The Other Real Estate Disaster
Kurt Brouwer July 11th, 2008
This is a very long article from Forbes on state pension funds and the leveraged real estate investments they have made. For years, those looked very good, but now problems have arisen [emphasis added]. The tone of the piece leans toward impending doom, which is no doubt overdone because state pension plans have placed modest percentages of their assets in these leveraged real estate funds. However, the downturn in real estate is real and it appears as if pension plans are going to take a few lumps along with the rest of us.
The Other Real Estate Disaster (Forbes, July 21, 2008, Stephane Fitch)
Your state’s employee pension fund is probably (a) doing badly with recent real estate pools and (b) working very hard with the private equity operators of these pools to keep you in the dark.
Scott Lawlor and the managers at Pennsylvania Public Schools’ $63 billion pension fund had a beautiful relationship. From an office on New York’s Park Avenue Lawlor and his firm, Broadway Partners, ran real estate “opportunity funds,” fat with capital from the teachers’ pension and other institutions. He had invested the funds in a $10 billion pool of glamorous office properties like Boston’s John Hancock Tower. Lawlor delivered profits–or so the Pennsylvania fund managers reported–of up to 40% a year. The state fund managers kept capital flowing, both to his funds and to his pocket, in the form of fees.
Everything was private. No Wall Street analysts, no regulators, no outsiders and no interference. No ordinary Pennsylvania pensioner got to see Lawlor’s quarterly financial reports. The managers in their pension plan’s Harrisburg headquarters had all signed nondisclosure agreements with Lawlor.
The picture turned grim by March. Lawlor was struggling to keep his buildings, purchased with as much as 90% debt, from falling into the hands of lenders. He owed $1.2 billion of short-term “mezzanine” debt to New York investment bank Lehman Brothers (nyse: LEH) and other lenders. (The debt has since been extended.) The funds’ previous gains? Mostly, if not entirely, gone. It will be months before Pennsylvania’s 500,000-plus public school employees and retirees know how much of their $196 million in principal in Lawlor’s funds is left.
The retirement plan “has seen some decline in value this past quarter,” says Charles Spiller, head of private equity and real estate investments at the Pennsylvania teachers’ fund. But he refuses to comment on Broadway. Last September he valued positions in 58 private real estate investment funds at a total $3.6 billion. What’s this pot of money worth now? That’s a secret for a few more months, and Spiller isn’t releasing any of the communications he’s had from the fund operators about their recent results.
Enticing investors with the lure of returns exceeding 20%, opportunity funds are the slickest deal in real estate. They account for one-sixth of $2 trillion in total net assets in private equity, says the London firm Private Equity Intelligence, which tracks the industry. A year ago the most closely studied funds in the U.S. were holding $213 billion in commercial real estate equity, leveraged 70% on average. Traders of swaps contracts on the leading commercial property index were recently betting on a correction of up to 15% in values–which would result in $100 billion in writedowns.
This is the other meltdown–the one you haven’t heard much about. It’s not part of the real estate and credit contagion that started with the subprime calamity, then spread to all corners of the debt market. This misadventure has its own origins in hubris, battered further by dumb mistakes and bad timing. The catastrophe may not stack up quite as high as the $350 billion in writedowns that investment funds and banks have registered in the bond markets, but for small investors all across America whose retirement pools poured 1% to 5% of their assets into opp funds, heavy losses–only beginning to surface–could be a sizable blow. If the setbacks for pension funds are severe enough, it could force state governments to raise taxes to cover shortfalls and induce companies to cut back on dividend payments to shareholders in order to set aside additional money for their private workforce pensions.
Many opportunity funds are black boxes. What these investments are worth is often anybody’s guess until they’re liquidated, typically seven to ten years after they finish raising capital. They’re virtually unregulated–a recent statement by the Financial Accounting Standards Board leaves it to the funds to address fair value–and private equity groups don’t have to file regularly to the Securities & Exchange Commission. When they do give out internal rates of return, they’re usually expressed as a rough percentage of money originally invested. Rarely are they adjusted for leverage.
The failure to account for leverage is what makes these private equity pools so popular. In a rising market, which real estate enjoyed until a year ago, leverage turns average performers into seeming geniuses. In an up market a mediocre real estate manager enjoys million-dollar paydays, according to the customary formula that gives operators of private equity pools up to 20% of gains.
Say the manager buys a building for $100 million, putting down $30 million of your money and borrowing the rest. Over the next three years it appreciates to $150 million. Interest on the mortgage adds up to 20%, or $14 million. Before fees, you have made $36 million, a 120% return. That comes to 30% a year. But the unleveraged return was only 14.5%. Which return number, 30% or 14.5%, is the one most likely to be talked about?
In a down market, of course, leverage turns average performance into a disaster. But the operators of the pools are not expected to share 20% of the losses. No, the losses belong 100% to the providers of the equity capital. That would be you, if you’re a taxpayer…
See California Public Employees Take Big Hit On Real Estate for more on real estate investments in state retirement plans.
