Real estate private equity funds are on a frantic hunt for inefficiency. Bursting with cash and acutely aware that a storied 13-year real estate run is long in the tooth, the funds are snatching up what they consider to be undervalued properties and real estate companies — real estate investment trusts (REITs), hotels, and overseas assets, to name a few — and are even providing developers with equity and mezzanine capital.

Pension funds, foundations, high- net-worth individuals, endowments and other investors have poured some $121 billion into about 305 real estate private equity funds since the late 1980s, according to Ernst & Young. But more than half of that amount flowed into the funds between 1999 and 2004, and money continues to cascade into these pools. This segment of the industry has become so big that Ernst & Young began conducting its own private equity fund survey in 2001.

According to Ernst & Young's 2005 survey of nearly 180 private equity funds, sponsors indicated plans to raise $18 billion in 23 new funds. But those numbers have likely increased since the survey concluded last August.

What's the attraction? Private equity is flexible: It can flow into and out of different property types, geographical areas and financing instruments with ease. Unlike publicly traded REITs, which are regulated by the Securities and Exchange Commission and under pressure to keep debt levels at 50% of market capitalization, private equity funds aren't regulated and can structure deals using much more leverage. In fact, real estate private equity funds on average combine their cash with about 70% in debt financing, Ernst & Young found.

But the biggest appeal centers on real estate private equity's total returns. On an annualized basis over the last several years, returns have hovered near 20%, give or take a few percentage points depending on the type of private equity fund — opportunity or value-added. While managers of both funds typically hold assets for five to seven years, opportunity funds target failing properties for radical repositioning or other major improvements, and value-added funds shore up less risky but underperforming assets. Opportunity funds aim for slightly higher returns than 20%; value-added funds may accept returns a few percentage points below 20%.

Even as appreciation peaks and interest rates climb — the 10-year Treasury yield hit a two-year high of nearly 4.93% in mid-March — private equity fund managers refuse to lower their return targets, says Gary Koster, Americas leader of real estate fund services for Ernst & Young in New York.

“Private equity players are continually shifting their investment focus to find those returns — moving from primary to secondary markets, moving from domestic to foreign markets, or shifting to whatever distressed asset class (is the next hot product) coming around in the cycle,” he says. “They have to be creative and be able to change their business plan every couple of years.”

Shifting strategies

Case in point: Somerset Partners, a nearly $1 billion private equity fund based in New York, a couple of years ago concentrated on acquiring apartment properties in secondary markets such as Little Rock, Ark., and Tulsa, Okla. At the time, apartments in those areas could be bought for capitalization rates of around 10%, says Marshall Allan, principal and co-founder of Somerset Partners. By comparison, apartment cap rates were roughly between 6% to 8% in larger markets, so it was clear to investors that cash yields were higher in secondary markets.

But the tidal wave of capital washing into real estate eventually flooded the smaller markets and compressed multifamily cap rates. That has made it tougher to generate decent yields. Over the last several months, the annual cash-on-cash returns have dipped to as low as 6% in some of the secondary property markets, Allan adds. Subsequently, Somerset Partners opted to widen its strategy. In addition to acquiring as well as developing apartments, the firm is now buying office buildings in the Northeast and Mid-Atlantic and making mezzanine loans.

In January, for example, Somerset Partners paid $250 million for 1801 K Street NW in Washington, D.C., a 13-story, 563,000 sq. ft. Class-A office building that's 85% occupied. Gross rents average $45 a sq. ft. — slightly lower than the average market rate of $47.60 per sq. ft. But most of the leases are expiring over the next five years, and Somerset Partners is planning a $100 million renovation. The firm anticipates charging $65 per sq. ft. after the rehab.

“We could keep the building the way it is with minimal capital expenditures, and it would perform for us,” says Allan. “But there's just so much upside in the location and the size of the floor plates that we decided to pursue a full reposition.”

Meanwhile, Denver-based Amstar Group for two decades has focused on repositioning underperforming hotels, apartments and offices. But last year, the $1.5 billion private equity firm expanded into retail and industrial properties. Amstar also is emphasizing new development as growing competition for value-added opportunities has driven returns in such projects to below 20%, says Gabe Finke, Amstar's general partner and CEO. In the Houston suburb of Katy, for example, the company recently broke ground with partner Houston-based Vista Equities Group to build a $50 million, 240,000 sq. ft. lifestyle center.

Growing popularity

Private equity's foray into real estate began more than 10 years ago, when a handful of vulture funds launched to buy distressed properties that littered the landscape after the savings and loan debacle in the late 1980s and early 1990s, says Dennis Yeskey, national director of real estate capital markets for Deloitte & Touche in New York. The funds acquired troubled properties for deep discounts to cost, then eventually leased them up and sold them for big returns as real estate rebounded.

