Rich Folks Go Where Pensions Dare Not

 A new pattern is emerging for the real estate business, and there’s good news for commercial real estate in particular. Commercial real estate investments by the wealthy are sure to continue for now.

By Craig Karmin | The Gainesville Sun

As big institutional investors pull back from investing in high-risk real-estate funds, these funds are turning to a new source for capital: rich people.

Starwood Capital Group, Lone Star Funds, Carlyle GroupCG +0.39% and others have raised billions of dollars over the past several months from wealthy individuals seeking to get in on the firms’ newest “opportunity” funds, which buy or develop riskier properties and use higher levels of debt in hopes of reaping high returns.

Traditional investors in opportunity funds—public and corporate pensions, foundations and endowments—reduced their allocations to the funds or began avoiding them altogether after the funds racked up huge losses during the real-estate downturn that started in 2008.

“In their place, you’ve seen high-net-worth investors,” said Barry Sternlicht, chairman and chief executive of Starwood Capital. While pensions and other large investors can require a lengthy review period before their boards approve any new investment, wealthy individuals are appealing in part because they can act quickly. “They are very fast, flexible and intuitive,” Mr. Sternlicht said.

Mr. Sternlicht declined to discuss details of his firm’s fundraising. But people who have spoken with Starwood officials about the latest opportunity fund said it raised about $800 million from high net-worth individuals. That accounted for about 40% of the total $2 billion raised, up significantly from its previous fund. Starwood’s fund is targeting distressed properties and debt, and new construction, including a condo and hotel project near the Brooklyn Bridge.

Carlyle raised about 10% of its $2.3 billion fund from high-net-worth individuals, while Lone Star took in more than $1 billion of a $5.5 billion fund that closed last year from these investors.

Even Blackstone Group, which has had no trouble attracting institutional money for its current real-estate fund, has turned to individuals to diversify the investor base. More than $1 billion of the $13 billion that Blackstone is expected to raise has come from high-net-worth individuals, said people who have spoken with Blackstone officials.

Real-estate executives say the case for commercial-property investment is easy to make when compared to other investments.

Bonds, for example, offer skimpy yields that range from about 1.8% for 10-year Treasury debt to around 3% for a corporate bond. The stock market has been volatile.

Meanwhile, property prices are well below their highs, and many funds are targeting returns of about 15% or higher.

Most individual investors didn’t participate in the commercial-property bubble, so they haven’t been as shell-shocked as pension funds have after it burst, noted Vincent Costantini, chief executive of Boston-based property investment and advisory firm Roseview. “They had been staying on the sidelines,” he said.

‪Affluent individuals are contributing from around the world, with increasing participation from wealthy Asian families and businessmen, private-bank officials said. In the U.S., they range from young entrepreneurs with new windfalls to retirees.

‪ The growing prevalence of individuals investing in real estate has also been a boon for the private-bank divisions of J.P. Morgan ChaseJPM -0.40% & Co., UBS AG, UBS +0.54%CitigroupC -0.85% and other big banks. These banks funnel money from their private-bank clients to the funds, earning a generous referral fee of as much as 4%, which is paid by the client and the fund.

Wealthy investors typically need to have a net worth of at least $5 million to invest in opportunity funds and must invest at least $250,000.

So far, the banks are referring clients primarily to brand-name real-estate funds with multiyear track records of good performance. That means hundreds of first-time property funds looking for investors are essentially cut out of the action.

Ultra-high-net-worth investors with Citi Private Bank, who typically have between $25 million and several billion dollars in assets, are interested in this product, said David Bailin, global head of managed investments. Citi partners with funds that can “source excellent transactions” and focus on primary markets like London and New York, he said. The sponsor needs to be reputable and also of “institutional quality.”

Drawing from wealthy individuals carries some risk. Individual investors are more likely than institutional investors to run into financial trouble that could cause them to renege on their commitments to inject promised capital. That is something that rarely happens with a pension fund.

Some real-estate advisers say funds that rely too heavily on individual investors can have a harder time raising institutional money. Pensions and other big investors require more disclosure and regular reporting information than individual investors, and they like to invest alongside others that share their interests.

“Real-estate fund managers may not be as sensitive or attuned to these issues if a fund is predominantly high-net-worth individuals,” said William Atwood, executive director at the Illinois State Board of Investment.

‪High-net-worth investors may also be quicker to sue fund managers if returns aren’t as advertised, said Roseview’s Mr. Costantini, adding, “These investors can be a bit of a wild card.”

‪ Investments in commercial real estate by the wealthy aren’t a totally new phenomenon, more a return to the past. Before the 1990s, individuals financed many property transactions. But starting in 1989, the government began selling off distressed real-estate and property loans held by savings and loan associations.

‪ Private-equity firms formed real-estate funds to buy up these assets and began tapping institutional investors. Within a few years, pensions became the cornerstone investor for most funds.

‪ Real-estate funds found it more efficient to raise money in a few large chunks, and investors in a first fund could often be counted on to reinvest in subsequent funds. Pensions, meanwhile, enjoyed annual returns from the higher-risk funds that frequently topped 20%.

‪ But when these funds suffered staggering losses during the financial crisis, the relationship between institutional investors and real-estate funds became strained.

‪ Pensions like the California fund known as Calpers said it was moving away from higher-risk funds in favor of lower-risk property funds. The Harvard University endowment started favoring direct property investments over pooled funds. Other pensions bargained hard for lower fees or better terms.

—Julie Steinberg contributed to this article

Virginia MacKoul

Virginia is a graduate from the University of Florida's College of Design Construction and Planning with a degree in Sustainability and the Built Environment, and a minor in Urban Regional Planning. Virginia joined the Front Street team in 2011, as an intern. Upon graduation, Virginia joined the Front Street team full-time as the Director of Client Services. Ms. MacKoul’s addition furthers Front Street’s continued growth and expansion within Gainesville and other North Central Florida markets. She was promoted to Director of Marketing in 2014 and now manages the firm’s team of interns and oversees all marketing and branding activity. Virginia was born in Boston and moved to Lee County, Florida in 1997. Virginia graduated her high school's International Baccalaureate program and started at the University of Florida with a focus on Architecture. Virginia shares Front Street's passion of giving back to the community and those in need. Virginia's hobbies include photography, cooking, football, movies, music, and spending time with her dog, Brinkley.

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