April 1, 2012
Interviewed by: David Snow
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Hard Lessons From the Crash

What did these seasoned veterans of the private real estate learn when a booming market turned into “a perfect storm?” Experts from RREEF Real EstateGreenOak Real Estate, and Kirkland & Ellis share anecdotes and analysis gleaned in the aftermath of the real estate crash.

What did these seasoned veterans of the private real estate learn when a booming market turned into “a perfect storm?” Experts from RREEF Real EstateGreenOak Real Estate, and Kirkland & Ellis share anecdotes and analysis gleaned in the aftermath of the real estate crash.

David Snow, Privcap: We are joined today by Todd Henderson of RREEF Real Estate, Sonny Kalsi of GreenOak Real Estate Advisors, and Steve Tomlinson of Kirkland & Ellis. So gentlemen, thank you for joining Privap today.

We’re talking about real estate. Real estate has been an interesting place to be over the past few years. There’s been any number of terms attached to it– downturn, depression, interesting times. All of you were part of these interesting times, the downturn, and so I’d like to talk about what lessons have been learned from this rather excruciating experience. But maybe we could start with the beginning of the downturn and when it became evident to all of you.

Maybe starting with Todd. Was there a moment when, maybe it was in 2008, or maybe even earlier, when you took a look at the market, looked at some indicators, or maybe even heard an anecdote and said, this might not turn out too well?

Todd Henderson, RREEF Real Estate: I think we first started noticing some differences in how the market was reacting in probably the middle of 2007. We were selling things and we noticed significant variation in how people were evaluating the risk. We, internally, evaluating the risk versus potential purchasers. 2007 for us became a year where we became a net seller for the first time in quite some time.

As 2008 continued, as we continued through 2007 and into early 2008, it became very apparent to us that there were real challenges. The mortgage-backed securities market started faltering. We saw Bear Stearns obviously, and then followed on by what happened with Lehman. Interesting enough, the summer of 2008 felt much better than the spring of 2008, before the global financial crisis really set in. We began seeing a number of different things that were happening in the transaction market.

You usually see, between smart buyers and smart sellers, generally a pattern. When that pattern gets really dislocated around what people view is value, and what kind of returns they’re looking at going forward, it makes you ask the question. That’s when we started asking the question of ourselves in the mid 2007.

Snow: Sonny, what was the moment when you took a look at things going on in the world and said, might not be going straight up.

Sonny Kalsi, GreenOak Real Estate Advisors: I wish it as earlier than it was. So a couple of dates. April 2007 I was at a small private dinner that was hosted by Bob Rubin, and I remember leaving that dinner and he scared the crap out of me, just talking about stuff I’d never actually heard of. I’d never heard of a SIV before that. But talking about a lot of things that were going on. I went back to my team. I was at my former firm at the time. Went back to my team and we talked about it. We were like, yeah, this is– the financing market. Maybe because we’re primarily equity investors, we were more focused on how crazy the financing market was, and maybe necessarily how crazy we, as equity investors, may have been. So that was kind of wobble number one.

Wobble number two was July 4 of 2007 because we were doing a big take private of a company in Australia. We went from having six financing quotes in a week for $6 billion take private to having one half of a financing quote. So that’s when I knew we had a big problem.

Then I’d say the third date is– we started marking the portfolio down in September of 2007, and kept marking it down. So I think that it’s interesting with Todd’s comments. We were not a net seller in 2007, but we were net neutral. So we sold a ton, but we bought a lot too. Just the way these funds work, you’re selling from older funds, you’re buying newer funds. I think that from a market standpoint, if I rewound the tape a little bit, I think about different critical steps along the way.

We had a really tough second half of 2006. We didn’t buy anything. We lost everything we bid on. We were not competitive. We came into 2007 saying we’ve got to maintain our market position. Expectation– we have to maintain our market position. You think about these things in hindsight. Had we gotten it six months earlier, I think it still would have been a couple of painful years where they would have been a lot less painful.

Stephen Tomlinson, Kirkland & Ellis: There are three transactions. One I bought a big house in Fairfield County. I knew that was the top. Two, Equity Office and the speed with which that transaction turned into a flip, which nobody really– we kind of sensed but didn’t really know. I think everybody kind of stepped back when the dust settled and said, wow, that was an amazing execution. Which was the flip side of that. Ee were involved in each of those transactions in one form or another. The difference of the dynamic was dramatic. I think there will be looked at in the rear view mirror for a while as emblematic of what they were at the time and what was happening in the marketplace to the points that Todd and Sonny were making of. You just knew that type of activity couldn’t be sustained. It was very, very out of the norm of what people had been experiencing I think.

Kalsi: You mentioned two transactions there. I would say that I’ve obviously spent a lot of time doing a lot of soul searching over the last five years now. Jeez, it’s been that long? So it’s five years. I don’t know if there’s such term as a negative alpha. But one of the thing certainly that I’ve done is we’ve launched a new business, and we spent a lot of time with investors, and we try to reconstruct what we did well and what we didn’t do so well.

