Knock on 'Opportunity': Sharp Losses Article

more in Real Estate Main »Email Printer Friendly Share: By ANTON TROIANOVSKI In a sign that pension funds and other institutional investors are about to get clobbered by losses in commercial real estate, Morgan Stanley told investors to expect as much as a 60% fourth-quarter write-down on the equity in a marquee $8.8 billion real-estate fund, according to a letter reviewed by The Wall Street Journal. Morgan Stanley hailed the commercial-property MSREF VI International fund as "the largest-ever real-estate fund" when it announced its debut in June 2007. The Wall Street firm projected a 22.4% overall average annual return for the vehicle, which made big, highly leveraged investments on commercial properties scattered mostly in Japan, Germany, China and Australia. The fourth-quarter losses come on top of a $1 billion shortfall during the first nine months of 2008, which means the fund has lost about two-thirds of its $6.5 billion in invested capital in 18 months. Among the fund's bad bets: a $3 billion acquisition of more than two dozen office buildings in Germany in July 2007 at a very low yield of 3.5%. The fund invested $350 million of equity in the project. As of September, Morgan Stanley valued the equity stake at just $23 million, according to the fund's third-quarter report. MSREF and other "opportunity funds" were among the many tantalizing investments sold by Wall Street to large institutions over the past five years. Opportunity funds are different from other real-estate funds in that they make extra use of borrowed money for purchases, sometimes more than 70% of the value of the properties, compared with about 50% for more traditional real-estate investments. The leverage makes it easier to produce higher profits if values rise. But if they fall, the decline can quickly wipe out equity. For the fund managers, there was another benefit: Opportunity funds rewarded them with high fees and a cut of any increase in asset value. The value of the assets held by opportunity funds jumped from $134 billion at the end of 2005 to $280 billion at the end of 2007. Many of the buildings in the funds are now worth less than their mortgages. Even worse, some of them are no longer producing enough cash flow to service their debts, meaning the funds have to invest more or face foreclosure. Industry experts say write-downs in excess of 50% for 2008 will be typical. The decline in values, however, has been difficult to track because the managers of privately held real-estate funds have been slow to mark down property values -- especially compared with the precipitous decline in the stock of publicly traded property companies. Of course, the funds could still reverse some of their losses because investors don't expect to get paid for several more years. But much of what institutions invested in real estate in the past few years could be gone for good. The appearance of dismal returns shows how steep losses sustained by the commercial real-estate industry are being absorbed by retired teachers, policemen and other beneficiaries of the institutions that were chasing the funds' high returns. The looming declines will likely increase the pressure for higher taxes to shore up government-employee pensions and more cutbacks at universities and foundations. Investors in MSREF VI include the Pennsylvania fund responsible for investing school-teacher pensions and the Montana fund that manages the pensions of state employees. Many of the other giant investment banks, like Goldman Sachs Group Inc. and Lehman Brothers Holdings Inc., also offered opportunity funds, as did numerous boutique firms. Cheap debt allowed these funds to leverage their investments in commercial property and tout annual returns in excess of 30%. Colony Capital LLC, another big name, marked its Colony Investors VIII fund down by 45% for the first three quarters of 2008, according to the firm, and Colony CEO Tom Barrack is warning investors of more pain to come. The Colony fund made big bets on Station Casinos Inc., which is now mulling bankruptcy, and French retailer Carrefour SA, which has seen its stock price tumble 45% in the past 12 months. Write to Anton Troianovski at anton.troianovski@wsj.com