09/16/2009

In Hopeful Sign, Some Funds Edge Into Black

More than one-quarter of high-yield funds capitalized by U.S. institutional investors managed to post positive returns in the first quarter, a sign that the sector may be close to hitting bottom.

A review of 123 high-yield funds by Real Estate Alert found that 35 ended up in positive territory from January through March (see list on Pages 11-14). That was up from only a handful of funds in the fourth quarter. The sample, roughly one-quarter of active funds, is believed to be representative of the sector's overall performance. Debt funds performed relatively well, with 11 of 20 edging into the black for the quarter.

To be sure, most funds remained in the red. What's more, many of the vehicles that reported first-quarter gains are still underwater since inception. And many funds are still expected to recognize losses in upcoming quarters. But the broad trend suggests that following hefty writedowns in the second half of last year, the worst may be over for the sector.

It's important to remember that quarterly returns can be misleading because funds have investment horizons of at least five years. Writedowns don't always reflect realized losses, and valuations could still rebound.

Also, comparisons of the results of individual funds can be dicey because all vehicles didn't start investing at the same point. For example, a fully invested fund that takes a big writedown is in much worse shape than one that has invested only a small portion of its equity. And the returns of funds that haven't yet invested heavily can be disproportionately hurt by the impact of fees.

The funds that have posted positive returns since inception generally fall into two categories: Those that primarily invested before 2006, in advance of the big run-up in property prices, and those that started investing last year, after the worst of the downturn was over. The vehicles in between, which started investing as the market was peaking in 2006 and 2007, have generally gotten hammered, with many showing cumulative losses of 40% or more.

The review was based on information supplied to investors by fund managers and obtained by Real Estate Alert. Funds report results on a delayed basis. First-quarter data were distributed in July and August.

The funds in the sample that posted the highest first-quarter returns were AEW Europe's European Property Investors (up 20%), PCCP's Southern California Growth Fund (up 8.7%) and Invesco Real Estate's Invesco High-Yield Debt Fund (8.4%). At the other end of the spectrum, CIM Group's CIM Real Estate Fund 3 plunged 99.7%, Frogmore Property's Frogmore Real Estate Partners fell 84.3% and Morgan Stanley's Morgan Stanley Real Estate Fund 6 International was off 72%.

Funds that have posted wretched returns but have invested only a fraction of their equity have hopes for a turnaround as the market improves. For example, while the CIM fund has a negative 99% return since its 2007 inception, investors said the sponsor has invested only about 6% of its $2 billion of equity. Likewise, Rockpoint Group's Rockpoint Real Estate Fund 3 is down 110% since its 2007 inception (including the impact of fees), but has invested only about 13% of its $2.5 billion equity base.

Others have a more difficult row to hoe. Frogmore's £330 million ($550 million) vehicle is off 81% since its 2006 inception, but has called more than 80% of equity commitments. And Colony Capital's $4 billion Colony Investors 8 fund is off 76% since its 2007 inception, but has already called 75% of equity commitments.

Some operators are stabilizing their funds by paying down debt. That "helps in the short run, but may limit the long-term potential returns as they will not be able to lever back up to acquire assets," said one fund executive.

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