the books no matter how much they raise taxes. When states cannot raise sufficient¬†revenue the next step is to cut services, adding to the risk associated with owning real¬†estate. Commercial real estate owners make an assumption regarding the availability¬†of municipal services for garbage collection, snow removal and school quality. If these¬†services adversely change, how will that affect real estate taxes, the willingness of¬†tenants to lease space and ultimate real estate values? If tenants start to flee, assets¬†will get re-priced. ‚ÄúI don‚Äôt think these risks have been priced in yet,‚Äù observed Pagliari.¬†Costello concurred, ‚ÄúI do not think very many firms are thinking about the state of¬†municipal finance issue in a structured way, they just assume the issues will get worked¬†out.‚Äù If issues aren‚Äôt resolved, smaller, growth oriented firms may start to relocate and¬†larger firms will continue to shift portions of their business to less expensive markets. Look¬†at how much of the financial industry‚Äôs back office has already moved to states like Utah.¬†Inflation isn‚Äôt here yet, and in some ways, that may be a problem. The fed has been¬†buying long dated government securities in the hopes of lowering the cost of capital¬†for borrowers so they will invest more. The greatest impact of this so far has been the¬†lowering of lending rates for commercial property with fixed rate 5-year debt at 5% or¬†lower. According to Costello, ‚Äúthese rates are helping firms carry assets, but it‚Äôs not yet¬†having the total effect that was hoped for. There is not that much demand for money¬†at the moment and that is keeping inflation in check.‚Äù ‚ÄúInflation is actually a good thing for real estate,‚Äù Pagliari pointed out, ‚Äúreturns are highly¬†correlated with inflation because rents will rise when markets are at equilibrium as they¬†are today.‚Äù Marketing and Capital Raising Discussion: What is the new world order for fund managers? Seventy percent of the meeting participants are currently in the process of raising capital.¬†Discussions ranged throughout the day on how to make sure those funds find the right¬†investors and successfully close. A challenging process in the best of times, capital¬†raising today requires more imagination, creativity and diligence than ever before.¬†A few questions discussed during the round table follow. Can a fund be too small to be taken seriously by investors? The consensus believed that fund size needs to be appropriate for whomever the fund¬†is being marketed to and the deal the size. As funds target who they reach out to,¬†managers should be cognitive of any percentage of fund limitations. There are groups¬†with caps of 3%, 5%, 10% and 50%. For example, a fund manager looking to raise¬†a $100,000,000 fund might want to skip CALPERS because they will either take the¬†entire fund or decline to participate. Markets seem to exist for funds of all sizes. A $75 million fund might include family¬†offices and endowments on their prospect list. One manager pointed out, ‚ÄúIn our¬†$250 million fund we might have one or two $50 million investors, and that rules out¬†all of the large investors. Then we are targeting the $10 million to $25 million investor¬†to complete the fund.‚Äù Is co-investment a good idea? Funds usually use co-investment as a marketing strategy to gain a leg up in the fund¬†raising process. ‚ÄúIncreasingly, limited partners are asking for co-investment opportunities¬†and think they have the organizational readiness where they can execute the strategy,‚Äù¬†said one manager. ‚ÄúIt can work, but it is difficult. For us it‚Äôs all about portfolio construction and how things fit with our other direct investments.‚Äù ‚ÄúA couple of other funds are pre-specifying the size and nature of deals that are eligible¬†for co-invest and have a number of investors commit to a sleeve, but it is an opt-out¬†sleeve. We are also getting inundated with inbound inquiries to put our capital along¬†side sovereign capital. Making that work creates other challenges as there needs to¬†be minority investors and it‚Äôs tough to make co-invest deals work from that position.‚Äù When you try to marry foreign capital with domestic capital it becomes more¬†problematic because club deals are difficult to get approved even when investors¬†are on the same wave-length. What are some good ideas for¬†structuring marketing and strategy? Many limited partners have very structured multi-step due diligence policies beginning¬†with a review of the marketing flip book and PPM. After internal review the decision is¬†made to go forward or not or request a face-to-face meeting. Funds will try to circumvent¬†the process, but for purposes of consistency, internal review protocols are observed.¬†One investor noted, ‚ÄúWhat I love to hear upfront before the PPM and before the any¬†due diligence begins are three things: What is your edge? How does that translate into¬†performance in the past? And why should I believe it will translate into performance in¬†the future. We need to hear something that would encourage us to spend our limited¬†time because time is our most limited resource.‚Äù Staying in touch is important throughout the process, and even if investors aren‚Äôt ready¬†to invest initially, they may be interested later. Things change. But it is essential that¬†whenever you connect to investors, don‚Äôt just ‚Äúchat‚Äù or ‚Äútouch base‚Äù. They need to hear¬†what and why ‚Äì what has changed and why it makes sense to come into a fund now. What about third party capital raisers? The promise of introductions to pre-qualified prospects is alluring, but results may vary.¬†Many participants in this meeting expressed reservations about the effectiveness of¬†some third parties and were concerned about the cost. Many third parties require upfront¬†retainers or monthly fees. They frequently do not make appropriate connections. Some¬†attempt to control the direct relationships with investors until there is a first meeting.¬†However, some funds have had success with third parties when raising funds outside¬†of the United States. There is a good amount of European interest in US real estate,¬†but the process is very slow. Third parties can be beneficial for filling gaps. One new fund had success with a third party because the group fulfilled a strategic¬†need. The outside resource added credibility to the fund. They also provided unique¬†strategies for helping market the fund. Also, because of their extensive experience,¬†they were able to take the fund through the step-by-step process of fund raising. At the end of the day, whether going through a third-party or raising funds yourself,¬†there seem to be few short cuts. Success here is a long-term process. Regulations Restrictions and Laws: What Should Capital Raisers Watch for Now? Regulation, compliance and oversight may be areas of the greatest challenge for¬†investment management companies in 2013. Regulations are becoming more complex¬†and unclear every day, and at times they even seem to be in conflict as the government¬†is trying to solve multiple problems in the economy at once. Arthur Don, a Partner of¬†Greenberg Traurig tried to bring some clarity to an often foggy subject during the¬†day‚Äôs discussion. According to Don, ‚ÄúThe easiest way to think about the JOBS Act is as the anti Sarbanes-¬†Oxley Act.‚Äù President Obama signed the Jumpstart Our Business Startups (JOBS) Act¬†for the purpose of increasing American jobs and economic growth by improving access¬†to public capital markets for smaller and emerging growth companies. But it has the¬†effect of softening some of the provisions put into place to protect investors. Two changes¬†authorized under the act:
- The elimination of the prohibition on general advertising and solicitation¬†for private offerings
- Authorization to increase the maximum raised in a Reg A offering from¬†$5 million to $50 million
- As a new growth cycle continues to evolve, and the profiles and priorities of investors¬†change, there will be ever more demand for clarity, compelling strategy, transparency,¬†and flexibility.
- Regulations will become clearer, but we will have to be very careful until they are¬†completely in focus.
- More data, more standards, and more technology are around the corner.