Private equity funds have reemerged as a return-driven vehicle that institutional investors are often choosing as a means to increase their commercial real estate investment allocations.

One of the leading sponsors of such private equity funds is Blackstone Real Estate Advisors (BREA), the real estate investment arm of The Blackstone Group, the New York-based private merchant bank. BREA in the last several years has acquired more than 325 individual real estate assets - mostly hotels and office buildings - valued at approximately $6.8 billion, as well as approximately $700 million of equity interests in 10 real estate operating companies, according to the firm.

Blackstone has recently begun to raise funds from institutional investors for its third real estate fund, Blackstone Real Estate Partners III. Its second fund, Blackstone Real Estate Partners II, had aggregate commitments of more than $1.1 billion, and its first fund, Blackstone Real Estate Partners I had invested $85 million of capital, according to the firm.

Blackstone credits much of its success to anticipating and exploiting trends in the market. For example, the group was ahead of the curve in identifying the 1990s recovery in the lodging and CBD office building sectors. Blackstone was one of the first firms to purchase assets from the Resolution Trust Corporation (RTC) and exchange large-scale corporate recaps in real estate. Blackstone also was an early U.S. investor in the Canadian and French markets.

Thomas J. Saylak, senior managing director at Blackstone in New York, spoke with NATIONAL REAL ESTATE INVESTOR about current market conditions for institutional investment in real estate, the role of private equity funds in relation to other means of investment such as public REITs and the older commingled funds, and Blackstone's activities in the market.

NREI: Considering the lackluster performance by many REITs in the past 12 to 18 months, have many institutional investors shifted their real estate investment away from public companies and into private equity funds?

SAYLAK: Institutional investors have been investing in private equity funds for a much longer period than the new era of REITs, which basically began in 1993. Even when REITs were booming, there was still a lot of institutional money flowing into private funds. With REITs being virtually locked out of both the debt and equity markets, it makes a much stronger case for institutional investors to enter into transactions with private equity funds.

It's not so much a rediscovery, but more of a consistent and growing appetite for private equity funds that is not dependent on the vagaries of the REIT market at large.

In terms of REIT performance, from the perspective of a private equity investor, I really think that much of their performance problems has a lot to do with the way REITs were marketed by investment banks. The audience for REIT shares were growth- or momentum-oriented investors. What happened is that at the first signs of moderation in the growth rates of REITs, many of these investors made a fairly rapid rotation out of the sector. They switched investments and REITs plunged.

There is a relatively thin volume in these shares to begin with, and that, combined with a funds-flow out of the sector, has made for a witch's brew that precipitated the fall in REIT prices, which is only now beginning to correct itself, and the correction is still spotty.

NREI: Have many private equity funds been aggressive sellers of assets in the past 12 to 18 months? What has determined the timing of sales?

SAYLAK: A lot of private equity funds have not been selling their assets. Most of our competitors would say that Blackstone is unique in that that we have sold between 60% and 70% of our portfolio in 1998. Most other funds have not had sales of that extent. Why have we? It is a combination of things. The Blackstone Group buys under-appreciated assets. Most of the assets in our portfolio have a flaw. They are under leased, need rehabilitation, have a major tenant who is rolling over or in one way or another need extensive asset management.

Once we complete our asset-management function on a property, we sell the asset. We are not in the business of holding assets once they are of institutional grade. At the end of 1997, we had a significant part of our portfolio in which the asset management function had been completed. When we saw the prices being paid for assets at that time, we felt the timing was right to sell from both an asset management and a capital markets perspective. Between April and December 1998, Blackstone sold $3.2 billion in assets, representing 26 different properties.

NREI: Are institutional investors looking at private equity funds as a primary means for real estate investment? How do private funds compete with REITs?

Saylak: Public and private pension funds represent the majority of private equity funds, but not a majority of pension fund money going into real estate. Private equity funds are, however, becoming an increasingly important part of their real estate investment.

For some institutional investors, the opportunistic arena is representing an ever-increasing component of their allocation, while others take a more balanced attack. The separate-account business is alive, and the REIT market is still growing, although finding opportunities there has become more challenging over the last 12 to 18 months.

Pension funds are growing. Most pension funds in the United States are under their target allocation for real estate, and at the first of every new year they find themselves further behind because of the overall growth in their portfolios. This makes for an increased commitment to real estate and private equity funds such as Blackstone's are the beneficiaries of that.

Private equity funds are able to compete with REITs as a form of institutional investment by having an appetite and ability to invest in transactions that have characteristics which are inappropriate for most REIT structures.

Basically, a REIT is structured to be a dividend-paying machine that has to meet quarter-by-quarter expectations and manage its balance sheet fairly conservatively. Therefore it is difficult or impossible for REITs, even the larger ones, to invest in all of the kind of deals that do not generate big cash returns in the early years of the investment.

Private equity funds have a much higher tolerance for problems in a deal and higher tolerance for leverage than do most REITs. Assets with eccentric cashflow patterns or transactions that benefit from higher levels of leverage that are inappropriate for REITs are more suitable for private funds. Right now, even more conventional real estate transactions are the purview of private equity funds, because most REITs have curtailed their investment activity because they don't have the capital to invest.

The irony is that most of the private equity funds have anything but a long-term perspective and have multiple exit strategies - many different ways to liquidate assets - while REITs by and large are not in the business of selling but are instead building up assets for capital appreciation and cashflow.

NREI: How do today's private equity funds differ from other methods in which institutions invested in real estate in the past such as the commingled funds that were popular in the 1980s? Isn't today's scenario more of a joint venture between fund manager and institutional investor?

Saylak: The commingled funds of yesteryear typically featured little or no investment by the general partner and had very long lives. They had relatively little subordinated incentives for the general partner and instead paid substantial fees to the general partner based on appraised values of assets.

In today's private equity funds, such as Blackstone's, the general partner is normally the second-largest investor in the fund, serving as limited partner, and makes no money based on appraisals.

In both of our two funds, Blackstone is the second-largest investor, with one exception. We have a lot of our skin in these deals. Our incentive comes from participation in the profits, and a profit only exists when an asset is liquidated.

Private equity funds are more of a joint venture. Partners have aligned interests and the fortunes of the general partner rise and fall with the fortunes of the limited partner. It is a structure that is much better appreciated by institutional investors and is far more balanced than the old commingled funds.