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By Arleen Jacobius
May 26, 2008

Real estate investors and investment management firms are patiently sitting on their capital as they wait for the dust to settle on the real estate market.

“The best strategy is to go for a long vacation in the Antarctic for nine months,” said Jeremy Newsum, chief executive and director at global real estate investment firm Grosvenor Group Ltd., London.

Investors all know their commercial real estate portfolios will take a hit. There isn’t much they can do about it, except maybe take a hard look at their investments to guard against any surprises, said Micolyn M. Yalonis, principal at consultant the Townsend Group, Cleveland.

A dearth of transactions is making it almost impossible for investors to determine the value of real estate, especially in the U.S. and other developed countries. Everyone expects property values to drop, similar to the problems now roiling through the residential market, but nobody knows when or how far they will fall.

With few exceptions, all but investors with large uncommitted real estate allocations are staying out of the market. “Everyone is waiting for the other shoe to drop or the transaction volume to pick up,” said Ms. Yalonis. Despite closing the $1 billion Canyon-Johnson Urban Fund III — sponsored by a partnership of Canyon Capital Realty Advisors LLC and Earvin “Magic” Johnson — there’s no hurry to invest the capital, said Bobby Turner, the fund’s managing partner.

“We will sit on the sidelines for a while,” said Mr. Turner, who is a managing partner of both Canyon Capital Realty Advisors and Canyon Capital Advisors LLC, Los Angeles-based money management firms. “There will be great opportunities if you are not investing for six to 12 months.”

Current sale prices are too steep, development costs are too high and distressed opportunities too sparse in commercial real estate, he said.

The problem is that in the go-go days, property prices shot up. While commercial property prices have not dropped much in most sectors and locations, the easy credit days ended when the banks, which accounted for roughly 70% of the lending, snapped off the loan spigot.

“People were convinced that real estate is a liquid asset,” Mr. Turner said.

Nervousness overall

Investors are nervous about the market and real estate in general. “It’s time to wait and see,” Ms. Yalonis said.

“Anybody who says they know what is happening is lying,” said Grosvenor’s Mr. Newsum, who will step down as chief executive on July 1 but remain with Grosvenor Group as a non-executive director. That uncertainty isn’t confined to the U.S. In the United Kingdom, for example, investors are making asset allocations based on appraisals, but the appraisers have a “jaundiced view of valuations,” which are causing valuations to fall more than they should, Mr. Newsum said.

While waiting, investors are reassessing their portfolios and looking for ways to prosper in a down market, Ms. Yalonis said.

One bright spot is distressed real estate. About 50 distressed real estate debt funds were raising funds the end of 2007, Ms. Yalonis said. And many more began fundraising this year.

“A lot of players without distressed debt vehicles are jumping in because the opportunity is so great,” said John Jacobsson, managing partner, Apollo Real Estate Advisors, New York.

Apollo closed a domestic debt fund last year and, although Mr. Jacobsson declined to talk about fundraising, the firm reportedly is busy raising a new European debt fund.

These debt funds are hoping to scoop up real estate debt held by banks as well as scour the U.S. looking for distressed opportunities.

These opportunities are out there now, Mr. Jacobsson said. “It’s more than a trickle. It’s a stream and will turn into a river by the end of this year and in 2009,” he said.

But that outlook might be a bit premature, said Gary Koster, director of the national funds practice at Ernst & Young, New York. Real estate loans typically have five-year terms, and most properties purchased five years ago increased in value. It’s the real estate loans made in late 2005, 2006 and 2007 that are “underwater,” he said. But those deals won’t turn into distressed opportunities until 2010 or 2011, Mr. Koster said.

So there are very few real opportunities in distressed commercial real estate. Most distress is in the residential sector, where the hard part is determining the bottom of the market and obtaining financing for a deal, Mr. Koster added.

Residential property deals are extremely volatile and can turn bad quickly, Mr. Koster said. One example is a $1 billion land deal struck by the California Public Employees’ Retirement System, Sacramento, with San Francisco- based MacFarlane Partners in February 2007. That investment is teetering between bankruptcy filing and a cash bailout by the $248.2 billion system. “CalPERS might have to take massive write-offs,” he said. “It just shows how volatile residential is.”

CalPERS spokeswoman Pat Macht declined to comment.

Better bored than worried

“I’d rather be bored than worried,” is the new adage in the business, Mr. Koster added. But Apollo’s Mr. Jacobsson said his firm is quite busy looking at distressed opportunities, and he expects the firm to get even busier.

But even in distressed bank debt — a market estimated at anywhere from $800 billion to $1 trillion — there is no flurry of transactions. For that to happen, sellers and buyers need to decide what that debt is worth, said Josh Zegen, managing partner and co-founder of Madison Realty Capital, a New York mezzanine lender.

“They have not reached equilibrium, but that will change in the next three to six months,” Mr. Zegen said. “Sellers think their debt is worth more than buyers are willing to pay.”

Buyers and lenders also have to be cautious, said Canyon Capital’s Mr. Turner. In the retail sector, for example, there is a tremendous risk of failure because of the consolidation and leveraging of retailers. So lenders and real estate buyers have to know the underlying credit quality of the tenants.

“Knowing where to fire your gunpowder is very important,” Mr. Turner said. “You have to pick opportunities where you can protect your downside.”

One small pocket of opportunity exists in the apartment sector, which is positioned for growth due to healthy demand from young people new to the work force, said Doug Callantine, president of Grosvenor Investment Management US Inc., Philadelphia.

In addition to investing in distressed real estate funds, investors are looking at real estate in emerging markets, including Eastern Europe and parts of Asia, Ms. Yalonis said. But the strategies can be risky. “It’s not for the faint of heart,” she said. The places offering opportunities for alpha come with risk.

Long-term investing in the so-called BRIC countries — Brazil, Russia, India and China — can be rewarding, Mr. Newsum said, but each country has its own challenges. And investors have to ensure that they will be receiving a premium for taking on risks.

Investors need to be aware of the risks and make sure they are compensated for taking those risks, Mr. Newsum said.

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