While publicly traded real estate investment trusts went on a fundraising tear earlier this year, private equity firms may have the most capital and risk tolerance to lead the charge in buying up distressed assets and mortgages in the years to come.

Altogether, private equity's money mountain may be worth at least $173 billion, and many private equity funds aren't finished yet when it comes to stockpiling capital, or dry powder. At the end of 2008, private equity firms worldwide had stockpiled an estimated $143 billion, according to Preqin, a private equity researcher with offices in New York and London. U.S. firms control about $78 billion of that figure, and one of the largest players, New York-based Blackstone Group, has more than $12 billion of capital ready to invest in commercial real estate.

Over the past decade, Blackstone flexed its fundraising muscles, leading the private equity pack to the tune of $26.9 billion cumulatively. But more recently the fundraising drumbeat has slowed from previous years. Through August of 2009, 63 private equity firms raised $30 billion year-to-date, the slowest pace since 2004. Yet that far outstrips the $19 billion raised by REITs through combined equity and debt offerings over the same period.

There are 186 U.S. funds now on the road soliciting investors, hoping to raise nearly $110 billion, according to Preqin. That easily beats foreign fund-raising activity, where a total of 21 funds are targeting $21 billion in new capital.

Tale of two players

Essentially the private equity business is divided into two camps, the “haves” and the “have-nots.” On one side stand some of the more aggressive firms that bought into the peak of the frothy commercial real estate markets in 2006 and 2007, a period marked by an abundance of cheap debt and sky-high valuations. But a scarcity of refinancing capital for these so-called legacy assets has brought many private equity firms to their knees.

The saga of Broadway Partners is a telling example. The nine-year-old New York-based firm purchased 28 office buildings in 2006 and 2007 in major markets using lots of leverage. The plan was to flip them within just two years.

Bad timing. It didn't help that Lehman Brothers was a primary lender on 10 of its buildings, and Broadway Partners now faces the tough prospect of refinancing its loans in an illiquid market.

In January the company defaulted on a $470 million mezzanine loan on the high-profile Hancock Tower in Boston. That trophy was auctioned off in March for less than half of the $1.3 billion Broadway had paid for it only two years earlier.

On the other side of the private equity fence stand firms that took a more conservative approach to commercial real estate investing. Many still have legacy assets, but they also have a stronger and longer track record of success on which to rely for continued money-raising success.

While private equity firms fueled the last boom, many pulled back just as the party was winding down, choosing not to deploy much of the capital they raised last year. These firms include many of the brand names in private equity such as Blackstone, BlackRock and Starwood, along with AREA, the firm formerly known as Apollo Real Estate Advisors in New York.

But this austere group is being joined by a host of new entrants, as the very definition of private equity is stretching to new limits. “The private equity universe is hard to pin down,” says Clay Adams, chief investment officer of Atlanta-based Jamestown, which has raised $450 million from individual German investors for its latest private equity fund.

To Adams, the market has broadened to include high-net-worth individuals. “The private equity world is bigger than a lot of people think it is. Some funds started in 1998 and sold in 2005-2007. People vastly underestimate how much money some of these people made and how much dry powder they have personally.”

No matter what the definition, track record is still king. “If a private equity sponsor had four funds that performed well, but their fifth and sixth funds got beaten up in the 2004-2007 vintage, and in 2007 they started to raise their seventh fund, they're going to be okay,” says Steve Pumper, executive managing director with Transwestern Commercial in Dallas. “That doesn't mean the fifth and sixth funds won't start giving properties back.”

Calling all capital

Unlike REITs, private equity firms rely heavily on institutional investors for their capital — pension funds, insurance companies, endowments and foundations — and these investors have experienced their own problems.

Many cash-strapped institutions, for example, have publicly and privately asked their private equity partners not to call for more capital under their existing agreements until the investors tackle their own liquidity crises. “A lot of the pension funds now are calling the private equity shops saying, ‘If you ever want money from me again don't call me,’” says Adams.

“There are groups out there that may have commitments of $2 billion, but that's not to say they could call their investors tomorrow and draw it all down, even though they're well within the documents' rights to do so in their investment period,” says R. John Wilcox II, senior vice president at New York-based Savills, a real estate investment banking firm. “Access to capital commitments still is an issue for some private equity firms.”

Thankfully for fund managers, this predicament comes at a time when transaction volume has reached a virtual standstill anyway, and funds are taking a prolonged wait-and-see attitude to making new investments, hoping to see a market bottom before wading in.

The question remains, when institutions are asked to pony up the agreed funds, now or in the future, will they refuse to take the call? “I think that is unlikely,” says Spencer Levy, senior managing director of capital markets and national head of restructuring services at CB Richard Ellis in Baltimore.

“The question is, what are their alternatives? Pension funds need 6% to 8% current yield, or they start losing money based upon their obligations to pensioners. Insurance companies have similar issues relating to their need to deploy capital to pay for their fixed obligations.”

Many institutions need to put whatever funds they have on hand to work earning a return, preferring not to sit on the cash. While the stock market may offer an attractive alternative to commercial real estate, not everyone agrees.

“If you buy into the stock market now, do you think that in five years you are going to be able to see the same kind of appreciation as you would buying into commercial real estate if you buy in 2010? I think not,” says Pumper.

One private equity firm is already jumping back into the market. PCCP, formerly known as Pacific Coast Capital Partners, based in suburban Los Angeles, paid $30 million for a three-building, 1.2 million sq. ft. industrial portfolio located in Lewisville, Texas outside Dallas for $30 million.

The portfolio was sold at auction in September as part of the bankruptcy of developer Opus West and was purchased by PCCP's $746 million California Smart Growth Fund.

