Blackstone Plots Exit From Properties as New Fund Invests

Blackstone's Real Estate Bulk Challenges Gray's Record $13.3 Bil
Jonathan Gray, senior managing director of Blackstone Group LP, poses for a photograph at the Park Avenue Armory gala in New York. Photographer: Amanda Gordon/Bloomberg

An 800-pound gorilla, the joke goes, can sleep wherever it wants. Blackstone Group LP, manager of the world’s largest real estate fund, has no time to rest.

Jonathan Gray, the 42-year-old head of Blackstone Real Estate, has amassed $50 billion in assets and built his division into the company’s biggest profit generator. Now he and his team confront the twin challenges of producing superior returns on their new $13.3 billion fund, a record for the property industry, while finding buyers for more than 40 previous investments. The holdings Gray may sell include Blackstone’s biggest deals, the 2007 purchases of Equity Office Properties Trust and Hilton Worldwide Inc.

“They delivered wonderful returns when they were much smaller,” said Mike Kirby, chairman of Green Street Advisors Inc., a Newport Beach, California-based real estate research firm. “Now that they’ve gotten huge, it’s virtually impossible to knock the ball out of the park.”

Blackstone is the largest U.S. owner of hotel properties, the No. 2 office landlord and the third-biggest owner of shopping centers, according to trade newsletter National Real Estate Investor. Its holdings range from New York’s Waldorf-Astoria hotel to warehouses to luxury malls through its stake in General Growth Properties Inc. This year, the firm began its first foray into U.S. residential real estate, buying foreclosed single-family homes in bulk and renting them out. About three-quarters of Blackstone’s holdings are in the U.S.

“They know every market and submarket in the primary, secondary and tertiary cities,” said Roy March, chief executive officer of Eastdil Secured LLC, the biggest real estate investment bank. “They can be on top of something quite quickly.”

Potential Successor

The growth of Blackstone Real Estate helped elevate Gray to the company’s board in February. Gray is considered by analysts and investors to be a potential successor to Hamilton “Tony” James, Blackstone’s 61-year-old president and chief operating officer.

Gray’s ascension signals how important real estate has become within the firm that Chairman and CEO Stephen Schwarzman and Peter G. Peterson created in 1985. Real estate accounted for 63 percent of Blackstone’s income last year, while private equity, the firm’s traditional business of buying and selling companies, made up 15 percent, according to data compiled by Bloomberg. The private-equity division had about $46 billion in assets at the end of the second quarter.

800-Pound Gorilla

“Considering the breadth of their portfolio, they are the 800-pound gorilla” in real estate, said Edward Shugrue, CEO of New York-based commercial mortgage-backed securities investment and advisory firm Talmage LLC. “They are everywhere.”

Growth and strong returns aren’t mutually exclusive, according to Gray.

“We have been hearing concerns about the unsustainability of our returns since Blackstone went public in 2007, yet our outperformance versus competitors has only grown,” he said in a statement. “Today there is an enormous amount of distressed real estate around the globe and few remaining large opportunistic investment firms. We think this is a terrific environment to continue to generate attractive returns.”

Gray declined to comment further for this story.

Schwarzman and James pushed deeper into real estate as traditional corporate takeovers waned during the past five years. Garnering more assets also serves to satisfy public shareholders who value Blackstone and other managers of alternative assets largely on the predictable fees generated by those holdings. As assets under management increase, so does the difficulty of outperforming rival funds.

Performance Focus

“Investors are concerned that the public alternative managers, like Blackstone, are more focused on growing AUM than maximizing performance,” said David Hodes, co-founder of real estate advisory firm Hodes Weill & Associates in New York. “Blackstone and others have to convince their limited partners that they are still focused on performance, not just accumulating assets. Given that they’re raising over $10 billion for their current real estate fund, they must be succeeding.”

Blackstone’s real estate funds generated 16 percent net internal rates of return, an annualized measure of performance used by private-equity managers, since the firm got into property investing two decades ago. That’s about twice the 8.4 percent annualized return over 20 years of the benchmark property index compiled by the National Council of Real Estate Investment Fiduciaries. The Ncreif index includes less leverage, the loans private-equity firms use to amplify profits.

Returns Slow

Blackstone’s property returns have mostly fallen as the funds got bigger. Its first real estate fund, which invested $467 million of equity capital from 1994 to 1996, posted a 39.7 percent annualized return after fees. The second fund invested $1.2 billion of equity capital from 1996 to 2000 for a net IRR of 19 percent. The third fund, with $1.4 billion of equity invested from 1999 to 2004, shows a net IRR of 21 percent. The fourth deployed $2.7 billion from 2003 to 2006 for a net IRR of 14 percent as of June 30.

By the end of the month, Blackstone will have finished gathering capital pledges for its new fund. Real Estate Partners VII, 22 percent larger than its prior $10.9 billion fund, already has made about 20 investments using more than $3 billion of equity capital. They include buying suburban offices from Duke Realty Corp., commercial loans from Bank of America Corp., grocery-anchored retail centers from Equity One Inc., shopping centers in Poland and a group of troubled U.S. loans from Germany’s Eurohypo AG. The new fund has a net IRR of 33 percent as of June 30.

Opportunity Fund

Blackstone Real Estate Partners VII is an opportunity fund that seeks to buy troubled or undervalued assets using debt and fix them up. Opportunity funds aim to earn at least 15 percent on the equity invested, almost twice the 8 percent yield that might be had from a low-risk investment such as a fully leased prime office building. Before the credit crisis, many opportunity fund managers targeted returns of at least 20 percent.

“It would be difficult to expect opportunistic funds to earn the same returns in this environment,” said Matthew L. Clark, state investment officer for the South Dakota Investment Council, an investor in Blackstone’s real estate funds since their inception. “In Blackstone’s case, they’ve done quite well.”

