PureVC

Why Commercial RE May Not Crash

Many market commentators have been predicting that commercial real estate is the next shoe to drop in the credit crisis. I've seen a handful of presentations with whopping statistics on the amount of outstanding debt that will need to be revolved in the upcoming years. However, there has not been the massive apocalypse in commercial RE. At least not yet.

And there actually may not be. At least for a long while. The reason is that early this year the IRS changed some rules to allow REITs to pay some or all of their dividends in the form of stock. Typically a REIT pays its dividend in 100% cash out of its funds from operations. Because it pays a certain percentage of all of its income as dividends, it gets favorable tax treatment as a REIT. Late last year when the credit crisis was in full swing, REITs suddenly had to reduce their dividends because their funds from operations were reduced. Additionally, the terms for renewing debt was highly unfavorable so many REITs were in a bind as to whether they could revolve the debt at all or even pay out a dividend. As you can imagine, failure to pay a dividend would cause investors to flee the REIT as the primary reason to even invest in one is for income.

So the overall prediction was that as REITs would need to renew their debt in massive proportions, the credit markets would continue to be frozen and many would become insolvent. However, that has not happened. Fortunately, this single IRS change has allowed REITs to continue to pay large dividends to shareholders by issuing the dividend partially or fully in stock. Thus, there has been no massive exodus and crashing of these REITs. With their stock intact or even elevated due to the recent market bounce, many REITs have even been able to issue stock to repay debt.

One potential side effect of this IRS change is that the current shareholder is diluted at each dividend payment. Essentially, by issuing more shares each quarter, the REIT is slowly diluting and watering down its own investors.

This form of dividend payment reminds me of PIK toggle notes. These "Payment In Kind" notes allow a debtor to defer payment of the debt and allow it to accrue for a certain period. In the LBO world, PIK notes are very favorable for the debtor because it allows the debtor to essentially change the terms of his loan if his cash flow is thin. As you can imagine though, the use of PIK notes are a clear indication of potential financial distress and in general are only issued during frothy boom times. Thus, it is surprising that in this time of financial crisis the IRS would allow payment of dividends in stock.

This either means that commercial RE will never have its projected crash. Or it means that the death will be slow and it will be inevitable.

We are #53 - Thanks PureVC Readers

Not that I really care or that I even keep track, but today someone informed me that TechCrunch has posted the top 100 VC blogs based on number of Google Reader subscribers. This blog came in at #53 and I thank all the readers who continue to enjoy its content.

When this blog started it was more of an experiment to help me flush out my thoughts and post on interesting topics specifically in the field of venture capital. Over time, I really couldn't help myself but post on all areas of private equity that I am involved in including real estate, hedge funds, leveraged buyouts, and general market commentary. Hopefully I haven't alienated too many readers by broadening my horizon.

While Google Reader is only one source of readers of this blog and this list doesn't really mean much, it does confirm that there is a hunger out in cyberspace for information on the overall venture and private equity industries. And we all know that where there is demand, supply will come.

I am happy to be one of those suppliers of information. Feel free to drop me a line anytime with questions, ideas, or comments. Thanks again for joining me in this rewarding endeavor.

The Hurdle

It's been a while since I posted but a reader recently asked me to comment on Hurdle rates. For those of you not familiar with what a hurdle rate is, it is generally the preferred rate of return an investor requires to make an investment. Some refer to it as "cost of capital". If you consider the many options of where money can go to make a return, for an investment to be attractive it should exceed the most commonly available rates of return. There are many differing opinions on what this common rate of return should be. For example, some people feel that a good preferred return is that of what money would cost to borrow from a bank such as 7% on a fixed 30 year loan or a few points above LIBOR. Others may use a benchmark of the average return of a broad stock index such as the S&P 500.

Another way to look at the hurdle is the percentage return after which a fund manager can charge fees. For example a manager may say that his fees will only be charged on the return in excess of the hurdle. The logic is essentially that the investment should return better than a commonly available return and thus only fees should be paid on that excessive return.

I have never been a fan of hurdles or preferred returns in private equity. The main reason is that I am not a nickel and dimer and if I am investing in an investment looking for an outsized gain I am not going to fuss over the terms of a preferred return. If I wanted a hurdle type of return I would just put my money in a mutual fund or buy a piece of commercial real estate and get a good cap rate. When I invest, I want the manager to make big returns and be rewarded on the back end for the great return.

