Real Earnings in Real Estate

(Private Equity Central)

by Marc Raybin

April 13, 2007 - If you listen to the news these days concerning the subprime debacle, you would have the impression investors are running for bomb shelters because the economy is set to experience a major blow up. There is no doubt the horizon looks grim due to the lending of money to people who could not afford to borrow, but considering investing is a zero-sum gain, or is it a game, when someone is losing money, another person is making money (typically off of the former’s losses).

Investment in real estate has been burning up the private equity asset class. In fact, investors raised a whopping $59.5 billion in capital for real estate deals last year alone, nearly a 61% increase from the $37 billion raised in 2005, according to Private Equity Real Estate. Based on last year’s numbers, private equity funds have the buying power equivalent to $180 billion. That is once leverage has been accounted for.

The Blackstone Group’s eye-popping, and protracted $39 billion deal for Equity Office Properties in February, is an example of the asset class jumping into the fray. Private equity investing in real estate has always been an important sector, however it has grown so much in the last year that we can no longer ignore it. Just as soon as Blackstone won the bidding war to acquire EOP, the firm began selling off properties at a rapid fire pace. Although exact numbers are unclear, based on media reports, the firm has already sold more than $23 billion worth of properties.

“All of a sudden, it transcends real estate and it becomes a major private equity deal,” says Susan Stupin, managing director and co-founder of The Prescott Group, LLC, a real estate merchant banking firm that works with private equity firms.

Prices are starting to drop and as the adage goes, buy low and sell high (something private equity firms are typically pretty good at). Alex Samoylovich, owner of Estate Property Group out of Chicago, says there are more private equity firms entering different niches in the real estate market, such as distressed debt and foreclosures.

Samoylovich, who currently works with a $400 million private equity firm out of Texas, will broker deals, including acquisitions and sales, on behalf of firms. He says foreclosures could prove to be a boon for private equity firms flush with cash. Firms, he says, will look to buy foreclosure packages in bulk from banks for as little as 70 cents on the dollar. Up to 100 properties may be bought at one time in some cases. Should the subprime situation worsen, which could very well happen, he sees the discount getting even steeper. Samoylovich jokes investors may even get back to the same situation as in the 1980s, when they were paying as little as 30 cents on the dollar.

It is not just the idea of buying low and selling high that may attract private equity investment in real estate, although that is certainly a big draw, there are serious tax benefits. Samoylovich references the 1031 Exchanges, which allow for investors who sell a property to find a new investment within 45 days and close in 100 days to avoid paying a capital gains tax on the original investment.

“You basically have tax free growth,” says Samoylovich. “I think that is why a lot of private equity firms and hedge funds look at it [real estate] as a great alternative investment.”

Samoylovich’s private equity client in Texas, for example, is working on this kind of deal. They are working quickly to acquire properties in Illinois, Florida, or Kentucky. While investors wait to sell the property, they will typically look for a small cash-on-cash return of about 7% in the short term, however, the gains of the tax benefits can be pretty good, says Samoylovich.

Even though we have only recently started to cover real estate investing as a separate sector focus, we have written about it on a secondary level. For instance, Kohlberg Kravis Roberts & Co.’s acquisition of Dollar General involved more than just buying up of the business. The company had a lot of valuable real estate to go along with it. Stupin says private equity firms have become adept at coming up with different ways to create value.

“[Private equity firms] will harvest the value from real estate that supports that business,” explains Stupin. “[It] has intrinsic value separate from the operating business.”

Considering it is all doom and gloom regarding real estate these days, it may be difficult to imagine real estate getting hot again. As Samoylovich says, the subprime collapse will not trigger the end of the world so much as it will simply flush itself out. New opportunities for investment will continue to pop up as a result.