Putting on Developers’ Hard Hats, Private Equity Managers Break Risky New Ground


In real estate, the money guy is not usually the construction guy—but that might be changing.

With the U.S. federal funds rate languishing near zero, real estate private equity funds have had to overturn more rocks to find deals that can achieve the lofty yields their investors demand. That used to mean—at most—buying marginal structures, some of which would need extensive renovation before they could be sold at a profit.

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However, more recently a growing number of private-equity managers are putting aside their spreadsheets and picking up a shovel, developing lots from the ground up to seize opportunities for outsized yield.

The experience of Los Angeles-based RedBridge Capital typifies why that approach can be so attractive. Rohan Gupta, the firm’s head of asset management, explained to Commercial Observer that his extensive experience in what he called “deep” property renovations gave him the confidence to dip his toes in new construction.

“We’re still pretty judicious in what we’re buying,” he said.

Examining the national market for student housing, Gupta found that, on some campuses in the U.S. Southwest, there were more than 10 students per available bed.

That made development at the University of Nevada, Las Vegas an easy choice. “We really like universities in core cities. We want to be in locations that already have existing housing pressure,” Gupta said.

RedBridge has proceeded rapidly. After acquiring the 3.7-acre plot at 1055 Tropicana Avenue in October 2016, the firm lined up the backing of two Asian financiers to share in the $56 million development cost. Gupta said the 207,000-square-foot dorm will be ready for the 2019 academic year, less than three years after RedBridge bought the land.

With seemingly can’t-miss deals like that in mind, real estate investors—a self-selecting group with an eye for rosy returns—have increasingly pressured funds to make their capital work harder.

“The best returns and the best opportunities are in [the realm of] development,” said Mark Grinis, head of EY’s global real estate group. “Investors like development. Many investors are [asking funds], ‘Are you doing development deals?’”

Historically, the answer was no. The highest-profile firms in the space, like Blackstone, have risen to prominence by eschewing construction and development work. Currently the largest real estate private equity manager in the world, Blackstone has never made ground-up development a prominent part of its strategy. (Representatives for the company declined to comment for this story.) Even its most adventurous schemes follow what it calls a “buy it, fix it, sell it” approach, which aims to locate distressed properties and refurbish them to sell at a profit.

For some smaller funds looking to ape Blackstone’s results, however, the temptation to take on the complexities of ground-up construction has been nearly inexorable—especially when a quick exit seems assured.

In Salt Lake City, where a thriving economy has pushed the construction rate to the highest level in 10 years, Connecticut-based private-equity firm Westport Capital Partners has been able to lease out its latest ground-up project with remarkable speed. Currently in the process of tearing down a former shopping center at 2290 South 1300 East, the firm has already leased 170,000 square feet of as-yet-unbuilt office space, to the University of Utah’s health care system.

The combination office-multifamily development, known as Sugar House, exemplifies how quickly a nimble private-equity firm can act on development opportunities it spots.

“Early on in the planning process, we sought feedback from the community on what they wanted to see in the area,” Greg Geiger, a principal at Westport, said in a statement. “More than 200 employees and hundreds of visitors will come into the area each day [to] shop, dine and support local businesses—infusing the economy.”

Grinis sees the logic in projects like that.

“You’re in a healthy real estate environment where yield has been pushed down through central bank activity,” he said. “A bit more risk gives you a better return.”

But industry insiders shared a wide range of opinions with CO on just how little that “bit” of risk might be. While some private-equity managers were bullish about the role of construction in their portfolios, other sector players described their view of private-equity development as an often speculative venture, pairing potentially lucrative returns with dramatic downsides that threaten to wipe out an investment’s full principal.

“The smart [private-equity managers] don’t want to be a developer,” said David Pfeffer, a construction attorney at Tarter Krinsky & Drogin. “You’re dealing with very smart, type-A personalities in private equity. They say, ‘We’re super-smart people—we can build a building!’ ”

But those managers may overestimate their know-how—and underestimate the complexities and risks.

“An error or omission in the plans can really turn a project upside down very quickly,” Pfeffer said.

