The private equity power players who helped fuel the real estate and REIT run-up of the 2000s will be largely sidelined amid fears the subprime debacle is spreading. That's especially true of the opaque debt class known as collateralized debt obligations, or CDOs, which repackage high-risk mortgage bonds.
Experts say that buyout groups rely on CDOs for 60% of the loans to finance U.S. acquisitions and may borrow 90% and more of the total deal value to make their purchases.
The slowdown in buyouts “isn't REIT specific,” says Craig Silvers, founder of Los Angeles-based Bricks & Mortar Capital LLC, a money management shop specializing in REITs. “However, given the large number of REIT and public real estate company acquisitions over the past couple of years, the slowdown in the number of acquisitions will be noticed by the media and investors.”
The apex in REIT values was reached in February, notes Silvers. REITs have had a remarkable seven-year run in which indices, including dividends, roughly quadrupled in value. This year REITs have plunged by about one-third since reaching a zenith concurrent with the $39 billion Blackstone Group buyout of Equity Office Properties Trust.
How long will it be until the huge private equity funds return to real estate? Until the CDO market firms up, and that may take months, explains Christopher Whalen, managing director of Institutional Risk Analysis in New York.
“Buyers who bought CDOs have had their fingers burned. It will be a while before their skin grows back,” Whalen says. Currently the $1 trillion CDO market is largely illiquid, and even if assets underlying a CDO are worth 80 cents on the dollar, they will sell for 40 cents in a fire-sale market.
In a conference call on Aug. 15, Kohlberg Kravis Roberts & Co. (KKR) co-founder George Roberts said buyout firms can no longer pay premiums for public targets, including REITs.
“It's very hard for people to get financing,'' Roberts said. “Stock markets [share prices in takeover targets] haven't fully reflected what's taken place in the credit markets.''
But the private equity doyens are imaginative when it comes to raising cash from investors, says Beth Di Santo, founder of the New York-based Di Santo & Associates law firm, which works on real estate portfolio sales.
For the next several months, private equity buyers might put down more cash and execute a “stock swap” for real estate assets, especially if REITs are selling cheap. Perhaps surprisingly, experts say private equity buyers, even big, leveraged ones, will come back by next year. “You see some nervousness in commercial real estate lending markets, but I am not sure that matters so much,” says Stan Ross, chairman of the Lusk Center for Real Estate at USC and a Los Angeles deal veteran.
“Many institutional investors are interested in commercial debt, such as insurance companies,” Ross says. “The fundamentals remain good for commercial real estate in most markets. There is not a lot of new supply coming on line.”
In the longer run, the same capital reality that financed the private equity buyers and caused the real estate boom — a worldwide capital glut, and resultant grasping for higher yields — will rescue property and put cash behind private equity buyers again.
“Some call it a ‘capital glut,’ but I don't think there really is an excess. There is a lot of global capital there to do what we need to get done,” says Ross. “It bodes well for real estate, very well for real estate.”