This is the fifth of six installments of my notes and comments from Institutional Real Estate, Inc.’s Dealmakers Summit (Sept. 14 – 16, 2009).  This section regards the state of commercial real estate equity.  See my blog at ToddAPhillips.blogspot.com for the other installments.

INSTITUTIONAL EQUITY

Earlier in the year, Institutions’ investment allocations were out-of-whack.  A quickly falling stock market made real estate appear over-allocated.  Real estate values have subsequently dropped and equities have recovered.  It appears as though allocations have been repaired and may now be in line for institutions to start investing in real estate again.  Given that even the least savvy investors can infer that bond values will drop in the near to mid future (hard for treasuries to go below zero), then there would seem to be a case for allocating even more to real estate. 

There is evidence of this happening – small pockets of pensions are announcing increased real estate initiatives.  Nearly everyone, however, is targeting at least second quarter of 2010 (if not later) for getting serious about putting capital to work.

New equity funds will likely be smaller, with fewer investors for two reasons: Limited Partner issues (read: too many cooks in the kitchen) and scarcity of debt for really large deals. Although in my opinion, there is a play in buying all cash today and leveraging up with non-recourse financing when debt markets recover. Complex waterfalls are likely gone in favor of more simple (and investor-friendly) models.

Real estate historically produces strong, positive cash flow which will continue to make it attractive when compared to other investments, especially when combined with a potential for appreciation. 

Institutional equity owns roughly $450 billion in real estate (give or take depending on whom you talk to).  Of this, there is another estimated $45 billion of committed capital sitting on the sidelines as a leftover from the previous buying cycle.

Institutional trading capital (short term) is somewhat active, but long-term investor capital is still on the sidelines.  There simply is no perception in the institutional community that tomorrow will be better than today.  Until that changes, expect most of this equity to stay on the sidelines.

ENTREPRENEURIAL EQUITY

Although there were very few entrepreneurs at the conference the general perception was that this group would be first to act and will likely profit the most from this buying cycle.

In my experience, this is a uniquely challenging market for entrepreneurial real estate investors.  Many of them are dependent on the debt market for at least a portion of their capital.

Compounding problems for the entrepreneurial crowd was their previous appetite for recourse loans during the previous cycle.  Most of these buyers are dealing with workouts in their existing portfolio and are, at the very least, having to de-leverage properties with debt maturities.  Deleveraging requires a great deal of capital which is difficult, if not impossible, to raise (can’t sell properties, can’t refi, and can’t attract outside investors).

I think that we’ll see only a handful of these investors active until the debt markets recover.

PUBLIC REITS

Public REITs have been the lone bright spot for real estate in 2009.  Public REITs have had their best year of raising capital on follow-on offerings since REITs were first conceived.  Through the second quarter, REITs have raised nearly $16 billion.  It is generally understood that most of this capital will be used to repair balance sheets versus invest in new deals.  However, once there is consensus that a REIT’s balance sheet is healthy, they will be given the green light by investors to start acquiring distressed deals.

What remains to be seen is whether this frothy equity market will carry over to IPOs.  It certainly did in Starwood’s case, but their new REIT is a mortgage REIT.  Other mortgage REITs are rumored to be in the works, but no one has been brave enough to launch a fresh property REIT.

PRIVATE REITS

Private REITs enjoyed a big run earlier in the decade.  It remains to be seen when this will rebound.  It would make sense that once public REIT IPOs start to come online, that there would be a spike in demand for private REITs. 

The second quarter for private REITs were a stark contrast to public REITs.  Private REITs (and LPs/LLC s) had one of their worst quarters on record.  There are two major drivers for this, (1) the private REITs on the market had spent a year or more ‘on the shelf’ and thus they have real estate acquisitions from the last cycle (aka legacy assets) and (2) due diligence officers have spent the better part of 2009 clearing old unsold REITs off the shelf rather than adding new offerings.  Those REITs from the 2007 / 2008 vintage that are still open have been heavily discounted, but that isn’t helping them sell. 

Once the public REIT market looks sustainably healthy and B-D’s have cleared their bench, I think we will see this market spike similar to the public REIT market in the second quarter.