Rethinking Real Estate
Dror Poleg has spent the bulk of his career, a little over 10 years, in China developing institutional real estate. There he developed around thirty million square feet of shopping malls space, offices, about twenty-six thousand apartments and some serviced apartments. Together with a Dutch Israeli fund some of these assets were sold to institutional investors, and they were partners with BlackRock in most cases selling other projects to private equity funds in Asia and to a REIT in Asia. His experience is, therefore, across the whole real estate development process from beginning to end; buying land, developing large projects, leasing them and then either selling or stabilizing them. He has consistently brought in financial partners and taken assets all the way to being owned by an institutional investor once they become mature quality assets. He arrived into the real estate world from the world of online development and design – digital design of all things. He was partner of a digital design agency in Israel which is where he is originally from, and then worked in Australia, in China and through helping real estate developers on some projects he gradually got sucked into the business from the marketing side to the market research side to the presenting to investors and government to leading the leasing of commercial assets and then finally to really just handling the big deals.
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Today Dror operates a small consultancy based in New York City advising large scale real estate owners and operators and private equity firms on innovation in real estate. He covers anything from understanding long term trends that are driven by technology such as, changes to the nature of work, how people get married, or education trends, autonomous vehicles different things that impact the real estate industry, longer term to more immediate terms such as different technologies and tools and business models that they can implement today in order to produce more value out of their assets, up to really looking at the underwriting of specific deals that involve some innovative components mostly co-working, flexible office, co-living, or anything along that spectrum. On the other side of his business he works with startups that are focused specifically on the real estate industry. This includes anything from modular construction, building management systems, different sensors and IOT, to kind of more communal ventures and operating systems for a whole neighborhood.
He does not have a typical client having worked with clients in Japan, in Turkey, in the UK, in New York, on the West Coast, in China. It is really diverse. His clients range from startups to very large owner operators companies like British Land which is a company with about $25 or $26 billion of assets under management, as well as some smaller real estate companies of around $5 billion assets under management and above, and some funds that are either based in the U.S. or based out of Hong Kong.
Private Equity
Private equity in Real Estate is, basically, using private money as opposed to public money in order to fund the equity or to acquire and operate real estate projects. Similarly, REITs are public equity that allow retail investors to own a piece of a real estate portfolio, and private equity mostly refers to funds that are managed in order to acquire and generate as much value as possible out of, usually, large scale real estate projects. These funds are usually capitalized by institutional investors or high net worth individuals.
Funds
For a private equity fund the clearest division is between what is called the general partners, people that are actually actively managing the fund and its assets and are also partners in the fund and the limited partners. The general partners sometimes put in some of their own capital into the fund and the limited partners are people that bring money into the fund but do not have any managerial responsibility and thus no liability in some ways, at least in terms of their legal exposure. Limited partners do, of course, have liability in terms of being able to lose the money the invest and have no control over, or limited control over, how the general partner manages the fund.
These limited partners are often institutional investors. People that have a lot of money to allocate are not necessarily real estate specialists, so like a pension fund, an insurance company, a sovereign wealth fund, people that manage a lot of money and have huge portfolios where usually a very small percentage of them is allocated to real estate. The general partners are the folk who manage the fund. They are usually property professionals or private equity real estate professionals that have experience of actually running an asset.
Typical Structure
It's an interesting because the daily life of a fund manager is changing in line with technology. Most of these funds originally have relatively small teams. If they have several offices or focus on different geographies they might have a handful of people in each area. That would mean, several general partners who are really the ones managing the fund, and then a few analysts. Sometimes, depending on the type of assets that they invest in they would have additional people that have operational capabilities or specific expertise, let's say in shopping malls or, office leasing. People that can help when you do due diligence on an asset or when you oversee the people that are operating the actual asset then you can kind of know when you know things cost too much, or you can leverage relationships that you have for other assets in order to make that specific asset better. But part of what is changing now is that real estate as a whole is becoming much more operationally intensive. And if in the past the operators were almost like commodities, and the owner could just hire people to do certain tasks, today more and more you see that the good owners, which means a good fund managers, are people that have unique operational expertise as well, or unique relationships and in some cases even unique technology.
