PREA Changing Investment Mgt Business

34 PREA Quarterly, Fall 2010

Investment Risk

Jon BraeutigamJoe Pagliari Keith Barket

C O V E R2 0 1 0fall

The Changing Investmen t Management Business: A R o u n d t A b l e d i s c u s s i o n

economic enviRonmentPagliari: Let’s start with your firm’s take on the general investment climate, your views on the capital market as a precursor to how we think about changing real estate investment man-agement practices. Keith, could you give us your view or your firm’s view?barket: Our firm’s view is not dissimilar from the

general consensus, which is that this has been a long,

deep recession and will be a slow recovery for all the

obvious reasons. We do believe there will be a recov-

ery, whether there is a second dip or not. I don’t think

we have a better vision than anyone else, but the signs

are pretty clear that we have been in the early stages

of recovery for six months or more. almost all

the indicators—retail sales, industrial produc-

tion, manufacturing capacity, auto sales, even

employment, as much as we are all disappointed

by employment—are all positive, though they are

weaker than one might expect at this stage of a reces-

sion. We constantly watch for signs of a double dip,

and if we saw such signs, we would reevevaluate our

investment approach accordingly. However, we’ve

been very active buyers for the past 12 months, and I

don’t think we will come to regret it.

In terms of what the recession means for real estate:

first, it means that for the first time in 20 years, you

have an enormous amount of distressed assets working

PREA Quarterly, Fall 2010 35

Jamie ShenPat Halter Glenn Lowenstein Marc Weidner

The Changing Investmen t Management Business: A R o u n d t A b l e d i s c u s s i o n

their way through the system. The estimates of $500

billion to $1 trillion of loans that won’t be able to be

refinanced at today’s levels are consistent with our pro-

jections. Many of these loans will default, and a lot of

them already have defaulted. They will work through

the system as those real estate assets become recapital-

ized. from that perspective, we think it is going to be a

tremendous opportunity.

Thanks. Jon, the view from Michigan?braeutigam: I’ll give you my view, not Michigan’s view.

I won’t speak for all of Michigan, but I think double-dip

recessions are rare historically, so our base case would

not be a double-dip recession. Our view is probably

similar to consensus, which is we are in the “new nor-

mal,” or slower growth, camp. In terms of the broader

market, bear markets over the last 50 years have aver-

aged about 14 months. average bull runs are 68 months,

and we’re about 17 months into that, so we think we

could be in a longer-term bull market, which would be

good for the economy. Commenting on deflation and

inflation: We don’t think we will see deflation, but we

are going to see very low inflation for quite some time.

Pat?Halter: We are definitely seeing a period beset by os-

cillating views of both risk aversion and risk taking

as we look at the markets today. We don’t really see a

double-dip recession on the horizon. My general view

is that the economy is on track for a positive growth

of perhaps 2% for the third and fourth quarters of

2010—admittedly unexciting but growth nonetheless.

Probably, like Jon, I don’t think we are seeing a period

of sustained deflation pressure on the horizon, but that

is something to continue to monitor. I don’t want to

shine too optimistic a light on things, but calendar year

2011 may contain the seeds of a more promising year

for the U.S. economy, particularly if policy errors can

be avoided. That is one of the key things that we feel

has been a problem over the last 12 to 18 months. Our

forecast is for GDP growth to reach around 3% in 2011.

We do think unemployment rates will start to decline

from the 9½-ish range that they are at right now and

hope they will end up closer to the 8¼% range by year-

end 2011. Some interesting developments will start to

create job growth. One of the key ones is that labor

productivity has declined. Typically and historically,

stronger forces of job recovery follow that, albeit with

a lag. We’re hoping that that starts to transcend itself in

2011 because in real estate, we are all concerned about

the job growth outlook to an acceleration in job cre-

ation. We hope to see a bit more positive trend line in

that going forward. It is actually interesting; people are

complaining about where the jobs are, but if you look

at the current trajectory of private-sector job growth,

what we are experiencing now in the last 12 months

... this has been a long, deep

recession and will be a slowrecovery for

all the obvious reasons. I don’t think we have a better vision than anyone else, but the

signs are pretty clear that we

have been in the early stages

of recovery for six months

or more.Keith barket



coming out of this recession is pretty similar to the last

two post-recession recovery periods. So private-sector

job growth is not really out of pattern from past reces-

sionary periods.

I’d like to drill in a little bit further. You men-tioned policy errors. What specifically concerns you from a policy standpoint?Halter: It is predominantly the uncertainty from the

Obama administration and the continued anti-busi-

ness attitude the Obama administration has toward

businesses. Obviously, health care has created a lot

of uncertainty in terms of the cost of business, the

cost of hiring people, and that is a significant factor

in terms of businesspeople thinking of adding or not

adding people.

Do the forecasts of deficits enter into that think-ing as well?Halter: forecasts of deficits are definitely a long-term

consideration, but obviously, the low level of interest

rates and the continued accommodating policy of the

fed right now are pro-productive in terms of getting

economic activity going again.

Thanks. Glenn? lowenstein: Out of 100% probability, there is a 40%

probability that we are in anemia, which is just flat to 1%;

a 40% probability that we have a double dip and possi-

bly will go negative on some of the key indicators; and

a 20% chance that we come out of this OK. If we had to

attach one word to what we are going to experience over

the next six months to three years, it is anemia.

But either way, you are pretty bearish. You put only a 20% probability …lowenstein: Yes. I don’t call that bearish—I call it realistic.

OK, fair enough. One man’s realism is another man’s bearish. …lowenstein: Sorry to be so direct, but I don’t see the

creation of quality jobs. Most of the profits coming out

of corporate america are not being generated in the

United States; they are being generated internationally.

