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More pain for real estate private equity sector in 2010

Fund managers and others involved in the real estate private equity sector around the world expect further deterioration in commercial real estate prices throughout 2010 as unemployment leads to lower commercial occupancies and declining rents, a report from Ernst & Young’s real estate fund services practice in the US has found.

With the sector still in recession, many fund managers are preparing for the beginning of a “generational buying opportunity” that could manifest as early as the first quarter of 2011.

The report – Market Outlook: Trends in the real estate private equity industry 2010 – includes a survey of over 100 real estate private equity sponsors and investors in the US, UK, Japan, India and China.

The survey reveals that most market participants polled expect a gradual opening of debt and equity markets to occur by the end of this year as investors shift their strategy away from preservation of capital to search for higher returns on investment.

Almost nine in ten US respondents (87 per cent) believe that the availability of debt and equity capital will increase by the end of 2010.

However, few respondents see the US real estate levelling out before the end of this year and most expect 2011 to be the year in which investment opportunities start to appear in some abundance.

“Significant amounts of opportunistic capital have been accumulated to invest in distressed real estate, but simply stated, there is not enough distress to go around,” says Gary Koster, Ernst & Young’s global leader of real estate fund services. “Real estate lenders are not forcing the issue with respect to maturing debt which is under collateralised. If the banks won’t take action and instead choose to just extend loan maturities, there is little incentive for real estate owners to trade at current valuations. Given the impact that alternatives – such as foreclosure – will have on bank earnings and capital, it’s not difficult to see why lenders’ ‘extend and pretend’ strategy is still being widely deployed for maturing loans.”

A majority of respondents to the survey believe the commercial real estate crisis among US banks is still only in the middle innings – 70 per cent expect that banks will feel increasing pressure to trade troubled loans at reduced valuations or move to foreclose on problem assets by the end of this year.

Koster says: “The consensus, at least in the US, seems to be that 2011 will be the year in which transaction velocity in the real estate private equity market returns in earnest. However, before fund sponsors can take advantage of the returning market opportunity, they must address any existing problems in their legacy investment portfolios and generally set their houses in order.”

The report also points to a central dichotomy in the mindset of US real estate private equity managers.

“The banking community’s strategy of deferring the impact of distress is a double-edged sword for the real estate fund sector,” says Koster. “The lending community’s reliance is a lifeline for investors short on capital and holding problem assets, but it’s a challenge for investors long on capital yet to be invested and anxious to put that capital to work at current valuations. Whatever the eventual outcome, one side of the market will ultimately be disappointed.”

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