Raising Capital
The vast majority, or a lot of the time of the fund managers, is dedicated to raising funds, and some would even say that their main skill is the ability to raise funds, so more than actually picking the right investments, and definitely the traditional fund, the ones that are still leading the market today are. Their success is very much attributed to the relationships that they have and that they've built over the years with the investors so their ability to raise capital. When they set up a new fund they go and try to raise money for it, they usually have a target. They either rely on their direct relationships, they can rely on companies that are called placement agents, which are companies that assist limited partners so institutional investors and high net worth individuals who allocate their own capital into different funds. Placement agents are another type of middleman. They're theoretically familiar with all the different funds around the world. There are other third-party companies that grade some of these funds assuming that these funds have a track record. When institutional investors are looking for investment they may have placement agents to assist them and they have third party bodies that, that give them feedback or kind of rate the type of funds that they about to invest in.
The general partners go to institutions and the institutions there are individuals who are responsible for huge amounts of assets that they have to deploy and they have to allocate a certain amount. An institutional private equity will fund to raise $50 or $100 million from any individual institution, and that will typically be based on the relationship, probably with, maybe just one guy at the institution that they have, whose job it is to allocate those funds. Now at the institutions they're going to have investment committees and whatever else they're out to authorize the divestments.
So relationships matter but it is definitely not one guy's decision. There are investment committees. These institutional investors to begin with have their own mandate and very strict criteria in terms of their risk profile. Sometimes geography, sometimes type of asset, sometimes the holding period. The fund has to feed all of these. Another thing to note, is institutional investors also vary in terms of the size of the team and level of expertise that they have. If you start at the top you have some sovereign wealth funds like JIC from Singapore, or the Canadian pensions which have very relatively large and very professional real estate teams. They really have their own knowhow and ability to evaluate funds. They also invest in assets directly because of their capabilities, and on the other hand you might have, we can call it poorer institutional investors that manage a lot of money but have very small teams and very small budgets in terms of their own overhead. Something like the Illinois pension management board or institution which operates with a very small team and really relies completely almost on other people's opinions and feedback when they decide how to invest.
How Fund Makes Money
The second that they close the fund, basically once they're done raising the money, they're already starting to make money, in theory. So, the compensation models for these funds is along the lines of what is called 2 and 20. They take a certain percentage, 2 percent, but these days probably less, one and a half or one percent of the total funds raised per year as a management fee and 20 percent or, less these days, in a carried interest profit which is the added value that they create through those assets, so, 20 percent from the upside.
Deal Types
Depending on the strategy of the fund, there are four main strategies that private equity funds look at, starting from core investment which are really the most stable best quality asset in the center of main cities. Core plus which are assets of the same kind but that might have some, some very limited value add potential such as leases that are lapsing or renovations or certain little things that could improve them, then complete value add which are assets that are still relatively good and developed but have some more major potential for value creation. Either the occupancy is quite low and there is room to change things or there's one tenant that has issues that could be replaced or needs some type of negotiation skills that the existing owner can't handle or several leases that are lapsing within the next year or two that the new buyer assumes that he could find better people for that will pay significantly more, or sometimes on the financial side, restructuring, refinancing of different kinds that can ultimately create a higher return for the new equity. The last category is opportunistic investment, which entails significant more risk. This includes anything from ground up development, taking distressed asset and repositioning them; basically doing things that are riskier and targeting much higher IRR, towards a 20 or higher.
Deal Execution
Fund managers do not typically execute on the business strategies themselves although sometimes they might. Sometimes they cooperate with others. They go and look for deals, like the rest of us in some ways. They use brokers, all the large broker firms like Cushman and Wakefield, Jones Lang LaSalle, CBRE, Savilles, Colliers. They have their own capital markets team or kind of investment brokerage and people that tend to these types of clients and try to find them opportunities. They also leverage their own relationship, again, through their own network, looking for opportunities to invest in. Some funds also specialize in sourcing deals and they have unique sources for whether its different types of foreclosures or other similar large investors that own certain things but need to liquidate for certain reasons. They buy or sell from other funds that are focused on different strategies.
Let's say, there's one fund that has an opportunistic strategy. It owns an asset that was under development and once the asset is almost stabilized it can sell the asset to another fund that has let's say a value add strategy and can take that asset from 80 percent occupancy to 96 percent occupancy, at which stage you could sell it to a core plus fund or to a core fund that could just buy it as a stable asset for a much higher price and not bring much more value but just enjoy the yield, which is what institutional investors ultimately want. Institutional investors don't want to take a very high risk. In a perfect world they would just buy you know something that brings in 5 percent a year or 6 percent a year, and not have to do anything to it and just be happy. But it's getting harder and harder to find assets like that especially when you have so much more new money to allocate each year.