It is sort of analogous to investing in public equity for dividends. I am not a dividend investor and would never invest in a stock for its dividends but more for its appreciation. Additionally, in a private venture type investment, taking a dividend in a startup does not make sense to me because you want the cash to stay in the company to add value to the equity. An LBO is a different scenario because the company is cash flow rich and taking a dividend should not weaken the company materially.

Thus to me the hurdle rate should be a non-issue and in a private deal where I am looking for a good return, I do not want the manager to focus on the hurdle. I would rather that it be clean and simple. I want to be able to calculate the return and fees that I paid to the manager in my head or on the back of a napkin, not through a complicated spreadsheet.

If I am investing in a fund, I am looking to build a relationship is someone who can earn good returns over any cycle. I may negotiate some terms or fees, but the hurdle certainly is not one of them. I would rather go with a talented manager with a low hurdle than a first-timer with a high preferred return.

It's Time To Get Opportunistic in Real Estate

By now everyone is well aware of what has been going on in the real estate markets. The subprime debt market has had its effects in every industry and most directly on the big financials. The residential real estate market is the obvious point of pain. But recently I have noticed that the commercial markets have started to soften.

What this means is that big developers are finally starting to let go of valuable property. In some areas we haven't seen available good pieces of land at attractive prices for probably a decade. But now I am seeing signs that there will be some opportunities for people who want to develop properties.

The difference between the residential meltdown and a commercial slowdown is that the residential markets are directed by the average home investor, most of which are not that savvy. The commercial market has a lot of pros and REITs that have a lot of cash that they could put to work. What this means is that as things start to become available, I don't think you'll see a "crash" mentality that we've seen in the housing market. The sharks will circle good deals for a while before they get gobbled up. But the point is that they will get gobbled up.

There are deals that will start to appear that will pencil in at nice profits even with 3 and 4 year holding periods. One of the great things about economics is that with every boom and bust cycle there is always another wave of opportunity for people to create new wealth.

Getting Your Start in Real Estate

I recently received an email from a woman wanting to know how she could get her starting running her first real estate development deal. She had a project idea in mind, a location, and was basically looking for funding. What she did not have was really any extensive experience in the industry.

If you are an ambitious person who wants to create a real estate empire, you have to start somewhere. But where do most successful real estate developers start?

Of the developers I know, most got their start working at a development firm and learning the ropes from established players. When they had saved up enough money and felt confident to break out on their own, they did. One thing about real estate that I have said many times before is that real estate is really a local industry. There are key developers in every town or city that do most of the meaningful projects. Breaking into their circle may be difficult, but feeding off of their projects is a smart way to get experience and projects under your belt before becoming the lead developer on a project.

If you are ambitious, you may consider hustling and putting deals together for other developers while taking some equity for your work. Alternatively, you can put together a deal and then go out and find a financial partner who will back you for the deal. Working out the specific equity splits can often by complicated but your goal should be to get the project off of the ground while earning a slice of equity for your work.

One key thing to figure out before you really start is what type of real estate player you want to be - a developer from the ground up? a developer who only does rehabiliation projects? a collector of income generating properties? what sector do you want to focus on - residential, commercial, industrial, retail, mixed use, or special projects?

I think it is a great time to get your start in real estate on the residential side. Over-extended developers are trying to get rid of their land on the cheap. There are a lot of houses available for sale all over the place. It's a good time to be opportunistic.

The Most Important Thing About Running Money

I continue to receive a lot of inquiries from people who want to run money or put together deals. Typically what I see comes in three flavors:

1) an entrepreneur looking for capital
2) a fund looking for LPs
3) a developer looking for equity or debt for a real estate development

I welcome these inquiries, but for those who are sending information here are some thoughts that might help you understand our process. All of our deals go through an investment committee. Occasionally I will invest personal funds into deals that the committee rejects. However, typically, we either file the PPM or decide that it is a promising manager but that either we do not know them well enough or it does not fit any of our stage, geographic, or stylistic allocations. For those managers that we like and we do not commit to, we encourage them to keep us in the loop and begin a discovery type of relationship. We encourage them to send us correspondence regularly and treat us as if we were an LP in their fund. I can say that 99% of the time this does not happen. However, the 1% of the time it does happen, it allows us to really understand the ethos and style of a firm. We have found that firms that are willing to take this effort and have this type of "open door" policy are the types of managers we want to partner with. We will wait in line to invest and partner with these types of firms, assuming that their performance is good.