At the time, the risky strategy marked a radical departure from how major institutions such as pension funds bought real estate: Institutions typically allocated 4% to 6% of their assets to real estate advisors, who would acquire stabilized properties in all-cash deals to receive annual yields of 10%, Koster adds. Typically, the institutions held the real estate, known as “core” properties, for 10 years or more.

But over the last five years, the distinction between core and private equity investors has blurred, private equity experts point out. Institutions such as pension funds are allocating more cash toward real estate — experts anticipate allocations will ultimately range between 10% and 15% of institutional funds — and an increasing amount of that capital is flowing into real estate private equity funds. Traditional institutional advisors are launching their own funds that employ riskier strategies to reap potentially larger returns.

Of course, the incessant cash stream is ratcheting up competition for assets, which is driving up prices and making it harder to generate fat returns. But until an alternative investment emerges to replace the lucrative real estate payoff — or until high property prices or rising interest rates scare off investors — private equity funds likely will remain flush with cash.

“The big question in our industry is, ‘How long can these returns last?’” Yeskey asks. “The biggest risk is that some other investment catches fire or the stock market starts generating 20% annual returns. But that hasn't happened in six years.”

Targeting REITs

Even within the broader equities market, real estate has outperformed other asset classes. The National Association of Real Estate Investment Trusts reports that publicly traded REITs in the U.S. have generated annualized returns of 19% over the last five years, compared with the S&P 500's returns of less than 1% and the Nasdaq's minus 2.24% performance over the same period.

But private equity funds are betting that they can squeeze even more cash out of REITs, primarily because sponsors believe REIT share prices fail to reflect the full value of the underlying assets, says Scott Farb, managing principal of the national real estate group for Gumbiner Savett, a boutique accounting firm based in Santa Monica, Calif.

Last year, private equity firms acquired eight REITs for $20 billion compared with three acquisitions of about $3 billion in 2004, Farb says. Most recently, New York-based Blackstone Group announced that it was buying Washington, D.C.-based CarrAmerica Realty Corp., an office REIT that owns and operates some 26.3 million sq. ft. in a dozen major U.S. markets. The price of $44.75 a share, or $5.6 billion, represented an 18% premium over CarrAmerica's stock price in mid-February when the deal was struck.

Blackstone and other private equity behemoths, such as Los Angeles-based Colony Capital, also are hoping to generate returns by plowing money into what has become the hottest property sector: hotels. Over the last two years, Blackstone has paid some $15 billion for hospitality companies and individual properties. Meanwhile, Colony Capital and Saudi Prince Alwaleed bin Talal in January announced they would acquire Fairmont Hotels & Resorts for $45 a share, which represented a 28% premium over the stock at the time the $3.3 billion deal was structured.

New niches of opportunity

As domestic deals get harder to find, more money is heading overseas into previously untapped countries such as China and India. Last fall, for example, Citigroup Property Investors and Citigroup private clients from Asia, the Middle East and U.S. plowed $250 million into a $400 million private equity fund sponsored by Singapore-based property giant CapitaLand. The first venture: financing 80% of a mixed-use project in the Chinese coastal city of Ningbo that will feature 1,300 mid- and high-rise apartments as well as office and retail space.

In some cases, private equity funds have discovered niche markets in the U.S. One such sponsor, Phoenix Realty Group, is developing market-rate housing in urban infill areas for middle-income workers such as teachers, firemen and policemen.

Phoenix Realty's first $250 million fund comprises institutional investors such as the California Public Employees' Retirement System and Citicorp North America. Combining its cash with debt, New York-based Phoenix Realty has provided residential and retail developers with almost $1 billion in financing for projects primarily in San Diego and Los Angeles.

Phoenix Realty is on the verge of launching another $250 million fund, which will implement the strategy in New York, Connecticut and New Jersey. Typically, the company provides developers with $3 million to $7 million in equity. The investments are generating internal rates of return ranging from 12% to 16%.

“It's probably a wild comment to hear, but we still don't have a lot of competition,” says Keith Rosenthal, president of Phoenix Realty. “We've institutionalized a marketplace where [until recently] developers weren't able to go to big institutions for capital.”

Given the amount of cash still flowing into real estate, however, it's hardly far-fetched to predict that middle-income infill housing will get even more attention. “The great fund managers out there are constantly changing their strategy,” says Ernst & Young's Gary Koster, “because as soon as the world catches up, the pricing changes and diminishes the ability to bring home those high returns.”

Joe Gose is a Kansas City-based writer