I would say 2/3 of the negative alpha from my prior life, frankly came from public to privates. If you think about that kind of phenomenon, not something that happened a whole lot in the real estate industry. I would say that in my career, I’ve probably been involved in one public to private that was successful, and that was take private of Canary Wharf in the UK. Even that its bumps along the road.

Everything else that we were involved in turned out to be a disaster. I would argue that maybe other than Equity Office, because of the way the dynamic ended up going and an interloper getting involved, and the fact that they had to flip out of a lot of it, I am still looking for another one that people would look at again and say, gee, that’s kind of what we wanted to do. The risk reward profile really worked.

At the end of the day, you’re competing against a public market. You’re using very significant amounts of debt, which were very cheap and very high loan-to-values.

Look, it’s funny. We would convince ourselves that we were making some of these investments and saying, these are not that competitive. Yet, they’re the ultimate, most competitive transaction there is because you’re competing with millions of shareholders. So that to me, certainly from a lesson learned perspective, if you just took one type of investing out of the equation and you said, that was it. That was 2/3 of the mistakes we made in that time period.

Henderson: Sonny, I’m curious. Is it more of what you paid for them and the execution strategy that didn’t work, or was it the leverage that was used to make these things work? My sense of your lessons learned, leverage magnifies results. And when you’re in the top of a market, we all knew– if you look at where rents were, you look at where trades were relative replacement, everything–

Kalsi: Nothing was cheap.

Henderson: Nothing was cheap. We were at peak levels in almost every market, and every day something traded for a price that was higher than the day before. And it was a new record on a price per square foot in every major market. Then we took that and assumed that rents were going to continue to grow. We bought at 2% or 3% cap rates and we financed at 5 at 80% levels. So to me, there are a lot of mistakes in that equation.

But I’m curious with respect to the public to privates, was it more leverage or was it more execution?

Kalsi: It was both. All right, when I look at the series of funds that I used to manage, and we think about what leverage levels were kind of in ’06, ’07 vintage, LTV as a percentage wasn’t actually that much higher. Now the V was a lot higher, obviously in hindsight. But the LTV wasn’t a lot higher.

The couple of things that were different about these. One, the type of financing was different. So a lot of it was corporate financing. Was not five, seven year property-based mortgage financing. You had much shorter-term debt, two or three years, which was done at an entity level with a view that you’re going to refinance stuff to the portfolio. The other big presupposition of a lot of these was you’re going to be able to flip a decent amount of the assets out. And maybe it was only 20% of the assets, but that’s significant from the standpoint of deleveraging.

So when you’ve got kind of the type of financing more so than the amount of the financing. So the type of financing you’re putting in place, and then the business plan which is based upon being able to go into the market, and over the next 12 or 24 months, dispose of the things that you consider non-core or not part of your strategy. Then you have the market event that we have happen. You got squeezed on both sides.

Actually, you get squeezed on three sides. You get squeezed because the financing, which was two or three years, was not replaceable and it was not term. You couldn’t execute your business plan because you couldn’t sell anything. Then your operating results on the stuff, on everything, started to suffer because rents did correct very quickly downward. It just became the perfect storm of in hindsight, wish we all the benefit of it. But in hindsight, frankly everything was wrong about the strategy.

Snow: Well, with the benefit of hindsight, were there certain indicators or was there something about the history of real estate up to that point that sort of made it inevitable? That if you took a look at how real estate had performed over the past, whatever, 80 years, you could not help but underwrite certain opportunities based on the history up to that point.

Henderson: Sure, real estate operates in cycles. We’ve seen them. Sitting here we’ve probably been through three or four major real estate cycles where we’ve seen significant peak to trough devaluation. I think the challenge is this was not a real estate depression. This was a global financial crisis that resulted in every asset class being highly correlated and sinking to the bottom of the pool. So it’s very difficult to underwrite three and four standard deviations of a financial crisis.

That being said, I think that there still are lessons learned. A crisis is a terrible thing to waste, and we’ve taken advantage of that. I think what we’re learning is that our industry needs to think more about how they diversify their portfolios, from an income perspective or from a beta perspective, and from an alpha perspective. How do you diversify a portfolio globally? How do you diversify from a geographic perspective? How do you diversify a portfolio from a sector perspective? How do you diversify a portfolio from an income perspective versus an appreciation perspective? If you get that right, you’re going to outperform, there’s no doubt about it.

The challenge in our industry has been that the data, historically, has either been poor, or the time series of data hasn’t been such that it will allow you to do a lot of the top-down things that the other asset classes have been able to do for quite some time, the equity in a fixed income market.

We have built that apparatus coming out the crisis. We’re using that to help our clients to better diversify their portfolios, to better understand what they want out of real estate, and how to get that to them in an environment that can be very choppy or cyclical going forward.

Snow: Steve, what do you think will be one of the biggest changes in the way that either the investors or the managers promulgate a real estate strategy based on the lessons learned of the most recent, and perhaps the ongoing downturn?