If you look at who is really creating value, what loca-

tions in the United States real estate investors can invest

in, you’re down to 10% to 20% of the traditional loca-

tions for investment. It is going to take us a while to

deleverage and get real productivity back online.

How about inflation versus deflation? Do you have a firm view on that?lowenstein: We are not economists, but I would say

we see a three-year period where it is really difficult to

raise prices, broadly speaking. There will be some price

increases and niches here and there in different parts

of the economy. I don’t see super deflation. Then, ulti-

mately to deleverage, we will need to have inflation. In

summary, we do not see deflation, but minimal infla-

tion, 0% to 1% once again for three years and then some

real inflation.

Jamie, a view from Callan?shen: We believe that this is, as Keith started off say-

ing, a long, deep recession with a slow recovery. as there

is so much capacity in the system right now, we don’t

think there is an immediate threat of inflation, but we

also agree that the supply of money can become a factor

down the road. We are talking with our clients about

how to be thinking about inflation. Though no asset

class is a perfect hedge for inflation, some asset classes

might perform better in an inflationary environment,

and real estate is obviously one of those. We are looking

at client portfolios and looking at adding asset classes

that could perform better in an inflationary environment,

like real estate, timber, agriculture, TIPS, commodities,

and private energy funds.

Thank you, Jamie. Marc, please finish off this discussion.Weidner: I would differentiate between the developed

markets and the emerging markets that continued to

benefit from high growth rates.We are cautiously opti-

mistic on the U.S. economy and, at the very least, are

underwriting a very modest recovery in the U.S. and in

Europe. The double-dip probability has gone up recently,

but it is still a relatively modest and low probability. What

is interesting is that the center of gravity of the world

economy is shifting to the East. While the U.S., Europe,

and other developed countries have experienced a very

hard recession, there have been many places where it

was barely a blip on the radar screen, including australia,


China, and India. That shift is likely to continue, but that

may actually have a positive impact on the U.S. economy,

which to a large extent is still very integrated into the

global economy. So we are cautiously optimistic over the

long term, and we certainly see today’s environment, in

which there is a lot of uncertainty, as an opportunity to

take advantage of market inefficiencies.

In the debate between deflation and inflation, the glass

has been either full or empty and there has been a back

and forth between fear of inflation and fear of deflation.

It seems we passed from a scenario where inflation was

at the top of everybody’s agenda to a scenario where de-

flation is now at the top of everybody’s agenda. That shift

was only a few months ago if you look at headlines and

research papers; now everybody is focused on deflation.

We are likely at some point to get out of the deflation and

depression mood that we are in and start worrying about

the deficits and higher interest rates again. Therefore,

inflation might become an issue again, which to Jamie’s

point, might be actually very good for real assets, like

infrastructure, as well as for real estate.

Thank you, Marc.

ReAl estAte stRAtegiesGiven everyone’s economic backdrop, let’s move to real estate investment strategies and talk about how the strategies themselves are changing. I’ll ask Jon to comment first.braeutigam: first, in the market, there definitely has

been a shift toward core and value-added, especially after

many opportunistic investments over the last few vintage

years have really been troubled. But investors are still put-

ting money toward opportunistic strategies, definitely in

the distressed or fixed income side or direct loan side of

the equation; everybody is looking there for opportunity

and higher returns. They are also looking internationally,

but I would say asia and maybe Brazil; they are not look-

ing toward Europe right now. Michigan has mirrored that

as well. We’ve always had an emphasis on core and value-

added, and we have some opportunistic. for us, it is re-

ally no shift; the strategy would be continuing that. I think

there is an emphasis on current income versus total return.

Right now, the State of Michigan Retirement System has

to pay out net of employer contributions about $2.4 bil-

lion every year; that is about 5% plus of our whole portfo-

lio. at some point, you need income so you can help pay

the benefits. That is one reason we have an emphasis on

current return. When we look at the market, it could be

attractively priced in the U.S. if you look at the spread of

cap rates over ten-year Treasuries, which are near historic

highs. We know we are buying real estate assets below re-

placement cost. We know we are not in a period similar to

2006–2007; today, the cap rates aren’t including paying for

the vacancy; there is no assumed lease-up on that vacancy

in today’s market. all that makes for a fairly attractive asset

class for a part of a broader portfolio.

Jon, just as a frame of reference, how does the 5% payout today that you mentioned compare to where it was five or ten years ago?braeutigam: Since becoming CIO, have I have not

gone back to look at the net payout over the last decade.

But many times, states—and Michigan is no different—

look to solve their general fund budget deficits with

early outs. That helps the immediate need of the general

fund of a state, but it puts more burden on its pension

system. So those payouts could even increase a little bit

further with early outs. Michigan just had an early out

for our public school employees, and 17,000 people

took it. a normal year would be much fewer than that

in terms of retirees.

Thanks. Pat, how are the real estate strategies changing at Principal?Halter: In general, opportunities for core exist today,

and you should be truly accumulating core properties;

we believe we are either at or near the market bottom.

accumulation is more favorable with dollar cost averag-

ing approaches; that is our view of how to implement

and put money into the market right now. It is clear

that a couple of indicators truly are substantiating put-

ting money into the market now. One, over the last

three or four years, property values have declined much

faster and further than income on properties, which we

think suggests a buy signal for core. Obviously, current

spreads of cap rates to risk-free rates are at their widest

level probably in eight or nine years. So core is where

we are focusing a lot of our energy right now. I think the

other thing that is important is where transaction and

volume are right now. Our view is that the broader uni-

verse of buying opportunities is likely to expand over

... the center of gravity of the world economy is shifting

to the East. While the U.S., Europe, and

other developed countries have

experienced a very hard recession, there

have been many places where it was barely a blip on the

radar screen. ... That shift is likely to continue, but that may actually

have a positive impact on the U.S. economy.