In one case, private equity developers appeared to lack the rudimentary project-management finesse that traditional builders take for granted, tripping into costly pitfalls.

In early 2014, construction neared completion on the Rise at Northgate, a tower in College Station, Texas, built to house students at Texas A&M University. The building was a bread-and-butter project for the real estate arm of Kayne Anderson Capital Advisors, which grew quickly from its launch in 2007 to become the No. 1 buyer of student housing in the U.S. just four years later.

The early 2010s had marked an explosion of investor interest in private student housing, according to Dave Borsos, a vice president at the National Multifamily Housing Council. “A lot of [other] sectors underperformed and had a lot of troubles [during the recession],” he said. “Lots of kids went back to college or extended their college stays. As people started to deploy capital during the recovery, they looked for sectors” that had been resilient to the downturn.

In response to the investor interest, Kayne Anderson and other private-equity firms rushed in.

“Student housing seemed like the holy grail,” Ari Rastegar, the founder of Rastegar Equity Partners, told CO from his car phone. (He was scouring southeast Texas for deals.) But he described a steep learning curve on the way to successfully managing an investment in the sector.

“There are so many moving parts [that] you’ve got to check your ego at the door,” Rastegar said. When equity managers take on complex work they don’t understand, he said, “it’s a fatal, fatal error.”

To design the College Station apartment complex, at 717 University Drive, Kayne Anderson hired Hill & Frank Architects—a firm with experience building other dormitories, libraries, hotels and churches. Hill & Frank drew up plans for an 18-story design: The first five stories would be a rectangular parking garage, topped by a pool deck and a 13-story, L-shaped apartment tower.

Only once construction was nearly done did builders notice a set of apparently inexplicable errors. According to a lawsuit that Kayne Anderson filed against Hill & Frank in Harris County Court in Texas, the pool, situated directly above the parking garage, was designed and constructed without crucial waterproofing material. Water that then seeped into the building’s structure festered there because the pool module had also been built without a standard overflow drain. Worse, nearby structural joints lacked crucial elements called “waterstops” that protect the most critical components of the building’s frame from corroding.

According to the lawsuit, structural cables had already begun to delaminate when the problems were discovered—a process that, if left unchecked, could have led to the collapse of the garage and perhaps the entire apartment complex, according to an audit conducted by consultancy Engineering Systems.

Photos included in lawsuit documents show the pool drained and partially excavated in late January, as forensic engineers investigated the structural danger. It is unclear whether the garage was closed during that period, but the residential tower appears to have remained open. A representative for the building acknowledged that the pool was closed this summer for renovations but said that it is now open again.

Gary Hill, a founding partner at Hill & Frank, declined to comment on the lawsuit, noting that student housing development had been a lucrative and successful aspect of the firm’s practice. Bill Lewittes, the director of Kayne Anderson’s student housing practice, also declined to comment on the suit but said that disputes were commonplace in real estate development, even when more traditional developers managed construction.

Borsos, the multifamily housing researcher, also pushed back against the notion that student housing projects were especially prone to setbacks during construction.

“I think the people who are investing and developing in [the student-housing sector] are as sophisticated and knowledgeable as those we see in the multifamily space,” he said. “The building codes that exist today are very strong and are guiding investors to develop a quality product.”

That may be so, but a succession of industry observers spoke to a disconnect between private-equity developers and the contractors, architects and engineers that round out project teams.

“The construction industry is more of a boots-on-the-ground, seat-of-the-pants kind of business,” said Jack Callahan, the chief construction adviser for consulting firm CohnReznick. Private-equity firms’ inexperience in construction and short investment horizons make them unnatural collaborators for contractors, he explained.

In particular, Callahan said, private funds can run into trouble in negotiating the financial relationships that undergird large-scale construction. “A lot of the contracting world relies on surety credit, and the surety market space has been very suspicious of the private equity investor because [surety firms] build their relationships for the long term. The private-equity model is three to five years. That gives everyone a little cause for concern.”

Pfeffer, the construction lawyer, also singled out financial arrangements with contractors as a source of risk for private equity.

