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Real estate

Institutions, managers building again

Construction rekindled as multifamily, hotel opportunities draw new interest

041513 boesky
Stuart Boesky says loans aren’t a problem for good deals in New York City and parts of California.

Real estate money managers and institutional investors are starting to develop properties for the first time since the financial crisis brought most construction projects to a halt.

They are particularly interested in building multifamily projects and hotels in hot, mostly coastal, markets where demand is exceeding supply, real estate managers say.

The C$5.7 billion (US$5.6 billion) Ontario Municipal Employees Retirement System's real estate investment unit, Oxford Properties Group, Toronto, has a joint venture with Related Cos., a New York-based real estate development company, on a $15 billion residential and commercial project on Manhattan's West Side known as Hudson Yards. Oxford also announced in December a 50/50 joint venture with Gould Property Co., Washington, to develop a 620,000-square-foot office building in Washington.

The C$176.2 billion Caisse de Depot et Placement du Quebec's real estate investment arm, Ivanhoe Cambridge, Montreal, is building with co-investor and developer Hines a 45-story office tower and 1.5-acre public park in Chicago's West Loop.

The $258.3 billion California Public Employees' Retirement System, Sacramento, and the $161.5 billion California State Teachers' Retirement System, West Sacramento, each bought stakes in separate real estate investment management and development firms last year. CalPERS invested about $100 million in Bentall Kennedy (US) LP, making it a one-third owner. CalSTRS bought 90% of LCOR Inc.

“We believe it's a great time to develop stabilized assets in certain markets,” said Avi Shemesh, principal and co-founder of Los Angeles-based real estate and infrastructure investment firm CIM Group.

CIM Group is developing — along with Harry Macklowe and co-investors — a New York residential tower that will be one of the tallest residential buildings in the U.S. Mr. Shemesh declined to identify the co-investors. CIM Group investors include CalPERS — for which it runs both real estate and infrastructure allocations — and the $72.5 billion New Jersey Division of Investment, Trenton.

“We are building apartments that we believe will achieve very attractive returns on cost. For us, it is a time to generate relatively high returns for that level of risk,” he said.

Choosy lenders

When it comes to development loans, lenders are choosy. Construction loans are available for apartments in hot markets such as Manhattan and surrounding New York City boroughs and the California cities of San Jose, Los Angeles and San Francisco, said Stuart Boesky, founder of New York-based real estate debt manager Pembrook Capital Management LLC.

The real issue in these deals is not construction risk, which is usually not great because apartments are generally built with simple and standardized construction methods and materials. The problem is with so-called lease-up risk, or the risk that rents and stabilized occupancy will not be enough to make the project successful, he said.

Pembrook offers construction mezzanine financing to proven developers in strong markets.

“Properties proposed by proven developers in strong markets that have high barriers to entry are a very good risk for construction lenders,” Mr. Boesky said.

Real estate managers that develop projects need to earn returns at the minimum in the high teens, industry executives say. The longer it takes to lease a building and the lower the rental prices, the lower the return.

Ronald Dickerman, president of Madison International Realty, a New York real estate money management firm, noted that not all managers have those expectations. “What's really startling is that the return potential of most developments is very modest,” with some around 7%, he said. “I would think they (managers and developers) would want 15% to 17% return.”

Despite the interest of some of the larger institutions, investors typically stay away from development deals due to the risk. Maury Tognarelli, CEO of Chicago-based real estate investment firm Heitman, said investors' risk comes in the two years it typically takes to complete construction and lease a project. “You have a window where you are exposed to changes in demand, and that creates higher risk for some investors,” Mr. Tognarelli said.

Even so, development projects can be a winning strategy for some real estate investors.

“Building today makes a lot of sense for certain investors who have a broader portfolio,” Mr. Tognarelli said. “This is an opportunity to access more return for higher risk, but on a measured basis.”

Hotels is another sector that is attracting money managers willing to develop new properties, said Aik Hong Tan, principal of Greenwood Hospitality Group, the Denver-based hotel real estate manager.

2013 and 2014 are projected to be big years for hotel construction, he said. According to hotel research firms PKF Hospitality Research LLC and Smith Travel Research Inc., there was 0.5% growth in 2012 in terms of hotel room count, the most common measure of supply in the hotel sector. This compares with a long-term average of between 2% and 2.5%, Mr. Tan said. That 2012 figure is expected to double to 1% this year and to 1.5% in 2014, with the construction of more hotels.

Supply seems to be more concentrated. Hotels are being built in cities like New York, considered the best market because it is a tourism hub and financial center, Mr. Tan said. But other big areas of hotel development are around shale fields in North Dakota and Pennsylvania, where there are too few hotel rooms for the number of oil field workers moving to the areas, he added.

"More aggressive equity'

Unlike in the past, it is not the lenders that are behind the movement into commercial real estate development, said Jeff Johnson, CEO of Denver-based real estate firm Diversified Property Fund, which is not investing in development deals, “Construction is possible because there is more aggressive equity,” Mr. Johnson said, citing the institutional investors and equity real estate money managers seeking out these deals.

Lenders are still a bit wary of construction projects and, unlike the pre-financial crisis development heyday, banks are not issuing non-recourse construction loans. (With non-recourse loans, lenders cannot go after the borrower's personal assets if the borrower defaults.)

These days, lenders are requiring equity or collateral in the form of other real estate, said Mr. Johnson, who was chief investment officer at Equity Office Properties before the mammoth real estate investment trust was sold for $39 billion to The Blackstone Group LP in 2007 — a deal that signaled the height of the real estate market.

A local developer needs to get an equity joint venture partner such as a pension fund or a real estate money manager to get a loan, Mr. Johnson said.

“In 2007, when people bought EOP's (Equity Office Properties) assets, those people were getting 90% to 95% financing with no recourse.”

Today, the lenders have eased up on their standards a bit, but it is nowhere near 2006 levels, he said. The increase in development really comes from the availability of cash from real estate money managers eager to invest capital and investors looking to bring their real estate allocations up to targets. n

This article originally appeared in the April 15, 2013 print issue as, "Institutions, managers building again".