For entrepreneurs or developers looking for capital, we are happy to give you feedback and/or direct you to partners or colleagues within our network who may have an interest.

Now that I've cleared that up, here is the main point of this post:

Whether you are looking for capital for your startup, for your fund, or for your RE deal, the bottom line is that you are "Running Money". I use this term loosely because "Running Money" typically refers to the money management business. I happen to believe that when you take someone's funds with the promise of some sort of return, you are Running Money.

The most important thing about Running Money is to understand that Running Money is really about building relationships. I know that sounds pretty cliche, but the best managers or entrepreneurs are those who understand this concept. They are not so focused on bagging the big fish one time. They understand that in finance, your last fund or deal or company is not all that matters. It really is about your track record of performance and your track record of how you treat people. If you treat each investor or partner as a lifelong business partner, you'll soon realize that people on the other end are not necessarily just about returns. They do have an interest in being a part of something successful and larger. They do have an interest in building something rather than just riding coattails. But you have to consciously make efforts to do this through your words and actions. We continue to back managers and entrepreneurs who have had an unsuccessful fund, company, or deal if they have acted responsibly and continue to have promise. Similarly, we expect our partners to continue to back us if we have an average fund.

It's quite easy for me to distinguish when someone just wants money versus someone who wants money, advice, or a partner for their business journey. I continue to enjoy working with and investing with younger managers or entrepreneurs or established managers who are lifting out on their own for this precise reason. If you take the long view you will not just focus on this one fund, or one RE deal, or one company but rather perhaps on your firm, your career, and your network of relationships.

Where Would You Invest In Private Equity?

Poll results are back for Our First Poll here at the PureVC blog.  73% of responders indicated that they would not invest in the Blackstone IPO. I was among the nays of the group.

I'm not sure what it means, but it clearly shows that readers of this blog can taste the frothiness of PE firm valuations. It will be interesting to see how this closely followed IPO turns out. The rumor mill has been churning these last few weeks of an Apollo Management and a KKR filing. I can't wait to get my hands on the filings and see what has been behind those closed doors.

So now it is time for our second poll. In an effort to stimulate some thought and in light of all of the emails I have received about the different types of private equity, this week's poll wants to know if you had to choose one category of private equity in which to invest, which would it be: Venture Capital, Buyout Funds, Hedge Funds, or Real Estate?

Once again, the poll password is purevc

The CXO Network

I've been running this blog for a few years and every week and month my readership has been increasing. I'm getting more emails from entrepreneurs, investment managers, students, and curious people than ever before. Some people respond to specific posts, some people have specific questions they want answered, some people are pitching their businesses, and others are looking for funds or advice. I welcome all of this communication and will try to get back to you as soon as possible, following my own set of Business Etiquette rules.

At CXO Ventures and CXO Private Equity, we have always had a relatively closed network of investors, entrepreneurs, investment managers, and advisors. We tend to do business with people we know or people who know someone that we know well. It's not because we don't trust people or because we don't do due diligence. We have found (and others have too), that investing in successful people or people you have worked with before (and thus know very well) has a higher likelihood of success. In addition to feeling more comfortable working with people within our network, we feel we are better serving our investors and adhering to our fiduciary duty to manage their financial interests. In some areas of Private Equity such as Real Estate and Leveraged Buyouts, we feel it is essential to know the developer or the management. In other areas such as Venture Capital or Hedge Funds it is important but less realistic to have every deal done within our network.

This blog has generated a lot of interest in our firm. We have found that the readers of this blog tend to be a select group of people. If you have found this blog, you have found it by word of mouth, by reading someone else who links to us, or by searching for a specific topic on Google and wading through those results to find us.  We have been close to doing business with several people who have come to us through this blog. In fact, there are definitely readers with whom I ping regularly on several topics.

In an effort to formally expand our network and to perhaps better serve you readers, I am extending a formal invitation to readers who want to be added to our network list - entrepreneurs, investment managers, investors, students, and anybody else. Here are some details of each list:

Entrepreneurs - Network of entrepreneurs in our network that we would typically contact if there is an opportunity within one of our companies or if we have an idea we are willing to fund and are looking for someone to run with it. If we know an investor that may be interested in finding someone with a particular background, we will pass the entrepreneur's information on to them.