Controls
One of the projects Dror developed in China was a shopping mall. It was still a new mall not fully stable yet at around 80 or 85 percent leased. About 80 percent of the space that was leased was already open and operating. They received an investment from a fund that is owned by BlackRock, which is more known for managing other investment products but they also have like a, small about 10 billion dollar real estate private equity business and they bought 50 percent of the holding company of Dror’s mall, and became their partner. To do that though they arrived at the deal through a broker, in that case through Jones Lang LaSalle. They spent, a lot of time several months, doing due diligence ahead of agreeing to a deal, looking both at the market at large and specifically, at the project and everything the operator/developer could tell them about it including assessing them as managers, so spending a lot of time with the team. They challenged them on the rent roll and on each specific tenant that they had; Why did we give them these terms? Why not those terms? Blackrock looked at underlying assumptions about the additional space that will be filled et cetera. Once they became partners, they sat on the board, they had a seat on the board of the project, and in the operating agreement which was signed when they invested, they also defined certain key decisions that they have a say about, or even a veto on. The original company remained operating the asset but major decisions such as major capital investments, changes to more than a certain percentage of the tenant mix and other things had to be approved with them or by them.
The most contentious issues are things that are purely financial. For example, if the management team wants to refinance the assets. If they want to sell a piece of their ownership. What to do in case there is an opportunity to sell the whole project. What to do if they buy the whole project and the managers don't own it anymore. What are the responsibilities in terms of operating it and ensuring that there is a successful and smooth transition. Mostly these type of things are very common to any type of kind of merger or acquisition elsewhere.
Default Triggers
Triggers that could allow the investor take over the project included terms of not performing as had been projected. Although the investor does not want to run the project, at the end of the day, they invested in an asset that they assumed that they're almost unable to operate, without their partner. But the terms allowed for them to bring in a third party. Part of the assumption is that they're taking a big risk and that they trust you and if they wouldn't, they probably wouldn't go into the deal to begin with especially with something like a shopping mall or a hotel which is very operator dependent.
The investor can, de facto, replace certain people in management. In an extreme situation they can replace the manager completely as operators of the assets, who would remain their partners in ownership until there's a new buyer but who would have to cede the actual operation to another operator. There may be a budget approval procedure each year with quarterly reviews. During that process, if they want to make life difficult for the manager in terms of how they spend money on a project they can make it difficult.
There are bad boy clauses, key man clauses. These limit what the manager can do if they have some really talented person there that the manager might want to move to another new project that's something that they may not be able to do. There's all sorts of things. In China mostly the bad boy was about indemnifying investors in case the manager did certain things like bribing or doing something that is illegal, locally or internationally. These terms are very similar in the US too. The investor’s goal is to be completely indemnified as much as possible from anything that the manager does but on the other hand they want to have as much power as they can get away with, in balance with the previous point.
Promote & Fees
Deal structures can vary. In some cases, the sponsor could be a straight up partner, or it could be a 50/50 partnership. In those cases there's no waterfall and there's no promote. Basically, both own the asset. If the asset does well, both make money. In that case it also means that probably the 50 percent that the private equity fund owns, or was sold to it by the sponsor who originally brought in the project. So assuming that the sponsor already made some money already, on that piece of the deal on that half and when they both sell in the end, they're going to make more money.
Other structures, have a promote which is very similar to how it works in smaller deals. The sponsor can get sometimes a small piece in the beginning just for bringing the deal. Something between half a percent to 2 percent, which sometimes is expected to be reinvested or kept as part of the deal. Then upon exit or other major financial events such as refinancing there's a promote structure that means that once the returns for the private equity investors meet a certain hurdle, and that depends on the type of the asset. It could be 5 percent 8 percent, 12 percent 15 percent. Then the rest of the returns are split between the two partners. Whether it's 80-20, 70-30, 50-50, or even with a few different steps and a more complex waterfall.
Impact of CFRE on Private Equity
There are several ways in which crowdfunding impacts private equity, both directly and indirectly. First and foremost, technology means that access to information is being democratized, so, suddenly everyone can know almost anything, both about investment opportunities and the investment details of specific opportunities. Also, they can know a lot about the market, like today. Definitely in development markets in a place like New York City almost every building that you look at, you can find online. You know how it is performing, who are the tenants who bought it before who bought it later, if there are any violations or complaints. You have access to rich information that previously only people with unique expertise, or with unique relationships, had access to. Technology does that and crowdfunding contributes to that and benefits from that.
