Structuring public REIT-sponsored private capital fund : the case of US industrial and retail REITs

Abstract

The private capital business for public REITs was started by Kimco Realty, Developer Diversified, AMB and ProLogis during the years 1998-2000, at the time when the public equity was not easily available. Over the past decade, public REITs have used their private capital funds to take out REITs' existing portfolios and newly completed projects, to finance land purchases and development pipelines, and to diversify their rental income into a fee income business. Given the limited disclosure of public REITs in their private capital funds and a lack of standardized industry terms and practice applicable to this field, this research can be described a fact-finding study. By studying each of the private capital funds managed by 7 leading REIT managers, I categorize these funds in terms of fund type, inception year, fund life, fund style strategy, investment target, geographical focus, fund terms, target leverage, key investors, parent REIT's ownership, gross fund assets, distribution frequent and incentive design. In addition, I argue that the private capital business of public REITs would not have grown successfully without fuel of the merchant development activities under the public REIT's framework. This is particularly true with respect to the industrial REIT sector. I carefully examine the case of ProLogis' business model, comprised of three indispensable pillars - merchant building, fund management and core portfolio, to substantiate this claim. By creating a new structure diagram of "public REIT-sponsored private capital fund", I demonstrate the "co-opetition" phenomenon among pension funds, real estate investment managers ("REIMs") and public REIT private capital funds in the value chain of the institutional real estate investment.

(cont.) The concept can be described by the fact that two primary investors (pension funds and REIMs) of this field could themselves replicate what public REIT private capital funds are doing. I also relate this observation to the real estate M&A deals that occurred in 2007, where REIMs were observed to "arbitrage" between public REIT and private real estate markets by taking the public REITs private. Moving forward, public REIT-sponsored private capital fund is well positioned to grow as it complements a niche market for pension funds and REIMs to add private real estate exposure in a predictable and sizeable format. However, concerns on above 75% FFO coming from merchant development and private capital for leading REITs (such as ProLogis) may trigger regulatory scrutiny from Internal Revenue Service, as this represents a huge deviation from original purpose of being a REIT - to act as passive investor for core portfolio holding and pay out as dividends most of its net income. In an extreme scenario, REITs like ProLogis may voluntarily or involuntarily spin off their private capital business. Under current capital market conditions, this might actually unlock public REITs' shareholder value. Referencing from mid-cap asset managers' comparable (such as Eaton Vance and Janus Capital), REITs' private capital business can be valued from the 4x price-earnings multiple to a likely 20-30x range.