Marc Weidner



the next few years both from an increased pace of reso-

lution of troubled loans and from more non-distressed

sellers bringing properties to the market as values begin

to move off the bottom. We think a lot of that activ-

ity will be in core initially. So just from a transaction

perspective, we think that is where a lot of the activ-

ity will be. There is a pretty significant bid-ask spread

differential for value-add and opportunistic investments

in terms of a seller’s willingness to sell at a price and a

buyer’s willingness to buy at that price.

In terms of some specific areas of general focus rela-

tive to core, from our perspective, trying to buy core

buildings in an off market or limited-bid transactions is

really the key to the strategy. a lot of these—whether it

is Eastdil or CB Richard Ellis—deals are being bid out,

and there are 25, 30 bids on each transaction out for

core. You want to try to avoid that, try to find off-market

deals if at all possible, and consistently be conservative

on leverage, although I think some leverage is good today,

and 30% to 50% loan-to-values for fixed-rate financial

leverage on new acquisitions is a prudent strategy, as is

focusing acquisition activity on demographically strong

markets. Even though there is a history of excess supply,

the Southeast and parts of the Southwest look interest-

ing to us today. We really like positioning our investment

into lEED-certified properties and some geographic ar-

eas with favorable supply constraints, such as the Pacific

region, because they have strong demographic drivers,

yet are of interest to us. So core is where we are spend-

ing most of our focus at this point; we think that is the

best opportunity on a risk-adjusted basis.

Pat, how does that compare to where you were four years ago or so?Halter: We were doing a lot more value-add at that

point in time along with core.

And Glenn, with your “realistic” view, not your “bearish” view, how are your real estate strate-gies changing?lowenstein: We keep the same strategies. We don’t

call them core, value-added, opportunistic; we call

them low risk, medium risk, and high risk. I’m actu-

ally seeing opportunity in all three of them. Here is

the way I would frame each of them. In the core seg-

ment, it is true if you get a fully bid asset, your yields

are low, but some of the real estate that is in high de-

mand by capital and tenants is what we would call “a

bridge over troubled waters.” With low leverage, ex-

actly as just was said, you can get a sustainable plus

7% cash on cash that grows nicely over ten years. We

like that as a hedge against a slow economy, and we

get inflation protection. Then when it comes to value-

add, there is a huge spread between a stabilized cap

rate on a transitional asset and a core stabilized asset.

It is the biggest I have ever seen in my career. So you

can buy a less than 75% leased asset for 50% of peak

pricing. Now granted, there are not a lot of trades, so

you wouldn’t design a whole strategy around it, but

there are absolutely good investments to make. In the

opportunistic space, we see pricing at 20% of peak

value, so our overall theme is “price to anemia.” If

you take the realistic view that we are flat or down for

three years with a gradual rise out, and you can price

to that scenario, then you can make money and make

a good investment without principle risk on all three

of these categories. The most volume in the next two

years will be in core, then value-add, and then oppor-

tunistic, in our view.

Jamie, what real estate strategies is Callan recommending?shen: We do everything on a client-by-client basis,

and it really is dependent on the client’s objective. We

try to meet clients’ objectives by taking on the least

amount of risk. Today, we are favoring core invest-

ments because we believe they can meet the return

objectives utilized in asset allocation for the asset class

by investing predominantly in core. for 2010 year-to-

date, through our search process, we have allocated

82% of capital to core strategies, 9% to value-add, and

9% to opportunistic strategies.

When you talk about the investment allocation models and real estate’s role within them, is it still the case that you look at it as an inflation hedge, an attractive current return, and offer-ing some diversification benefits? How has the thinking evolved, if it has at all, with regard to real estate’s role in a mixed-asset portfolio?shen: We view real estate as a strategic placeholder in

our asset allocation model, and that view has remained


constant. We have always looked at real estate as being

something between fixed income and equity on both a

risk and return basis. We like the current income aspect

of real estate and the potential for some appreciation. I

think the industry began looking at real estate as provid-

ing more alpha or more private equity type of return,

but we continue to believe that real estate is more of a

diversification play and should offer investors current

income with some low level of appreciation.

Thank you. Marc, let’s swing toward your view of the real estate investment strategy world. Again, give us both the domestic and interna-tional views.Weidner: Sure. Over the last five years, we became in-

creasingly cautious about the United States to the point

where we stopped investing in the U.S. market altogeth-

er about two and a half years ago, while our investment

programs elsewhere in the world actually were being in-

creased. We are coming back to the U.S. market. There is

obviously a great opportunity here if we are being selec-

tive. Our strategy for the U.S. market is focused on high-

quality assets trading at substantial discount to replace-

ment cost. When selecting managers today (we are multi-

managers), we find managers that can capture core or

core-like assets outside of competitive bidding situations.

One of the characteristics of today’s market is that a lot of

stressed and distressed situations reside with the owners

and/or the structure of the ownership of the assets, when

there is actually nothing wrong with the assets. We think

this is a particular point in time that is unusual in a cycle

where you can access well-leased, well-built, and well-

located assets in these stressed or distressed transactions

at a substantial discount to replacement cost. although

volume for these types of transactions is low because it

is obviously complicated to extract these assets from the

current ownership, we believe that the investors focused

on that opportunity will be handsomely rewarded on a

risk-adjusted basis.