Second, it democratizes access to capital. Which means that developers or sponsors today, that have a good deal or a track record. They can go directly to people with money and raise money from them instead of relying on private equity funds or larger investors. They can pull together resources from smaller investors and still get larger and larger projects done. As is happening. Which means that to an extent it poses an alternative to private equity funds. Not a significant one yet but a growing one. It empowers, in a way, the flight of talent, from, big funds, and big developers. So. If in the past someone was managing, working for a private equity fund and they were doing really well, they could maybe go and find a job with a similar fund. But today, there's actually an alternative for that person to say 'Hey I'm actually really good at finding those deals. I have relationships with developers and maybe even with the government. I know the market better than anyone. Why don't I just go and syndicate myself?' They can then put themselves out there and raise money through crowdfunding. It's incentivizing executives to go at it alone albeit in a limited way
CFRE also does things that in some way benefits the larger private equity, real estate funds. Crowdfunding is mostly focused at the lower end or the lower part of the market and, in a sense, it makes the market much more fragmented than it was because it empowers a lot of small players which means that those funds that are really large and usually have unique operational capabilities as well are only getting bigger, and it's harder for medium size funds, or for medium sized operators to compete with them or gain leverage when facing them. If we need an example, we can start with the retail world because their dependence on the operator is most obvious. You can have companies like Simon or Westfield which have unique operational capabilities. They're proprietary brands they have proprietary technology they have proprietary relationships with tenants. And they have their own fund management business so they can raise money. And they leverage their network and their scale to benefit all the different assets that they own. To the extent that if someone just buys one shopping mall, it would be very hard for them to compete with these guys, in terms of their leasing capabilities marketing capabilities, and asset management technologies etc. And when the middle and bottom of the market is getting more fragmented, it means it's harder and harder for people to climb out of that space and compete with those really large operators or fund managers. Another example is Blackstone. These guys manage more than $100 billion of different real estate assets most of it is office, and they're investing in startups and companies that specialize in operating office space and in technologies that optimize the way energy is used, and the way space is marketed etc. And unless you're a very large, it's hard for you, as an owner of one asset or five assets or even 20 assets, to compete with them. This is going to get harder and harder.
Impact of Tech on Real Estate
Technology at large, meaning not one technology but different technologies together, are creating dramatic changes in the real estate industry, starting from the way they impact the way people work, the way people raise their families, the way people move or don't move, the stability of jobs in general the fact that even people that are doing well and are educated and experts, don't have 20 or 30 year careers with the same company which means that, they are less likely to stay in the same place less likely to take a mortgage, sometimes less likely to even want to own anything. Technology is impacting real estate this way which is indirect but it's very significant.
More directly, technology is basically redefining all the basic tenants of real estate value, starting from the meaning of location, and the value of location, and the meaning of visibility and accessibility. The meaning of regulation. We've seen in the past few years, the technology redefined each one of these aspects because of, you know, ride sharing, autonomous vehicles, remote working, online marketing, which means that you get your lead not by being in the most prominent location but actually most of your tenants come through online channels and other channels.
The fact that disruptors can leverage the crowd to undermine regulation and rules. If you look at what, for example Airbnb has been doing. The hotel industry was assuming that since Airbinb was illegal, it's not going to compete with them but they've seen that Airbnb has so many users that depend on it, and love it, both the people that lease space and the people that are guests, that governments in many cities basically succumb to or had to adjust regulation, in ways that people couldn't imagine before. Technology is undermining all of these things and that boils down to maybe the most important point which basically means that real estate as a whole, even the most stable asset that people assumed previously, that are valuable forever, just because they are where they are so they have inherent value. These assets are becoming destabilized to the point where unless they're operated very intensively and very creatively and probably, reinvented and readjusted constantly, they do not retain their value. To cite an example, if you look at office buildings in central Manhattan, that until a few years ago people assumed that they can just buy them and they'll have a stable yield and it’s a very boring business. Today they are competing with people like We Work in the building becomes dependent on its operator. If we look at retail, retail on Fifth Avenue again, until a few years, the safest bet on earth. No longer safe. A hotel next to Disneyland. Likewise, Airbnb suddenly comes over, partners with a local developer, and starts competing with your hotel and create new supply that is not zoned as a hotel even, sometimes, basically serves your potential customers.
That's the ultimate impact of technology really destabilizing what real estate means. This has immense implications to the institutional investors which means immense implications for our own pensions and our own savings for the future, what we can assume about the returns that we're going to see. Something to keep in mind.