Hedge funds getting real

Hedge fund managers are gravitating toward real estate — either by including an increasing amount of it in their funds or by adding dedicated real estate hedge funds to their offerings — to capture the higher returns compared with other asset classes.

In the process, they are taking advantage of overpriced market niches such as real estate investment trusts.

At the same time, they're getting a piece of the money flowing into real estate from increased allocations by pension funds, foreign institutional investors and syndicates of high-net-worth individuals.

Although a few hedge funds had invested in real estate securities for two or three years, what's new is that some are investing in so-called hard assets — offices, apartment buildings and hotels.

Most are investing in publicly traded securities, mezzanine debt and opportunity fund-type deals, rather than the large core or core-plus real estate deals.

A recent example: Donald Trump secured $160 million in financing to build a 90-story Chicago skyscraper from a private equity firm and two real estate hedge funds — Blackacre Institutional Capital Management, the real estate subsidiary of hedge fund manager Cerebus Capital Management LP, New York, and Grove Capital LLP, New York, hedge fund titan George Soros' real estate hedge fund.

New York hedge fund manager Och-Ziff Capital Management Group invests a small portion of its $10 billion hedge fund in real estate. Last year, Och-Ziff hired two executives from Blackstone Real Estate Advisors LP, New York, to form a real estate private equity fund.

Other hedge fund managers devoting a portion of their hedge funds to real estate include Farallon Capital Management LLC., San Francisco; Perry Capital, New York; ESL Investments, Greenwich, Conn.; and Baupost Partners, Cambridge, Mass.

A few large managers already have real estate hedge funds that invest mainly in real estate securities, including Lehman Brothers Inc., New York; Gem Investors Inc., Chicago; and Helix Realty, Chicago. Lehman plans to raise another dedicated real estate hedge fund.

One real estate manager — Apollo Real Estate Advisors, New York — went the other way and started the Claros Real Estate Security hedge fund in April. An initial $30 million came from high-net-worth investors and eight Apollo principals; fund executives hope to raise another $170 million within the next two years from institutional investors.

Claros is focused primarily on credit-intensive or credit-impaired real estate debt, with particular emphasis on securitized debt, said Richard Mack, managing partner.

"We believe the market is underserved and relative to core investing, the risk-adjusted returns are better," Mr. Mack said. "We hold securities through the process of resolving the impairment and then we resell it into the market."

Prudential Real Estate Investors, Parsippany, N.J., in a joint venture with Madison Capital Management LLC, New York, formed a hedge fund earlier this year to exploit inefficiencies of the real estate securities market, said Robert Falzon, a Pru managing director. The fund is trying to take advantage of mispricings in the REIT market vs. the public and private property markets.

Real estate hedge funds typically are limited partnerships that invest in REITs and other publicly traded real estate securities — both equities and debt — taking long and short positions on the investments, Mr. Falzon said.

"There are a lot of long-short (investment opportunities) with real estate securities," Mr. Falzon said. "There's a legitimate strategy around hedge funds targeted around REIT securities."

Eventually, the Prudential/Madison Capital joint venture will create two more funds. One will invest in opportunity funds on the secondary market, taking advantage of the difference between the price of the limited partnership and the value of the underlying real estate, Mr. Falzon said. Another will invest in smaller, bankrupt real estate companies.

Many private equity managers also are starting or considering real estate funds, said Sandy Presant, national leader for opportunity funds services with Ernst & Young, New York. The reason is simple: the relatively terrific returns in real estate compared with other asset classes, he said.

Rick Kleeman, senior managing director at Starwood Capital Group LLC, Greenwich, Conn., agrees. "Real estate has shown very good risk-adjusted returns over other asset classes, many of which are showing negative returns," Mr. Kleeman said. "People tend to pile into whatever's producing yield. There's no yield anywhere in the world, and real estate still offers attractive yields."

The National Property Index was up 3.42% for the third quarter and 10.8% for the year ended Sept. 30, according to the National Council of Real Estate Investment Fiduciaries, Chicago. The NCREIF index of core properties calculates returns gross of fees and without leverage.

The good news for investors is all these funds give them more ways to invest in the hot real estate asset class. This is a real boon to pension fund investors, who are lining up to get into more traditional real estate funds.

It's also a combination of two "sexy" asset classes that are attractive to institutional investors, said Jacques Gordon, managing director, LaSalle Investment Management, Chicago.

"A second factor is that the classic hedge funds are taking advantage of overpriced and underpriced markets through derivative strategies," Mr. Gordon said. "It's a mystery how hedge funds have raised money on the basis of 15% and 20% returns and have no background in real estate and jumped in and doing direct deals. It's very dubious to me."

At the same time, several real estate managers are starting to employ hedge fund-like long-short strategies, particularly in REITs, he said. "Long-short will become mainstream, even if they don't call themselves hedge funds," Mr. Gordon said.

But there is a downside.

"Now that hedge funds and private equity funds are in the game, there is more competition. The more competition, the lower the returns," Ernst & Young's Mr. Presant said. "They are paying more for the real estate, and (real estate managers) will have to get more creative with the real estate.

"There's no low-hanging fruit anymore," Mr. Presant said.

Hedge funds can invest only a small percentage in real estate for fear of endangering their liquidity, said Mr. Presant. Most hedge funds have to be able to give investors back their money within two years, with some on a quarterly return basis, whereas many real estate investments have a four- to 10-year life cycle.

Also, Starwood's Mr. Kleeman said hedge funds typically do not have performance hurdles to overcome before they earn performance fees. Typical real estate managers must get returns of 9% to 10% before they can command performance fees,he noted.

Still, real estate is becoming more attractive to hedge funds at a time of enormous growth in the hedge fund industry. "A lot of hedge fund managers are struggling to deploy the amount of capital they have under management," Mr. Kleeman said.