Keith, earlier you talked about “distressed” real estate. Can you talk a little bit more about that in light of your real estate invest-ment strategies?barket: Sure. We manage a series of opportunistic and

core-plus funds—core-plus meaning the lower-risk,

value-add strategy. The next few years will be a great

time to pursue those strategies in the U.S. Unfortu-

nately, many investors fell in love with opportunistic

and value-add strategies in 2005 to 2007. There was

too much capital chasing those strategies, and alloca-

tions were too heavily weighted toward opportunistic

and value-add for many investors. I think we are seeing

a swing back toward rebalancing where core becomes

the dominant part of a larger investor’s real estate port-

folio. I believe that is appropriate. However, I do believe

that a good manager, a manager who is really skilled at

adding value to real estate, will outperform core on an

apples-to-apples, unleveraged basis over a long period

of time and will probably significantly outperform. a

manager who is not so skilled could significantly un-

derperform. We are seeing a little bit of both right now

as we go through this recession.

Keith, would you agree with this statement: In other parts of the capital market, the dispersion among investment managers’ performance widens with the riskier strategies?barket: Yes.

Glenn?lowenstein: Our approach starts with demand for

space. We look at the nation in terms of locations that

will gain more than their share of demand over the long

term and where new supply is limited. Then we look at

relative capital scarcity. Through these two lenses, we

see potential for investment in our low-, medium-, and

high-risk strategies.

Fee stRuctuResLet’s move next to fee structures. In most fall-ing markets, there are downward pressures on fees, and real estate is not an exception to that general rule. Pat, will you start the conversation talking about where fees have moved to over the last 12 or 24 months?Halter: a perfect storm is brewing from an advi-

sor perspective; advisors definitely have less pricing

power for the reasons you mentioned, Joe. With a

down market and performance from advisors subpar,

it is difficult to see fees sustaining at current levels.

from an investor perspective, many of our investors

For 2010 year-to-date, ... we have allocated

82%, of capital to core strategies, 9% to value-add, and

9% to opportunistic strategies.

Jamie Shen


are public pension plans, corporate pension plans,

and other institutional investor plans that have ei-

ther unfunded issues or, if they are part of a govern-

ment body, significant budget deficits. There is this

intensive pressure on boards and vis-à-vis staffs to

renegotiate fees with advisors on existing mandates,

let alone new mandates. There is definitely a move-

ment in repricing fees in the marketplace.

In the marketplace discussion today, and at a re-

cent conference I attended, much of the discussion

centered around the best fee structure in alignment.

a significant amount of discussion centered around

what sort of benchmarking structures should be in

place relative to incentivizing the right types of be-

haviors by advisors and how they should align with

the investment strategy and with staff compensation

structures. This whole fee structure continues to be

fluid and always have new twists and turns to it. The

movement in fee structures is definitely downward.

This is not directly associated with fee structure, but

it is interesting: The financial services reform act and

the Volcker Rule will cause institutions to look at their

proprietary trading investment portfolios and where

they are actually putting money into funds. There is

going to be some profound pressure and change in

terms of how much co-investment opportunity funds

in particular and other funds are going to be able to

place in terms of new investment funds. That is going

to have a profound impact on investors’ willingness to

pay significant incentive fees if that co-investment capi-

tal is less or is not offered. That is another interesting

dimension to follow over the next couple of years.

Jamie, maybe you can follow up Pat’s discus-sion about fees since, I believe, you were at the same conference. shen: There is pressure on fees. any disruption in the

market highlights issues that may not have been foreseen

or that may have been foreseen but were downplayed; the

thinking was that these situations would not occur. Over

the next few years, we are going to continue to see some of

the shortcomings of the in-place fee structures and where

some of the misalignments exist. One area in particular

is on carried interest and how and when it is paid. The

investors are very focused now on wanting portfolio-level

distributions where they receive all their capital back first


before the manager receives any incentive fee. We haven’t

seen all the true issues from the previous fee structures

come to light. Specifically, we are going to see some chal-

lenges or continued challenges where some incentive fees

were taken early on in a fund’s life and how those will need

to be paid back to the investors. as pressure builds on

fees generally and fees come down, questions will be ex-

plored in great detail by investors, consultants, and invest-

ment managers, such as “What is the right compensation

for investment management professionals?” “How much

can they be compensated?” “What are the firm economics

with the new fee structures without embedded incentive

fees in their current funds coupled with even more back-

ended fees in future funds at this point?”

Other outstanding questions are related to the tax

changes for next year and incentive fees in the future

being taxed as regular income versus long-term gain.

Will investment managers try to demand a higher per-

centage of sharing? I don’t think the investors will sup-

port that. Is the investment management industry going

to have some type of wage deflation? Is it going to be

a less-profitable business? What are the long-term im-

pacts of that, and are we just in a new era where the

compensation is going to be lower than the promise of

the compensation over the last five years? There are a lot

of issues related to the fee structure, and a lot has yet to

run through the system and run its course.

Jamie, just a couple points of clarification. There were some promoted or carried inter-ests distributed early on in a fund, and inves-tors are looking to claw back those earlier dis-tributions. Was there a clawback provision in the investment management documents? If there wasn’t, are the investors just demand-ing it because they think it is the right thing for an investment manager to do?shen: In most cases, there is a clawback provision,

however, they haven’t been triggered yet because

many of the funds have remaining assets. That is

what I mean by it still hasn’t been played through

the system, but there is an expectation that many of

those clawback provisions will be triggered.

