Thursday, January 27, 2005

The Mega-Deals Are Back in Commercial Real Estate

From Knowledge at Wharton (Jan 26 - Feb 8, 2005)

It was around 11 p.m. one evening last August, as John Bucksbaum waited in his attorney's office in Lower Manhattan, when the phone rang with the news. He quickly buttoned his suit and picked up a folder that contained a single sheet of paper with a number on it — a share price. He walked across the street to the offices of the law firm representing the company he was about to buy. “I felt like I was in the movie 'Wall Street,'" recalls Bucksbaum, CEO of General Growth Properties based in Chicago, the country's second largest publicly traded real estate investment trust.


That night Bucksbaum closed a $12.6 billion deal for General Growth Properties to acquire The Rouse Company of Maryland, a large real estate developer and owner of shopping malls and office and industrial properties. With that transaction, General Growth's portfolio grew to encompass 221 regional shopping malls and other properties totaling 200 million sq. ft. in 44 states. Rouse came with 37 shopping malls, four community centers, and six mixed-use projects totaling 40 million sq. ft. It also brought along office and industrial properties of 9 million sq. ft.


Bucksbaum spoke about the challenges of putting together that mega real estate deal at a meeting of Wharton’s Samuel Zell and Robert Lurie Real Estate Center in Philadelphia. He was part of a panel discussion on 'Mega-Projects in Real Estate: Where Are They and How Do They Work?" The day-long conference with three panel sessions drew more than 500 attendees.


Besides Bucksbaum, the mega-projects panel included other industry leaders who have recently struck big real estate deals. Thomas Barrack, president and CEO of Colony Capital of Los Angeles, last September completed a $1.24-billion transaction to buy four casinos from Harrah's Entertainment and Caesars Entertainment, both of Las Vegas. Ronald Kravit, managing director of Blackacre Capital Group in New York City and another panelist, undertook the $3.8-billion purchase of LNR Property, a prominent real estate investment firm based in Miami Beach, Fla. In the LNR deal, Blackacre had teamed with its affiliate, Cerberus Capital Management of New York City, which has $14 billion in un-leveraged capital. The panel also included Owen Thomas, managing director and head of the real estate group of Morgan Stanley. Last May, Thomas orchestrated the $3 billion purchase of Canary Wharf, the developer of London's second financial district across 86 acres that is a half-hour ride from the main city. The Morgan Stanley-led consortium of investors won the day in the face of stiff competition from 10 other bidders and over a protracted deal cycle of more than a year.


Big Risks in Big Deals

“What makes large deals different, what's the risk in these deals, and what makes them worth the risk?" asked Wharton real estate professor Peter Linneman, who moderated the session. The session attempted to get glimpses into the challenges and creativity required to get big deals done. The panelists discussed aspects of structuring, underwriting, pricing, negotiating, financing and execution.


Conventional wisdom might suggest that whoever writes the biggest check typically wins the day. That is far from the truth, said Barrack, whose firm, Colony Capital, also acquired the Las Vegas Hilton last June for $280 million (although add-ons to the deal counted another $1.2 billion). “Money is the least important factor in transactions today; it's just a commodity," noted Barrack. “Controlling the deal is really the difficult part."


Just how does one go about controlling such deals, Linneman wanted to know. “Stupidity,” replied Barrack, in a word that conveyed it all. 'We are always trying to be some place where all the brilliant people are not." He answered Linneman's question by first explaining how he assessed the proposals to buy the Harrah's and Caesar's casinos. 'Gaming is a very simple business; it's the hotel business with the missing cash flow," he said. “In the hotel business you have great residual value but no cash, and in the gaming business you have limited residual value but unbelievable cash flow."


Barrack added that the gaming business had a natural barrier to entry because of the licensing and regulatory issues involved, so “smart people will not go there.” Another factor reduced the competition Barrack would face in the deal: Caesar's and Harrah's wanted to sell the four casinos before their $9.4-billion merger that was announced last July. They also did not want financial or regulatory contingencies; in other words, they wanted an acquirer who had already taken care of those aspects.


Barrack liked that setting. “We had a more narrow competitive field with a very short time frame (to consummate the deal), and a higher tolerance for risk because we were already licensed (in the gaming business)," he said, adding that “financing was relatively simple" for his company. He also saw a competitive advantage in the complexity of the deal because it further narrowed the playing field. “It was a subject of tremendous litigation, it had a complicated asset profile, and the employee base was demoralized," he said.


Morgan Stanley's Thomas believes complexity can be an asset in a deal, and he felt it gave his company an advantage in the Canary Wharf transaction. “It was very complicated. The company was 65% leveraged with complex securitizations, and had development land with complicated tax issues," he said. “That was an advantage for a large company that could handle all the complexity."


