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Dec 14 2010

Equity Capital Markets

Mini-bubbles, lower leverage and the higher bar for raising capital

By Eric Schultz '11


The first session of the 2010 Kellogg Real Estate conference explored the current state of equity capital markets. Moderating the discussion was William Bowman, Senior Vice President of Hartford Investment Management. The industry panel, representing a variety of perspectives across the risk-return spectrum, consisted of Peter Schaff, CEO of North American Private Equity at LaSalle Investment Management; Jeff Quicksilver, Managing Principal of Walton Street Capital; John Kukral ’82, President of Northwood Investors; and Mark Decker Jr., Director of Real Estate Investment Banking at Robert W. Baird.

Equity Capital
Panelists Mark Decker, John Kukral '82, Jeff Quicksilver and Peter Schaff discuss equity capital markets at the 2010 Kellogg Real Estate Conference
The first topic was the “mini-bubble” arising in a number of core real estate markets. Cap rates on blue-chip properties in core markets have decreased significantly over the past year, thanks to cheap debt financing and a limited supply of high-quality offerings for sale. According to Schaff, sellers have been taking advantage of this situation by requiring expedited due diligence and closing processes in addition to rejecting buyer financing contingencies. Kukral reminded the audience that while bubbles are often preceded by low interest rates, they are caused by overoptimistic operating assumptions such as rents and occupancies, which are already priced to perfection in many cases.

With regard to real estate values, the group’s biggest concern was the potential impact on exit cap rates from a future increase in treasury yields. The panelists each explained the approaches they are using today to determine exit pricing assumptions, including analyses of historical-average cap rates, yields to the next buyer, replacement costs and long-term cap rate spreads over treasuries.

The discussion then shifted to a debate over the appropriate leverage level in today’s environment, with Bowman candidly asking the panelists, “Given debt rates at 4.5% today, should you take the money?” Schaff indicated that many institutional investors are feeling risk-averse after the real estate crash and as a result are insisting on low leverage or no leverage on core properties. Decker shared a similar story, explaining that the public markets generally favor REITs with lower leverage because of the flexibility this affords.

Kukral also raised the question of whether the private-equity fund model, which was enormously successful during the 1990s, is still appropriate for real estate given the less favorable risk-return dynamics today. He also challenged the prevailing fee structure, explaining that “catch-up” provisions in particular can be unfair to investors when fund-level returns are past the hurdle rate— as fund managers can invest the remaining equity in poor investments and still reap a disproportionate share of the profits.

When it comes to raising equity capital today, Quicksilver summed up the industry sentiment by acknowledging, “It’s taking a lot longer to raise a lot less capital.” Decker went on to describe the difficulty in raising equity in the public markets, pointing out that REITs are facing a higher bar and have seen a number of equity offerings rebuffed by investors due to pricing.

This higher bar also applies to the private markets, where institutional investors are evaluating fund managers not only by their performance, but also by their behavior before and after the crash, according to Schaff. As a result, institutional investors have been downsizing their roster of investment managers in an effort to gain better transparency and control, forcing many lower-tier managers out of business.

About the Author

This article was written by Eric Schultz '11.