Could you roughly quantify the reduction in base fees and/or the preferences? In other


words, are fees down by 25 basis points? Have preferences gone to 10% from 8%, as one example? How should we think about those two dimensions?shen: Broadly speaking, the base fee in some

cases has remained constant; in some cases, the

committed capital fee has reduced from 25 to 50

basis points during the commitment period but

then switched to the traditional 1.5% on invested

capital. In some cases, where maybe the preferred

return was at 8%, it has come up to 9%. We are

seeing very few 8% preferred returns anymore; we

are usually seeing 9% or 10%. We are also seeing

a lot of tiered structures on the promote where

there might be a first hurdle and then the manager

gets a lower percent of the profits, say 10%, and

then a second hurdle and the percentage sharing

will increase.

What about co-investment and gover-nance structures?shen: We are seeing some more creative things be-

ing done to improve alignment or have more of the

return coming to the investors. I don’t know if it is a

better alignment from the manager’s perspective, but

the investors are trying to protect themselves a little

bit more on the downside.

Thank you. Glenn, back to you.lowenstein: We just did a large transaction setting up a

joint venture with a major fund, and what Jamie said was

dead on. My global comment on fees is if you want to be

an investment manager for the next 20 years, you really

have to love this business and have to be a lifer because

the low fruit has been picked in the past 20 years. The

way I would summarize the market is that the current

fees are going to be, as best as people can measure, ap-

proaching cost. The incentive fees are, as best as people

can structure them, going to create alignment, and we

will see a lot of creativity in this area of compensation.

When it comes to discretion, there will be more struc-

tures that have partial discretion at different points along

the deal cycle. I don’t think it is negative at all for this to

happen. I think what you will see is professionals who

really want to be great investment mangers stick with

the business, and people who are in it just for the money

may or may not last. My final comment is that you are

going to see tiers of firms form where the top 25% that

are recognized as best in the business will have pricing

power and the other 75% won’t.

Marc, you are in an interesting place, hav-ing the ability to look both domestically and internationally at a variety of investment managers and funds. What do you see with regard to fees?Weidner: In terms of fees, our approach is really to

align interests between the investors and the managers,

and obviously, that is a moving target. for the base fee,

we like to dig into the cost structure—whatever that

structure is—and the organization of the manager and

try to find a base fee structure that covers only the real

cost of operating the business and is not a significant

component of the profit. One of the issues with the

current model is the assumption that these managers

will be able to raise funds indefinitely. One of the unex-

pected consequences of the current fee structure is that

if your current fund-raising effort is delayed (and this

has been the case for almost everyone), your revenue

will go down automatically, and you may run into trou-

ble in your prior funds as well because the investment

management fees they generate are actually not cover-

ing the costs of managing these prior funds. They cost

much more to manage than the revenue they generate,

especially if the value of the assets has come down. In

today’s environment, you want to be fully staffed when

it comes to asset management, so the reality is that a lot

of managers have been forced to cut corners because

they cannot properly fund their operations and there-

fore make things even worse. In the past, this operating

deficit was sometimes funded by the incentive fees, but

that is gone now.

The incentive fees we like are the back-ended struc-

ture and the tiered approach where performance fees go

up progressively as realized returns go up. Something in

particular we are pushing back on quite a bit with some

success is the catch-up; is it really normal for the man-

ager to benefit from a full catch-up at 12% or 13% of

realized return? It seems to us a disproportionate share

of the profit. If real excess returns are being generated,

then perhaps, we can have a catch-up later or a higher

amount of promote.

... if you want to be an investment manager for the next 20 years,

you really have to love this business

and have to be a lifer because the low fruit has been picked in the past 20 years.

Glenn Lowenstein


I also want to comment on what Glenn just men-

tioned about pricing power. at the same time that there

is downward pressure on fees and that for the first time

in many years lPs have pricing power, the best man-

agers are also only emerging today because it has been

difficult in an upward-only environment to differentiate

the good, the bad, and the ugly managers. Everybody

performed well. Nobody lost money until everybody

started losing money on paper, and now we really are

starting to see which managers can weather the cycles

and make money on a consistent basis. These managers

are actually going to attract more funds, more capital and

will certainly be able to maintain or even increase their

fees. It will be a mistake in this environment to focus on

only cost at the expense of the quality of the manager.

Keith, from a value-added/opportunistic point of view, how do you see fees changing?barket: We actually just raised an asia fund, and it was

interesting—Marc touched on this—in due diligence,

we had investors who wanted to understand our cost

structure compared to our fees. Every time they asked, I

wasn’t sure whether they wanted to see if we were mak-

ing too much money or not enough. Investors were ac-

tually concerned about both, as many wanted to make

sure we were making enough to adequately staff the

fund. We did not get push back on our fees for this new

asia fund compared to the prior fund.

If I were an investor, there are a few things I would

focus on. first, I would push back more on the base

fee than the incentive fee. The 1½%, 1¾% fees that

most U.S. funds charge on committed capital might be

aggressive. I also believe that incentive fees should be

back-ended at the fund level, not paid on a property-

by-property basis.

On the other hand, if lPs were to push to drastically

cut fees—and I don’t see this happening—the man-

ager risks losing significant talent. The really smart tal-

ent would ultimately move to other industries—hedge

funds or private equity shops.

Jon, as an investor, what do you see?braeutigam: Real estate is just one component; you

have other asset classes as well. Everybody has covered

this topic really well, so I will try to be brief. There could

be tiering; there will definitely be changes on how to

pay. We are in a low-return environment going forward,

maybe in all asset classes, especially with the ten-year

Treasury sitting at 2.7%. What that will do is create an

environment where there is less return to pay people,

an environment where boards and chief investment

officers are trying to bring more back to the fund. So

there is a downward pressure on fees. The push back

to that is that you want to invest with quality manag-

ers, and quality managers, as Marc mentioned, have

proven themselves in this cycle when times have been

really bad, so they will have pricing power. The market

will end up where it is at give or take; the lPs, such as

us, will be pushing for lower fees because we think we

are in a lower-return environment. The GPs who have

proven track records will bring those track records with

them and say, just as Keith mentioned, “We need to at-

tract highly qualified people, or they are going to go and

do something else.” We do see, even in hedge fund land,

as Keith mentioned, larger funds negotiating some lower

fees. at the end of the day, you will see some lower fees.