Tomlinson: I think that Todd put his finger on one aspect of things, which is we do a lot of work in the fund area. My sense is in meeting with sponsors that the LP community is very, very alert to the kinds of things Todd is focusing on. Exactly how is this going to work? Really kicking the tires very hard about the strategy, what the value drivers behind the strategy will be, and the ability of the sponsor to actually execute.

I think everybody has figured out that capital structures are vastly more complex than they were. There was a very rapid increase in the complexity capital structures, sort of 2002 to 2007. I’m not sure that deal technology, everybody’s thinking about it kind of kept pace with the financial engineering. Some of things that Sonny pointed to of layers of debt in the capital structure, unsecured corporate debt, asset level secured debt, in combinations that a lot of real estate people weren’t terribly familiar with it– because they hadn’t really been done that much– became very difficult to work with.

So when things got bad, because real estate is operation complex, just at the asset level, layer on top that very complex capital structure that does not lend itself to people coming together and quickly making decisions about what to do. Because who can make a decision needed to be solved? Lots of legal uncertainty around that. It created a situation where you had the perfect storm from an economic standpoint. From our perspective, from a legal standpoint, you had structures that went into this perfect storm perfectly built to be shattered by the perfect storm because they couldn’t respond quickly. And that became a huge issue in a number of very, very large restructuring. Some in court and some out of court.

Snow: I’ll ask one final question that has to do with the skills that were highly valued in the lead up to the peak of the market. Was there an overemphasis placed on a certain kind– and maybe it’s the financial side of things. Was there an emphasis placed on a certain kind of skill that one can bring to real estate investing that turns out was not as valuable as it should have been, and possibly could have been harmful?

Kalsi: Financial engineering. Ultimately, if you think about the big evolution of what happened in the market, real estate went from being a non-institutional asset class to being an institutional asset class. What that really means is that all of a sudden 20 years ago your opportunities to have real estate exposure were pretty limited. By 2007, you could have had real estate exposure in all kinds of different ways.

So when it became a financial instrument, it started trading much more like a financial instrument. The people that got involved with the industry, increasing number of people got involved with an industry who were coming at it from a financial perspective and not from a real estate perspective.  So that definitely, whether it got overvalued or not, it got overused for sure. In terms of what Steve has said with the capital structure and how things worked. Certainly some of those structures for how people put things together.

Look, one of the things that’s very clear now. You go through this three or four standard deviation event and everything else is– we can’t financial engineer a whole hell of a lot anymore, maybe other than borrowing money from the government by multifamily. So you’ve got to make money the old fashioned way, you got to earn it. So you’ve got to buy something. Feel like you’re buying a Jeep. You got to roll up your sleeves, figure out how to lease it, how to do what you’re going to do. Then you’ve got to figure out how to really– and then you put financing in place.

I would tell you that we certainly are much more cautious in financing now– forget than we were in 2007– than we were in 2001. We just have a very different view on it because the end of the day, when people look back on this cycle, when they differentiate, they say, who did a good job and what’s a business that we want to support their continued growth?

I think people are very savvy to looking at, OK, who just took advantage of where the markets were, and who went out there and earned it, and made it happen? And I think it’s very important to kind of go out there and show that you can make it happen.

So everything we look at, for example, we price anywhere. We invest more than just in the US. We price it on an unlevered basis. And that’s one way to– it’s a very basic discipline, but it’s a very basic discipline of looking at something and saying, OK, let’s not repeat some of the mistakes of the past.

Henderson: What’s interesting about our industry is we leverage the least leverageable assets– the most. Meaning that cash flow is inherently leverageable, right? But in the core space, we put 30%, 40%, 50% leverage on it. For those things that are transitional and have zero cash flow, we push the leverage levels as high as we possibly can.

I think we have that backwards. I don’t think I’m going to change the industry, but it is backwards. I’m pleased to hear you say that you guys are looking at things from an unleveraged perspective clearly for transitional assets because at the end of the day, if you complete that plan, then you can leverage that asset significantly higher because of the cash flow you’ve put in place than you could at the beginning of it. You do it with significantly less risk.

It gets back to, again, establishing tolerance for risk levels and really understanding where you are in the risk return spectrum and building out a portfolio that you clearly know, to the best of your capabilities, the risks that you’re taking, both on the asset level and from a financial engineering perspective.

Tomlinson: To come full circle to the point Todd started with, I think again on the fundraising side of our business, what we hear almost constantly, operator funds. We want people who get operating real estate, who can drive value at the asset level. We want to understand how that’s going to work, and then we will talk about whether we’re interested in investing. I think everybody’s saying some version of the same thing. You need to understand the assets and how to drive value at the asset level. That story is one that doesn’t make sense. I think the market now kind of gets that.

In the commingled fund, business back in the ’80s, the bank sponsored commingled funds, when they blew up in the late ’80s, real estate was a bond and you’d get the coupon. Well, that didn’t work out so well. It didn’t work out that well 30 years later either.

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