Property Funds Hammered by 1-Year Losses

Several high-yield property funds launched by well-known operators in 2006 or 2007 posted poor 1-year net returns through midyear, and the list of weak performers is expected to swell as the fallout continues from the financial meltdown.

Funds that posted oversized negative returns include Fidelity Investments' Fidelity Real Estate Growth 3 (down 62.6%), CIM Group's Fund 3 (down 47%), UrbanAmerica's Fund 2 (down 42%), Colony Capital's Colony Investors 8 (down 35%) and Morgan Stanley's Morgan Stanley Real Estate Fund 6 International (down 20.2%), according to investors.

The return figures are based on the amount of committed capital that the fund operators have drawn down. To be sure, some of the funds have invested only a portion of their total equity so far, so it's too soon to say that they will fail to hit their return goals. And it's not unusual for funds to post negative returns in their first full year of operation. Nevertheless, some of the declines are much deeper than usual, reflecting the severe pain being inflicted by the market downturn.

Two factors hurt fund returns early in their cycles. For one thing, investments in the development or redevelopment of properties may not provide a stable flow of income for several years. Also, funds generally charge management and other fees before actually investing pledged capital, which drags down initial yields.

But fund returns have also been hurt by eroding property values, which have forced some operators to write down the value of assets - in some cases to zero for land investments. Eroding property values have also significantly slowed the pace of investments, exacerbating the negative impact of front-loaded fees.

Some fund operators also note that the declining use of leverage is sapping initial returns. A fund that uses 50% leverage, for example, would have to draw down capital faster than a fund using 70% leverage. If the two vehicles made similar investments, the fund using 50% leverage would have lower initial returns. In the tight credit market, operators are increasingly being forced to use lower leverage levels.

The UrbanAmerica, Morgan Stanley and Colony Capital funds have each had to write down assets, according to investors.

The $400 million UrbanAmerica 2, operated by UrbanAmerica of New York, was designed to plow half of its money into opportunistic development and redevelopment plays, and the other half into core-plus deals. At midyear, it had spent $111 million on opportunistic deals, including $66 million for land. It had also spent $65 million for core-plus deals. Investors said the fund, which seeks a 15% return, wrote off a $6 million purchase of a Washington parcel and wrote down $7 million of a $25 million investment in a Daytona, Fla., parcel. Another $35 million was used to buy a Baltimore parcel for the development of a mixed-use property. The initial design called for hotel and retail space, as well as residential condominiums. With the market downturn, the game plan now calls for hotel, retail and office space. The fund shop, which plans to commit another $30 million of equity to the project, is in talks with a hotel as well as a lead office tenant.

The Morgan Stanley-operated vehicle, which has a 15% return goal, had committed more than 90% of its $8 billion of equity on more than 50 investments in Europe and Asia at midyear. A handful of those investments were in public operating companies, most of which subsequently saw their stock values drop, leading to significant writedowns, investors said.

The $4 billion Colony Investors 8, which seeks a 20% return, wrote down the value of stakes purchased in two European real estate companies: Carrefour and Accor. Tom Barrack, chief executive of Los Angeles-based Colony, recently assured investors that his expectations for the fund haven't changed. The vehicle is expected to use the roughly $1 billion of uninvested equity remaining to buy distressed assets in the U.S.

Returns for the funds operated by CIM and Fidelity were hurt by a lack of investments, investors said.

The $2 billion CIM fund, which seeks a 20% return, invested or committed less than 10% of its equity as of midyear. Most of that money was used for three properties: the 484-room Oakland Marriott City Center in Oakland, the shuttered 738-room Lady Luck Hotel and Casino in Las Vegas and three condominium buildings totaling 492 units in Rockville, Md., that Los Angeles-based CIM is repositioning for use as apartments. Of the three properties, only the Oakland hotel was providing a steady flow of income. CIM traditionally uses less than 30% leverage.

The $875 million Fidelity fund, which seeks a 15% return, invested only about 6% of its equity by midyear, investors said. The Boston fund operator hasn't written down any properties.

Older funds, because they started buying properties before prices hit stratospheric levels during the bull market, have managed to maintain positive total returns despite recent setbacks. For example, the $150 million Bryanston Retail Opportunity Fund, operated by Chicago-based Bryanston Realty Partners, suffered a negative 59.9% 1-year return through midyear. But since its inception in 2004, the fund has posted a 36.3% annual return. The fund sponsor has already returned to investors twice their original equity commitments, even though the fund's investments are only about 50% liquidated. The fund wrote down the value of many of its remaining assets in the first half of the year.

Other funds that posted negative 1-year returns but have positive overall returns include:

*The $4.2 billion Morgan Stanley Real Estate 5 International. One-year return: negative 11.3%. Return since launch in early 2006: 38.2%. Return goal: 15%.

*The $1.5 billion Starwood Capital Opportunity Fund 7, operated by Starwood Capital of Greenwich, Conn. One-year return: negative 10.2%. Return since launch in early 2006: 8%. Return goal: 16%.

*The $350 million LaSalle Income & Growth Fund 3, operated by LaSalle Investment Management of Chicago. One-year return: negative 12.8%. Return since launch in 2003: 15.1%. Return goal: 15%.

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