Some of the companies that have great results will keep

their fees where they are, but in general, the industry

will have lower fees, whether that is base or incentive or

a combination of both.

barket: The other thing people will take a look at is,

what other sources of fee income does the manager

earn? The investment management fee is very trans-

parent, but in some cases, managers were charging ac-

quisition fees, asset management fees, financing fees,

and investment banking fees that weren’t so transpar-

ent and may have led to a misalignment of interests.

My guess is that there is going to be more scrutiny

over these additional fees and costs.

leveRAge And Joint ventuResLet’s talk a bit about leverage in terms of ratios, fixed versus floating, and maturity. Then, with regard to joint ventures, we can talk a bit about preferences and promotes. In these down mar-kets, painful lessons are often replayed. What have we learned and what are we doing differ-ently this time? Glenn, can you walk us through leverage and JVs?lowenstein: On leverage: There is going to be less of

it, and it will be longer term. Probably one of the best

things that has come out of this is that there is industry-



wide scrutiny on how managers made their money. It’s

one thing to have high returns; it is another thing to

get them from leverage and cap rate compression rather

than operations. In terms of joint ventures, industry

professionals today realize that any partnership arrange-

ment needs more stress testing. Previous market norms

will not cut it.

Jamie, as our representative from the consul-tant space, what is your view on leverage and joint ventures?shen: as far as leverage, my hope is that one of the

take-aways from this environment will be that when as-

sets are being priced to perfection, instead of maximiz-

ing leverage, we will see that as a point in time when

we should be minimizing leverage and protecting our

downside. We have seen what can happen and how we

can so quickly go outside of guidelines.

as far as joint ventures go, it seemed that people

had forgotten that there is risk with joint ventures.

When we went through this downturn, there was a re-

newed highlight that joint venture partner risk exists,

and you do have to be concerned about the partner’s

operations and going concern and whether or not the

partner can make capital calls. In some ways, I think

it was a good thing that we were reminded in this

downturn of all the risks that you need to address in

joint ventures. If an investment manager is doing a lot

of work through joint venture partners, there is going

to be more focus from the industry on whether the

manager has the capabilities to replace a joint venture

partner, whether the manager is putting in appropri-

ate safeguards in case that joint venture partner can-

not make the capital calls, and the way the manager

is underwriting the joint venture partner’s business.

There may be more of a focus on these items than

there has been in the last five years.

Thanks, Jamie. Keith?barket: first of all, I’d say leverage and fund guaran-

tees were the number one sin committed over the last

decade, and the rationale that managers used was that

leverage was cheap—too cheap—and therefore, you

should be on the other side of that trade. academically,

that is probably correct, but it is kind of like going to las

Vegas and saying my odds of winning on this wheel are

55%, so I’m going to bet everything. It doesn’t leave you

in a position to recover if you are wrong.

By “guarantees,” you mean what?barket: fund-level guarantees of debt versus non-

recourse debt. I can get 50% nonrecourse debt, but

I can get 75% with a full guarantee. If you look at

the funds that have really lost a significant amount of

equity, most of those have fund-level guarantees that

brought them down.

Going forward, I don’t think there should be a dif-

ferent strategy with respect to leverage; the amount of

debt you use should be responsible and largely non-

recourse and non-crossed. Whether you fix or float

should be dictated by the length of your expected

holding period. Spreads are wide, but Treasuries are

unusually low right now. In our view, if you have a

longer-term hold, it is a pretty good time to fix rates,

even if spreads may tighten over time. It is pretty sim-

ple when it comes to the leverage side.

On joint ventures and club deals, I totally agree with

Jamie. I really hate doing club deals with other op-

portunity funds; and these are funds that are generally

well-staffed and in a position to make quick decisions. It

simply slows down your decision making and may lead

to conflicts. funds may differ in their access to capital,

their incentives, their view on repositioning, etc., which

can lead to deadlocks and confusion. That is a signifi-

cant risk in club deals. In terms of joint ventures, there

are lPs who are in a good position to do joint ventures,

and if you look at what they pay their staff versus what

they would pay a manager, they can probably save

money in some cases. The key, though, is having a large

enough wallet to get the diversification you want and

having the appropriate size and quality of staff to make

it work. Some people, like Michigan, have been able to

do that over the years, but I don’t think there are a lot of

investors set up to successfully operate that way.

Jon, Keith made a nice segue to you. What is your view?braeutigam: Keith is too kind. leverage ratios are

coming down, but when we have low interest rates—

call me cynical—people are going to take the leverage

if they can get it. I think we are in an area where we are

all saying we like low leverage, but when somebody

Leverage ratios are coming down, but when we have low interest rates—call

me cynical—people are going to take the

leverage if they can get it. ... when

somebody gives us free money, some-

how the market will always take that.

Jon Braeutigam



gives us free money, somehow the market will always

take that. I think the fed is trying to re-inflate asset

prices to some degree, and it is going to be success-

ful at it. Keith makes a great point about how you use

leverage. Is it on a property-by-property basis? are all

these properties cross-collateralized? If you have a risky

asset and it blows up, does it blow up your good assets?