“Standard-form construction agreements benefit contractors and design professionals,” Pfeffer said. Typical contracts protect contractors against, for example, accountability for construction delays that could cost the developer tenants. “If there’s a waiver of construction damages on the agreement, the owner is out of luck collecting that big bucket of damages.”

Moreover, Pfeffer emphasized, even when a developer has the purview to bring a claim against a builder, the contractor may simply lack the assets even in liquidation to compensate for the developer’s losses.

“When you think about the people actually building your building, they’re very small companies,” Pfeffer said. “Even New York City’s largest excavation contractors are not large companies. So getting a contractor to actually pay on a claim or judgment is very difficult. It’s a problem that [private equity developers] don’t understand.”

But despite the gaping pitfalls that Pfeffer described, market conditions have conspired to push private equity firms towards ground-up projects they had not previously considered.

Struggling to find opportunities for investment, fund managers have maintained record-setting levels of cash. In the first quarter of 2017, private-equity funds closed a third fewer real estate deals than they did in the last quarter of 2016. And aggregate deal value fell, too, to $38 billion from $57 billion, according to data from research company Preqin.

A more granular look behind the industry’s curtain is notoriously difficult to come by: Because so much of its capital is privately held, public reporting is spotty. Even so, the sector’s broad outlines are well understood.

Private-equity real estate funds are generally divided into four categories, by level of risk and avidity. Most conservative are core funds, which often aim to acquire well-leased, multitenant properties in strong economic regions. Progressively bolder funds are classified as core plus and value add.

On the most extreme end of the spectrum, opportunistic funds make the chanciest gambles, purchasing projects often on leverage that might require extensive renovations or ground-up development before they can generate revenue.

One of the most comprehensive recent glimpses into the sector’s performance statistics lends credence to concerns about the opportunistic side of the business. A 2013 study of American and European real estate private equity by Jamie Alcock, today a finance professor at the University of Sydney, examined the entire spectrum of real estate funds and found that opportunistic strategies—even those that do not take on development—were significantly less reliable than more conservative options. By one standard statistical measure, opportunistic funds commonly produced returns that varied by as much as 42 percentage points above and below the average. In contrast, the returns of core funds typically deviated from the average by no more than 19 points.

In general, investors would hope for higher average returns to compensate for higher risk. But Alcock found that between 2001 and 2011, conservative core strategies actually outperformed opportunistic funds, returning 2.24 percent annually, compared with -4.26 percent for opportunistic funds.

In an even more troubling sign for the most intrepid real estate managers, Alcock found that leverage can markedly degrade performance: “[It makes] a significantly negative contribution to the total excess returns earned by the funds in our sample,” he wrote.

As expected, opportunistic funds were far more leveraged than core funds. They sported debt-to-value ratios of nearly 60 percent, on average, compared with only 12 percent for core funds.

Despite these apparent challenges, funds remain ambitious. Managers are currently seeking a total of $189 billion for investment in real estate, the highest target since 2009, according to Preqin. And of the 38 funds that reached capitalization in the first quarter of 2017, half planned to invest in value-add strategies, which would include projects that entail a significant level of development work.

“It’s hard for folks to find deals they want to acquire,” said Dan Alpert, a managing partner at Westwood Capital. “Folks are looking at development situations where they can get into projects at a reasonable cost.”

That trend, Alpert said, can extend private equity managers beyond their competencies.

“There’s a massive gulf between people who are good at moving money around and people who are good developers,” Alpert said. “To a certain extent, people who move money around tend to be fairly formulaic. When it comes to actually bringing a building out of ground, the skill set that many people don’t have is the ability to look at a construction budget or construction plan and know-how to value engineer that plan to the point that they’re not fooling themselves about the cost.”

Lewittes strongly rejected that framework.

“Private equity is our structure, [but] we have a tremendous focus on real estate fundamentals,” he said. “We believe in being very operationally focused. We’re a real estate company.”

Whatever the result of the College Station lawsuit, long-term revenue dents seem unlikely. Despite the construction trouble, a representative from the Rise at Northgate described a thriving private dormitory business there this academic year, with nearly 95 percent of the building occupied.

That’s a result that no one—be it a hard-hatted developer or an asset-manager with a car phone—would have a problem with.