In order to understand the present state of the real estate investment management industry, it is important to gain an appreciation of its past. Peter Schaff, CEO of North American Private Equity at LaSalle Investment Management, explained this historical context as he reflected on his 26 years in the business during an interview with first-year Kellogg student Eric Schultz.
When Mr. Schaff joined LaSalle Advisors (LaSalle Investment Management’s predecessor) in 1984, the institutional real estate money management industry was just getting underway in earnest. US pension funds were gradually adding real estate to their asset allocation models, initially targeting high-quality income-oriented “core” properties and thereafter migrating out to higher risk investments. By and large, the 1980s proved to be a formative decade for the institutional real estate sector, allowing firms like LaSalle to grow and mature amid the rush of new capital.
Then came the early ‘90s property bust, caused by a glut of overbuilding and the S&L crisis that followed. This period was a difficult one for the incumbent real estate money managers, which were roundly criticized for being slow to sell assets at the peak of the market and even slower to recognize write-downs in asset values once the downturn set in. However, the downturn also gave rise to the first real estate “opportunity funds”. Launched by investment banks such as Morgan Stanley and Goldman Sachs, who had not previously been involved in real estate investment management, these funds featured large co-investments by the fund sponsors and aggressively bought at deep discounts to both replacement cost and prior peak pricing. As Mr. Schaff described it, “While the old guard (firms like LaSalle that grew rapidly in the 1980s) was in the penalty box, these new players stepped in and attracted substantial institutional capital commitments.” The early opportunity funds were enormously successful – generating internal rates of return in the 20s and 30s – and led to sequentially larger follow-on funds and the establishment of large real estate investment management businesses at numerous investment banks and newly formed firms.
By the late ‘90s, property markets had recovered and the traditional real estate money managers—with their legacy issues now behind them—were enjoying a resurgence. During this period, firms such as LaSalle expanded into overseas markets and launched a number of new investment products. Several ownership changes also altered the industry landscape, as firms such as RREEF and Clarion were acquired by large financial organizations.
A new real estate “bubble” began in 2004 and, according to Mr. Schaff, led to an unprecedented run-up in property values and transaction volumes over the ensuing four years. The huge capital flows into the commercial property sector during this time brought about a number of changes within the investment industry. First, a wave of start-up investment shops came on the scene and became active players in an increasingly frenetic acquisitions market. As Mr. Schaff explained, “The new firms employed high leverage, aggressive rent growth assumptions, and even more aggressive exit multiples… and for a while were actually hitting their numbers. In the early years of this bubble, traditional investors were consistently outbid and watched from the sidelines. But as the success of the more aggressive bidders continued, the rest of the industry followed suit – subscribing to the idea that a secular change had occurred in real estate pricing and finance.”
Meanwhile, the flood of new capital gave rise to multi-billion-dollar “megafunds” at many of the larger real estate investment firms. The large size and inauspicious timing of these funds created issues of their own. With billions of dollars to invest over a short period, these funds bought ever larger deals and eventually entire public companies at what turned out to be peak market pricing. As a result, the megafund model has since fallen out of favor with investors, who feel that the high fees are not justified in light of poor performance.
This brings us to the current real estate downturn, which began at the end of 2007. Having lived through the last downturn in the early ‘90s, Mr. Schaff believes that the real estate investment community has acted much more prudently this time around. He explained how the industry has quickly recognized write-downs in property values and implemented better risk-management processes. Nevertheless, he acknowledges that the next 12-24 months will be challenging for the industry, particularly as capital flows remain muted.
Among the casualties will be many of the start-up investment shops that emerged during the 2004-2007 period. There will likely be a reckoning of sorts when many of these managers unwind their existing funds and are left with the bleak prospect of raising the next one. Mr. Schaff explained, “Investors vote with their money and won’t reinvest next time.” To a lesser extent, some reshuffling will also occur as poorly-performing general partners either sell out of their management contracts or are voted out by the limited partners.
The more established investment firms will fare relatively better but will still have to cope with lower management fees and lower capital commitments from investors. New fund launches at these firms will also be me more cautious over the next few years. That said, “There will still be appetite for well-focused market recovery strategies being executed by experienced teams,” Mr. Schaff added.
In another industry setback, a few large institutional investors are opting for a “do it yourself” approach whereby they intend to bypass the investment management industry and instead invest directly alongside operating partners—though it is yet to be seen whether this is a short-term reaction or long-term shift.
Mr. Schaff concluded the interview by offering some advice to MBA students looking to enter the industry. First, “If you want to be in real estate, don’t worry too much about when you start.” Given real estate’s cyclical nature, students should take a long-term perspective and place less emphasis on the timing of their entry, as a down cycle can be an excellent time to learn. Second, “Try to find a quality group with staying power and a track record of growth and innovation, as opposed to the firm that happens to offer the highest starting compensation. Demonstrated talent and productivity will lead to rapid growth in opportunity in the better firms, which in turn drives compensation.”