Is leverage on the fund? So all these areas have to be

looked at. We prefer modest leverage, in the 40% range

typically. Some of our assets don’t have any leverage,

some of them have a little bit higher, but we try to target

above 40%; that way, if bad times come, we think we

can survive. In fact, that has proven to be the case with

the current downturn.

With regard to JVs, the industry will always have joint

ventures. There are a lot of risks with joint ventures, but

what you are trying to get at is a deal pipeline where you

get expertise in sourcing and running property. Many

times, that is at the local level. as an investor, I would

ask our joint venture partners if they are well-capital-

ized. If they are not well-capitalized, we might still do

the deal, but we know that is an additional risk. How

long have they been doing joint ventures? Do they have

experienced staff? Have they retained that staff over the

years? I think Marc has pointed out that there has been a

tiering; I think you will see a tiering on the joint venture

side too. a lot of companies have just gone away, but

other companies have proven themselves by managing

through this, and they will have the advantage.

Pat, your view please.Halter: People have covered this quite well, but one thing

this discussion really highlights is that as a real estate in-

vestment management organization, you are going to have

to really demonstrate this duo excellence, not only under-

standing and managing the assets but also executing these

leveraged strategies on the liability side of the balance

sheet. That entails achieving the most favorable costs of

debt capital available and being able to use your relation-

ship with lenders to achieve the most flexibility. What I

mean by that is that loan assumptions, collateral assump-

tions, collateral substitution rights can all be impediments

to execute sale strategies. You want to make sure you ne-

gotiate and manage ways to reduce those impediments.

We have a general philosophy of asset liability matching.

We try to take the average life and duration characteristics

of the debt and hope they are generally consistent with av-

erage property lease maturities of the assets. We like to use

fixed-rate debt, unless it is a situation where we are near a

sale and planning to allow for a better matching of the as-

sets and the liabilities. To Jon’s point, you do want to avoid,

whenever possible, cross-collateralization, cross defaulting

of loans, in order to maximize the flexibility of that sort

of bet and put option with nonrecourse mortgage loans,

meaning if you have a bad asset, it doesn’t take down all

the good assets, also as Jon mentioned. This is obviously

not as critical now with my earlier points, as we are in

a sort of a bottom of the market cycle, and we’re going

to be seeing low-leverage strategies, but I think it is very

important from a risk management perspective to apply

that sort of mind-set.

Relative to joint ventures, Joe, obviously, post the

global financial crisis, the pendulum has swung back to

the capital partner’s favor. administration, the monitor-

ing of operating partners will increase and will become

more rigorous. There will be more established proce-

dures to follow. The oversight governance of the joint

venture is going to become more formalized, and the

level of discretion definitely has been narrowed. There

will be much more documentation and clarity as to how

dispute resolutions, or buy-sell provisions, work. One

of the things that people learned is there is a lot of nego-

tiation just as to how those things worked.

A lot of ambiguity in the legal documents that sometimes comes out in practice, right?Halter: I agree.

Marc?Weidner: The typical metric that has been used in the

past—loan to value, floating or fixed interest rates, and

debt maturity—has not been appropriate because it is

not enough. It was not enough to really understand the

true debt risk exposure and the impact that debt can

have on these assets and how they can drive the value.

The devil is in the detail, and the reality of the leverage is

beyond these starting points. In the past, leveraged anal-

ysis was really checking the box—Was it fixed? Was it

floating? What’s the maturity? What’s the lTV? Today, we

really need to peel back the onion and go much deeper

into the analysis because seemingly low-leveraged debt

can be extremely toxic if it’s associated with an asset that


does not produce long-term stable cash flows or where

there is high volatility related to the future prospects of

the assets. We pay a lot of attention to really understand-

ing the details of the loan documents, including all the

covenants, whether the debt is recourse and, if yes, re-

course to what, all of which has had far-reaching devas-

tating effects on some real estate funds.

Regarding the leverage level in today’s environment, we

believe the overall leverage level is only the starting point

of the analysis. We strongly believe that we need to differ-

entiate between the type of assets that are subject to lever-

age. So you cannot put in the same basket a 20-year lease

of a very good tenant credit with upward revision only

and compare the leveraged level of that asset to a construc-

tion loan. Today, we are seeing that the traditional debt

structure is back, as opposed to the exotic structures we

experienced in the crazy years between 2005 and 2008.

New debt is currently slowly becoming available at

reasonable lTV ratios with amortization, interest pay-

ments, and tight covenants, none of which was present

in some debt structures that are currently the most toxic.

a high level of leverage is basically not available today

for new loans. a lot of portfolios have very high lever-

age levels because the equity portion has been written

down, not necessarily because they had a lot of leverage

initially. These portfolios are obviously at risk and will

need new equity injections.

Regarding fixed versus floating rates, it has always been

our preference to focus on the real estate risks and the

value that is created by the real estate as opposed to trying

to take a directional bet on interest rates. Our preference

is therefore to get exposure to transactions with fixed rates,

especially in a low-rate environment like today.

investment mAnAgement business modelsOK, let’s have our first comments on business models, changing resources, and the like from Keith.barket: I think what is happening in the industry, particu-

larly the opportunistic and value-add industry, is that we are

evolving. Marc said this earlier, that we went through a pe-

riod of an up market, where it was hard to distinguish good

managers from weaker managers. The opportunistic industry

wasn’t really born until the early 1990s, so there hasn’t been a

significant down market until recently. There were more than

600 funds in the U.S. If you look at other industries, even the

core real estate market, fewer managers stand out and domi-

nate over time due to their proven long-term track records. It

is the same in the venture capital industry, which has been

around for 40 years now, and the hedge fund and private eq-

uity business. This is an evolution that is good for the business.