Investment Managers - Network of managers that are looking for deals in a specified category of Private Equity. We refer deals that come to us that fit the profiles of our managers.

Investors - Investors with an appetite for a specific type of deal or category. We see a lot of deals that we pass on. We can direct you to these deals or to people we know to help find what you are looking for.

Students/Interns - Although we do not offer an internship yet, we maintain a list of interested persons that we may have unique opportunities for in the future.

If you have an interest to be added to any of these networks, please contact me with your information (email, phone, address) and a little blurb about yourself and what you are looking for. We are sparing in our use of our network lists and typically we send out notes to people who confirm that they wish to continue receiving our contact. I hope this is ultimately of benefit to both of us. I am hopeful it will increase the efficiency of our deal and job matchmaking.

Please note the following: This is not a solicitation for investment. We do not solicit investors. We do not share information outside of our firm. We are protective of proprietary deal information. We will seek permission for information sharing for each specific transmission.

Debt-Equity Splits on Real Estate Deals

Could you comment generally on what the debt-equity split is normally on a real estate deal?

One of my readers has asked me this. There are many kinds of real estate deals and not every deal is the same. Therefore it is really difficult to say what "normal" is. In addition to the variety of real estate deals out there, there are many different ways to finance a deal. Creative financing is really what creative dealmaking is all about.

A typical real estate development in which a developer approaches a bank for commercial lending will usually need 20% to 30% in equity. Development loans are not like residential mortgages, they usually come in the 7 or 8 year flavor or maybe a 10 to 15 year flavor. Commercial banks know you are in the business of developing a product and that their financing is being used for that purpose. Therefore, they are going to charge you juice to use their money to make you money. If you are willing to pay a higher rate, then you may be able to get less onerous equity requirements.

You should know that a commercial lender is not like a traditional home mortgage lender. They will need to see the financials of the deal to make sure that their money is going to be used judiciously. They will need to see the financials of the developer and will need personal guarantees on the loan that is secured by the developer's personal assets or interests in other projects.  So in addition to equity, they need some sort of security.

You can imagine that if a well known developer has a high net worth and value of his personal securities, then that bank may not require as high of an equity requirement for the loan. However, the rules can only be bent so far. Commercial banks are federally regulated and must satisfy reserve requirements. In other words, they can only have a certain debt to equity ratio themselves - they can only lend out so much money based on their reserves according to law.

None of this really matters though if you are creative in your financing. Let's say you go to investors to raise money for your deal. They may be willing to provide the equity for the loan and therefore you don't have to put much hard equity in the deal.

Or let's say you find somebody who owns a plot of land that agrees to sell it to you and to finance the land themselves. You write a promissory note to them saying you will pay them a certain price plus accrued interest at a certain date. Then you go to the bank and use that land that you own as the equity for the commercial loan. Technically you have no equity in the deal, but on paper you have equity to get a hard money loan.

RE Arbitrage: Blackstone's Conquer & Divide Strategy of EOP

For those of you who haven't heard the rumors, Blackstone has all but sold roughly $25 billion in Equity Office Properties assets to various buyers. If you were wondering about Blackstone's ultimate strategy given the high premium it paid, they have revealed that "Gordon Gecko" is not just a character in a movie. This time the asset is real estate and not business divisions or spinoffs.

What this deal is a clear example of is Real Estate Arbitrage. I'm sure a handful of people don't really know what the term "arbitrage" means. Some people confuse it with the term "arbitration" and thus may confuse it with the legal process of settling disputes. Here is a generic link to a definition of arbitrage. If you're in the hedge fund or securities industry you practice arbitrage all the time. I tend to think that all business that make money buying and selling something practice some form of arbitrage.

One of the essential elements to arbitrage is the availability of a market that is somewhat liquid. A true arbitrage transaction is where the middleman does not ever hold the asset/security that is being bought and sold. Perhaps he holds it for a split second, but he definitely does not hold it when the market opens or closes.

Blackstone has essentially shown that it can conduct real estate arbitrage. It has bought and sold assets before it has even closed on the original deal. It doesn't take a genius to figure out that they have been lining up suitors for a while. I can only imagine how their list of suitors grew over the public contest for EOP. Only a well connected group of powerbrokers can simultaneously sell billion dollar properties before it has even acquired them.

So the dumb lesson is this: Anytime you own enough of something (in this case US commercial trophy properties) to make the market, you have yourself a pure arb play that is sweet.