Blackacre's Kravit found himself putting similar skills to the test in another deal a month before the LNR acquisition. Last July Blackacre's affiliate Cerberus had bought the Mervyn's department store chain from Target for $1.65 billion, in partnership with Sun Capital Partners and Lubert-Adler Klaff and Partners. San Francisco-based Mervyn's had 257 stores in 13 states. 'When we started looking at it, it was a business that was losing money, but it had a lot of real estate in California where it had 160 stores," he said. Kravit explained why his group was at an advantage vis-à-vis other bidders. “You have to understand bankruptcy, you have to understand vacant boxes and you have to understand development," he said. “You have to have a lot of those skills, and a lot of people don't have that to put it all together."


Linneman wanted to know what endurance these big time deal makers bring to the table, especially when negotiations get complex and protracted. “Did you hit a point where you said ‘Enough, this is too crazy, too complicated, it's too big a bet, I'm done?'" he asked. “About 10 times," said Thomas, referring to the Canary Wharf deal. “There were lots of emotional highs and lows. The key is to just continually reassess what's going on with the deal, what's going on in the market." Barrack took a similar approach in the casino deal. 'In a deal like this, as information is constantly unfolding in front of you, you have to question your assumptions on a daily basis." Bucksbaum too felt emotions run high and low during the Rouse deal, but found comfort in the fact that he was taking measured risks. “We were not betting the farm; the worst thing that we could do is slow down our growth."


What Investors Want

Backing these deal makers in their quests are bankers and other investors, who have been bullish beyond expectations on real estate in recent years. Joseph Gyourko, a professor of real estate and finance at Wharton and director of the Zell-Lurie real estate center, delved into those issues in a panel discussion he moderated on 'Financing Different Types of Real Estate: What Does Capital Require Today?" The panelists were Tom MacManus, president of GMAC Commercial Mortgage, Steven Roth, chairman and CEO of Vornado Realty Trust, Stuart Rothenberg, partner at Goldman, Sachs and David Steinwedell, chief investment officer of Wells Real Estate Funds.


“There has been a paradigm shift in the flows of capital to real estate since 2001," said Rothenberg. He attributed that to the lessons learnt by investors from the bust of the New Economy. “People [initially] thought that with the advance of technology and telecom, the world was changing," he recalled. He said that as investors saw that the world wasn't changing that much, and that there were big risks in investing in so-called New Economy stocks, “they started thinking about bricks and mortar" all over again. That reality check led investors to real estate, he said. “Look at the amount of wealth that is being created by long term investments in real estate, whether it is by corporations or families. There is a decent allocation to real estate; it had so far been under-represented and is now starting to fill up."


Steinwedell has been able to drum up a significant franchise amid that rising investment sentiment. “We've tapped the section that hasn't really been able to get into the real estate business, and that is the individual investor," he said. “With that, our business has grown from $2 billion a year (in investment funds) to $10 billion a year." Wells has 170,000 investors who have invested an average of $25,000. “Its penetration across all income segments is impressive: the smallest investment is $1,000, while the largest investor has about $5 million."


According to Vornado's Roth, “the world is underinvested in real estate in a huge way, and a very significant move is occurring" to correct that. “It is a very, very strong move, and it has a lot of life left in it," he said of the increasing investment appeal of real estate. Just what are the expectations of returns by these investors, Gyourko wanted to know. Steinwedell said his investors seemed happy with the 7% dividend in the first real estate investment trust fund floated by Wells, and also with the 6% dividend in the second fund. 'What's been fascinating to us is that we have almost a 70% dividend reinvestment," he said. “We are sending them their dividends and they are sending the money right back to us to reinvest. So there is a sense that they are looking for capital preservation as opposed to income."


Rothenberg of Goldman, Sachs has had different signals on investor expectations of returns. He said investors are shifting to be more focused on “yield bets rather than residual bets." In other words, investors prefer yields to the likely capital appreciation that can be realized when the real estate is sold. Also, his investors seemed to be comfortable with returns in the mid-teens these days, even though they were used to returns of 20% or more in earlier years. He said they also have preferences on how those returns are generated. He says investors want those mid-teens returns to be based not on Goldman making “some residual bets" but on investments in portfolios that produce [rental] income and carry low risks.

Vornado's Roth noted that investors weren't attracted by dividends, but by the “ideas and the ability to buy properties at prices that will allow for capital appreciation." He said that his company tried to make sure that the capital appreciation is created when buying real estate, and not when it is sold. 'We are in a very strange market, where capital is not important any more," he said. “What matters is the idea, and the talent of the team that's running the idea."

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