People are searching for an answer and wondering if it is fees,

if it is the structure, if it is the investment banking model. a

big part of the answer is that we needed this evolution to sim-

ply weed out the weaker players.

Glenn? lowenstein: I’d say there are two big things that I see.

One is that people will spend time annually remeasur-

ing incentives rather than looking at them just at the

beginning. There will be an annual assessment of what

everybody’s position is in the deal and what everybody’s

incentive is. The second thing that will happen is that

there will be a bigger focus on what risks are being tak-

en and how returns are being generated. Deconstruc-

tion of returns, not just the absolute level of returns,

will become increasingly important. I think an industry

standard will be developed.

Thank you, Glenn. Jon?braeutigam: I will go with the investor side first.

Investors are going to have to do a little bit more

with less. Most investors—and I’m talking about

the public fund world and maybe endowments and

such—will be loath to increase staff right now. They

will be either at a head count freeze or a slight staff

reduction, so you will see pressure for them to do

more with less. That is going to be the investor’s

business model for the next few years for the pub-

lic funds. from the 50,000-foot level, the advisor’s

business model is going to change. You’re going to

see a lot of advisors go, some come, and some get

stronger. from the 2007 peak, my guess is that em-

ployment is down probably 20% across the whole

industry. at the peak, about 10% of that was fat—

you didn’t need those employees anyway. I would

guess that about 10% of that will be hired back in

the next few years as people put money to work in

real estate. funds will attract capital, and the inves-

tor GPs will have to have staffing, so they will be in

a slight hiring mode.

The opportunistic industry wasn’t really born until the early

1990s, so there hasn’t been a significant down market until

recently. ... If you look at other industries, even the core real

estate market, fewer managers stand out and dominate over

time due to their proven long-term

track records.

Keith Barket



As someone who is trying to place students in jobs, I’m thankful to hear that, Jon. Pat, how about you?Halter: In this global financial crisis, a lot of us missed

the big picture. One of the things we have been do-

ing is really strengthening our firm-level macroeco-

nomic views and trying to get more of those linkages

and views into the various asset classes that we manage

from a global asset management perspective. Develop-

ing more robust quantitative and risk-modeling tools is

a big part of that also, as is redoubling our commitment

to risk management; we’ve created some dedicated risk

management roles within the organization and filled

those roles with top talent. That is very important going

forward. from a personnel perspective, engaging talent

is really important. The market pressures, the business

changes already discussed will unquestionably create

challenges around retaining and engaging key talent

going forward. That is really mission critical number

one for many organizations.

Marc?Weidner: It’s been a challenging time for all of us,

but we have been very fortunate at franklin Temple-

ton. During the crisis, we have been able not only

to maintain the level of resources dedicated to our

real estate group but also to increase it, and we think

that’s very much appropriate given the complexities

of today’s markets. We feel that going forward, there

will be very attractive opportunities, but they are not

going to be readily accessible. So a lot of due dili-

gence, a lot of work needs to be done, and the gems

are going to be hidden deep in the river; we will need

to turn each stone in order to discover them. This is

why we have increased the level of our resources.

Within the last 24 months, in the advisor business

model universe, what we are seeing is likely consolida-

tion of large players that have been able to integrate the

different expertise needed by their clients. It has been

a very difficult environment for start-ups and smaller

investment managers. a couple of them might be suc-

cessful, but the environment was certainly more con-

ducive to smaller, niche players in the past.

The change we are seeing is that our clients are un-

derstandably asking more questions, need more face

time, and want more information in real time. There

has been an overall increase in attention and desire and

need for information. Better projection, faster turn-

around, deeper analysis, accurate real-time information

is a trend we believe will continue. from a deal point

of view, doing a transaction takes more time, requires

more resources and certainly more analysis than ever

before, and we think this is going to continue in the

future, which is why larger, more experienced groups

may have a competitive advantage in screening all the

opportunities on an ongoing basis.

Thank you. And Jamie?shen: It is a due diligence challenge for us. We have

been talking about how to retool areas of our due dili-

gence questionnaire to account for some of the new is-

sues that are important to uncover when you assess or-

ganizations, staffing, and future resources. On the other

side of it, there is an underestimation of how much it

takes in monitoring these more complex investment

programs. One thing we are looking at very carefully

is that when we recommend these strategies and move

to a more complex program, is the staffing level of the

client appropriate? Can the strategies be supported by

the staff, and can the client get the resources it needs

to implement such a program? If you have fewer re-

sources on the investor or plan sponsor side, you might

not undertake a complex program or you might out-

source some of the monitoring that goes along with

more complex programs.

Thank you, everybody, for your time. It was an excellent and interesting discussion.

Keith Barket is Senior Managing Director of Angelo, Gordon

& Co.; Jon Braeutigam is CIO, Director of Bureau of

Investments for the Michigan Department of Treasury; Pat

Halter is Executive Director for Principal Global Investors

and Chief Executive Officer for the firm’s dedicated real es-

tate group, Principal Real Estate Investors; Glenn Lowenstein

is a Principal of the Lionstone Group; Joe Pagliari is Clinical

Professor of Real Estate at the University of Chicago Booth

School of Business; Jamie Shen is Senior Vice President at

Callan Associates, Inc.; Marc Weidner is Managing Director

of Franklin Templeton Real Estate Advisors.

In this global fi-nancial crisis, a lot of us missed the

big picture. One of the things we have been doing is really strengthening our firm-level macro-

economic views and trying to get more of those linkages and

views into the various asset classes that we

manage. ... Devel-oping more robust

quantitative and risk-modeling tools

is a big part of that ..., as is redoubling our commitment to risk

management.

Pat Halter

Economy & Finance

PREA Changing Investment Mgt Business