In an interview, Sanford Presant, national director of Real Estate Tax Strategies and Opportunity Fund Services at Ernst & Young, LLP, discussed the funds’ capital-raising and investment strategies, corporate governance changes and the outlook for the industry.

One of the consequences of the proliferation of funds is that we are seeing some funds adopt fee structures that were more typical in some of the older real estate syndications. —Sanford Presant

Portfolio: What are the unique characteristics of opportunity funds that an investor should be aware of?

Presant: Opportunity funds are private equity funds seeking higher returns, maybe 16 percent to 20 percent IRR (some higher) through more difficult real estate investments (such as construction or substantial rehabilitation, entitlement, properties in litigation or bankruptcy, environmentally challenged, etc.). They are blind pools where the general partner selects the investments. The funds typically are liquidated in seven to 12 years.

Portfolio: What types of investors typically invest in these funds? What are the typical entry requirements to invest?

Presant: Investors include public and private pension plans, educational endowments, private foundations, charities and wealthy individuals. Minimum investments can be as low as $100,000 or as high as $10 million.

Portfolio: Would an opportunity fund look to invest in REITs? Why or why not?

Presant: Opportunity funds seek higher returns than are assured over the short term with a REIT stock investment, and their investors generally can access the REIT equity markets directly. However, opportunity funds frequently have mezzanine or participating debt or joint venture transactions with REITs, acquire properties (generally challenged properties) from REITs, and sell properties to REITs after the opportunity funds perform their value-adding services and stabilize the properties.

Portfolio: How active are sponsors in raising capital for investment in the funds?

Presant: Most sponsors have either recently closed new funds or are in the process of marketing new ones. At the same time, sponsors are trying to sell assets held in old funds at the highest prices. It’s an odd juxtaposition to have the same sponsor trying to harvest old funds at the highest prices possible while trying to invest new capital at bargain prices. In addition, a number of people have left the major sponsors to start their own funds.

Portfolio: How much capital do funds currently have available for investment?

Presant: Ernst & Young’s “2001 Opportunity Fund Survey” showed about $20 billion remaining to be invested at year-end. Our 2002 survey is under way, and we’ll have more data shortly. Because so many funds have been raising capital, I suspect that the funds available for investment have remained steady or increased. The pension funds and other investors are allocating more capital to real estate because of stock market volatility, the relative stability of real estate, and the opportunity to realize comparatively high returns.

Portfolio: With all that capital looking for a home, are more deals getting done?

Presant: Many funds are staying on the sidelines, waiting for the spread between bid and asked prices to narrow. Others are currently finding investment opportunities, largely from super-motivated sellers or enabled by the low interest rate environment.

Portfolio: How active are funds in acquiring properties?

Presant: They are very active in trying to acquire class-A office product, particularly in central business districts in New York and other select cities.

Portfolio: Why class-A office properties?

Presant: They’re seen as virtually recession proof. Which is interesting, considering their current rent weakness. But a fund’s principal is secure in these properties, which almost always appreciate in value over the longer term.

Portfolio: What returns are funds seeking?

Presant: It depends on the type of fund. There are four types. Core funds, which focus on class- A properties, are looking for gross returns of 6 percent to 10 percent. Core plus funds are seeking returns of up to 14 percent, value added funds up to 16 percent, and opportunity funds from 16 percent to 20 percent, or higher.

Portfolio: Other than the U.S., what markets are funds targeting globally?

Presant: The central business districts of Western Europe are somewhat saturated with investment, so more investment money is finding its way into Western Europe’s suburbs and into Eastern Europe where there are more opportunities for higher returns. Investment in Japan’s distressed debt has remained strong amidst signs that the government may finally be moving closer to restructuring its banking system and dealing with its nonperforming loan problems. China is one of the fastest emerging markets.

Portfolio: What has been the effect on sponsor compensation of more funds coming into the market?

Presant: One of the consequences of the proliferation of funds is that we are seeing some funds—principally those targeted at taxable investors such as high net worth individuals—adopt fee structures that were more typical in some of the older real estate syndications. These structures include acquisition, disposition, financing, construction management, and loan guarantee fees. Residual “promote” allocations for general partners are as much as 35 percent (of the available cash exceeding investor capital and the cumulative preferred return) in these funds, although the vast majority of private real estate equity funds that are offered to pension plans, endowments and private foundations have capped at 20 percent.

Some funds are moving away from a “double promote” structure in which a joint venture partner gets, say, a 30 percent share at the back end of the investment and the general partner takes an additional promote of, say, 20 percent of what’s left. The double promote structure was unquestioned when returns were high, but some investors want to move away from it because returns have compressed.

Portfolio: How have opportunity funds been affected by corporate governance, accountability, disclosure and transparency issues?

Presant: Almost all of the sponsors are focused on incorporating best practices wherever possible, both in new and existing funds. These include business process improvements designed to streamline information reporting, outsourcing non-core functions to free up internal resources, Sarbanes-Oxley types of improvements such as adding more layers of internal review or introducing early warning systems, improving cash management programs, or improving fair value reporting. This is an evolving process.

Portfolio: Given that, are there concerns in this area when it comes to investing in an opportunity fund?

Presant: Both pension funds and opportunity fund general partners are attuned to the need for increased risk protection. We are constantly doing risk diagnostic reviews for funds these days where we assess tax and business risks at the request of the general partners.

Portfolio: What other issues are the funds focusing on?

Presant: As part of their best practices review, most funds are focused on business process improvement. This involves effective and efficient outsourcing, flow of information from the property level through to the investors, and tax, accounting, professional, cash management, construction and renovation monitoring, internal audit functions, procedures for complying with their reporting and contractual relations, double checks on waterfall computations and tougher local partnership agreements.

Funds are also looking for ways to ensure that the partners’ relative capital accounts (after allocation of income and loss) are in accordance with the intended cash waterfall distributions, including efficiently designing partnership agreements and developing procedures for effective monitoring. Almost all of the funds are currently reviewing their capital accounts against the waterfalls and incorporating cash savings clauses in their partnership agreements. This is to prevent any inadvertently incorrect capital accounts from distorting the underlying economic deal.

Most funds liquidate in accordance with capital account balances and need sufficient time prior to liquidation to make any necessary corrections to the capital account. Most funds also have increased efforts to minimize tax at the federal, state and local levels so as to benefit taxable investors and reduce the need for tax distributions to the general partner to deal with phantom income.

Portfolio: What’s the outlook for fund investment?

Presant: There’s a huge amount of money out there that’s invested in or looking to invest in real estate through funds and other vehicles. The bulk of this money was from more traditional financial investments but it’s not going to return to the stock market anytime soon.