PCCP's typical target price range of $20 million to $40 million keeps it under the investment radar of larger private equity firms. “We approached all of the lenders with Opus West assets seeing if we could buy debt and loans and assets straight out,” says Greg Eberhardt, chief financial officer with PCCP. “You need to be comfortable making decisions quickly and assessing risk and seeing opportunity.”

With its primary focus on the western U.S., Eberhardt sees more opportunity ahead. “Our strategy is basically workout and recapitalization. Everyone's looking for distress that's going to come out of the finance markets, and everyone is waiting for the banks to disgorge all of their troubled loans.”

New rules of engagement

Ultimately, the market can expect the future crop of private equity funds to operate differently. “We expect to see less institutional money and more from high-net-worth individuals and even foreign investors,” says Kevin Maggiacomo, CEO of Sperry Van Ness.

“Private equity firms will probably be specializing more by property type moving forward, be structured with far less debt than in years past, buy more debt than property, and be more patient with longer time horizons for their investments.”

One industry analyst thinks the recent travails of many private equity firms are helping institutional investors rewrite the rules on how their investments are handled.

“These institutional investors have learned that the real estate private equity guys aren't quite the masters of the universe they thought they were,” says Ted Leary, founder of pension fund advisor Crosswater Realty Advisors in Los Angeles. “The real estate investment management community is quite capable of losing vast sums of money.”

Leary believes the larger pension funds will lead the charge for change. “They're usually the lead dog that has the larger bite,” he notes.

For starters, funds will have to reduce their fees, which they typically charge for managing the assets in an investment portfolio. “Nothing drives these institutional investors madder than seeing a manager who midway through a fund has been able to reap very attractive fees, but at the end the fund has crashed and the investors lost money,” says Leary. Many fees for making acquisitions and dispositions, for example, may be eliminated entirely.

Leading indicators

The $64,000 question now seems to be when will private equity jump back into the investment game in earnest. Robert White, president of New York-based researcher Real Capital Analytics, points to a bellwether in determining when the floodgates might open.

“When somebody wants to make a big macro bid on real estate, then that sends a big signal — say if Blackstone bought a billion dollars of property from Wells Fargo,” says White.

Pumper of Transwestern believes early next year is a good bet when it comes to market timing. “We're still in the second inning of a nine-inning game. The real buying starts between February and May of next year.”

Others believe the trigger comes when investors get more comfortable with a long-term return horizon. “It's still a little early to say it's time to buy commercial real estate because the values next year are going to be higher,” says Hugh Kelly, principal of research firm Hugh Kelly Real Estate Economics. “But if you were to make the bet that three years from now they will be higher then you've got a safe bet on your hands.”

If the coming distress reaches even a small percentage of its potential, there will be plenty of product to go around for investors. “There is enough capital out there that will always be our competition,” says Eberhardt with PCCP. “But the distress is so widespread that I think if you have capital and you know what you're doing, you're going to have a field day.”

TOP U.S. FUND MANAGERS BY CAPITAL RAISED

Firm name: Capital raised 1998-2008 ($billions) Headquarters
Blackstone Real Estate Advisors 26.9 New York
Lone Star Funds 21.5 Dallas
Morgan Stanley Real Estate 21.3 New York
Goldman Sachs Real Estate Principal Investment Area 20.4 New York
Fortress Investment Group 18.6 New York
Colony Capital 11.2 Los Angeles
Carlyle Group 10.6 Washington, D.C.
LaSalle Investment Management 10.3 Chicago
AREA Property Partners 8.0 New York
Beacon Capital Partners 8.0 Boston
Source: Preqin

Ben Johnson is a contributing editor.

Are private equity firms ready to go public?

Both publicly traded REITs and private equity firms have amassed copious amounts of capital. The question is, which will pull the trigger on distressed investments and when? According to industry analysts, each is likely to play a pivotal role, but in different segments.

A general consensus is that REITs will not be major investors in the pending flood of riskier real estate owned, or REO properties, that now sit on many banks' balance sheets. “There is very little appetite for REO assets among income-oriented buyers, which are traditionally REITs,” says Spencer Levy, senior managing director of capital markets and national head of restructuring services at CB Richard Ellis.

When it comes to REO assets, Levy believes there are two types of deals — single properties and pools of assets. “When you're dealing with deals of size, north of $50 million, that is the arena where private equity firms will be the most competitive bidder in the marketplace because there are very few people who can write that check.”

For deals of less than $50 million, Levy believes that any REITs choosing to weigh into that end of the investment pool will be competing with high-net-worth individuals and foreign capital sources.

Private equity firms also tend to be more nimble when it comes to undertaking riskier deals. Recently Blackstone Group purchased half of the Broadgate Estate in the City of London from British Land, Britain's second-largest commercial property owner, for $300 million. The deal involved recapitalizing the project, taking over more than $4 billion in loans on 16 office buildings on the 32-acre site.

Far from shunning their public brethren, many private equity firms are exploring another strategy — going public themselves. “As REITs are acting more like private equity, private equity is and will be more like REITs,” says Kevin Maggiacomo, CEO of Sperry Van Ness.

“We expect some private equity firms, especially those responsible for REIT privatizations, to go public as a way of de-leveraging. We saw this in the early 1990s — companies going public to resolve their debt problems. Kimco was the first.”

For his part, Robert White, president of researcher Real Capital Analytics, agrees. “Private equity players are a little bit of a misnomer because they are just shrewd capital markets players and they go where the capital is most available and cheapest. It's more available in the public equity side.”

That doesn't mean REITs won't be players in value-add and more opportunistic investments. In August, Starwood Property Trust became the largest REIT IPO to list on the New York Stock Exchange in 2009, raising $810 million in gross proceeds.

Starwood intends to originate, finance and manage U.S. commercial and residential mortgage loans, commercial mortgage-backed securities and real estate debt investments.
— Ben Johnson