Competitive Nature

That challenge of leading Blackstone Real Estate falls to Gray, a Highland Park, Illinois, native, who joined the company 20 years ago, after graduating from the University of Pennsylvania with degrees in English and economics. He moved to the fledgling real estate unit in 1993 after a stint in private equity and corporate advisory work, becoming co-leader of the unit in 2005 with Chad Pike, and the global head in December.

Gray demonstrated his drive during a July trip to the London Olympics. The sports enthusiast extended his vacation to visit Blackstone-owned shopping malls in Poland and Turkey, traveling to five cities in all.

“Doing a good job for his investors is another form of competition for Jon,” said Keith Gelb, a co-founder and managing member of Boston-based real estate private-equity firm Rockpoint Group LLC, who shared an apartment with Gray at Penn and remains a close friend. “Whether it was an exam, a case study in a class or a game, Jon wanted to win. He’s an extremely competitive person, but in a productive manner, not an in-your-face manner.”

Blackstone Stake

Gray’s stake in Blackstone partnership units convertible into common shares is worth $537 million at the current stock price. He earned a cash bonus of $21 million last year as Blackstone began investing its new property fund. He got less than $3 million for his share of profits from real estate investments sold, according to the company’s annual report.

Blackstone shares closed at $13.23 on Sept. 4, less than half the $31 at which the company went public in June 2007.

Gray and his wife Mindy in May donated $25 million to Penn to establish a center for research into cancers associated with genetic mutations. The center is named for Mindy Gray’s sister, Faith Basser, who died of ovarian cancer at 44.

As Blackstone turns to investing its new fund, the firm says its bigger size is a help, not a hindrance. It can write billion-dollar checks and complete purchases without having to corral other investors. It can analyze complex capital structures that might deter other investors. Its vast holdings give it insights into different property types and potential deals, according to fund marketing documents obtained by Bloomberg News. Its size also gives it clout with lenders.

Survivor Bias

“If I could get a loan at ‘x,’ they could get a loan at ‘x’ minus 10 basis points because they’re such big borrowers globally,” said Laurence Geller, CEO of Chicago-based Strategic Hotels & Resorts Inc., a minority owner in the Hotel del Coronado in San Diego. Blackstone took a majority stake in the red-turreted seaside property, featured in the 1959 movie “Some Like It Hot,” after a 2011 debt restructuring.

Less competition also helps. The financial storm beached several of Blackstone’s biggest competitors, including Goldman Sachs Group Inc.’s Whitehall unit and Lehman Brothers Holdings Inc. Morgan Stanley, once the largest real estate investor among Wall Street banks, is managing fewer assets after losing part of an $8 billion fund that began investing as prices were peaking.

Gray made buyout history in February 2007 when Blackstone acquired Sam Zell’s Equity Office Properties Trust, the largest U.S. office landlord, for $39 billion and then flipped two-thirds of the roughly 500 buildings at even higher prices. In July 2007, Blackstone agreed to buy Hilton Worldwide, the world’s biggest hotel chain, for $26 billion, shortly before a market plunge that sent commercial real estate values down almost 40 percent.

Company Acquisitions

Blackstone moved away from buying mainly single properties to acquiring entire real estate companies after the 2001 terrorist attacks caused lodging property revenue and values to tumble. Starting with the $3 billion acquisition of Extended Stay America in 2004, Gray began to tap the surging commercial mortgage-backed securities market for cheaper debt financing, eventually making 13 acquisitions of publicly traded companies.

Blackstone didn’t shy away from using its weight to push lenders, said bankers who have worked with the firm. Because fixed-rate mortgages usually impose steep penalties for early repayments, Blackstone used mostly floating-rate debt and pressed banks to reduce or waive prepayment penalties to allow it to shed assets from companies it bought, bankers said.

Landlord Acquisitions

“They’re a very sharp group of guys and they worked relentlessly to achieve what they wanted,” said James Conopask, who helped arrange financing for Blackstone’s Hilton bid in 2007 when he worked at Bear Stearns & Co. “They would push you to the edge on every deal point.”

“However, Blackstone bought high-quality real estate, put substantial capital into their deals and enjoyed an excellent reputation in the mezzanine investor community,” Conopask said. “They earned a bit of flexibility.”

Once the credit crisis hit, Blackstone had to contribute equity and negotiate with lenders to rework the debt on its two largest deals, Equity Office and Hilton. Hilton in April 2010 completed a deal to reduce debt by almost $4 billion and extend the maturity by two years.

“While the jury may still be out on the ultimate fate of these portfolios, they are very well positioned to succeed,” said Shugrue of Talmage.

Biggest Buyer

Blackstone Real Estate survived the crash never having realized losses of more than 1 percent in its 21 years. As the market soared in 2005 to 2007, the firm sold more than $60 billion of real estate. It sold Extended Stay for $8 billion in 2007, later joining an investor group to buy back the hotel chain out of bankruptcy for $3.4 billion.

As prices bottomed in late 2009, Blackstone acquired more than $40 billion of properties to become the biggest buyer of commercial real estate since the low. In September 2011, Blackstone paid about $9.2 billion for the U.S. shopping centers of Australia’s Centro Properties Group.

“Of the big private-equity real estate firms, they probably had the best track record in the last five years,” said Timothy Walsh, director of investments for New Jersey’s $70 billion public pension funds, an investor in Blackstone’s property funds.

‘Major Disposition’

To sustain its track record, Blackstone needs to sell as well as buy. The company’s fifth and sixth funds, which include Equity Office and Hilton, still hold unrealized investments representing about $13 billion of equity invested. They show net internal rates of return of 9 percent each as of June 30.

“I expect by the end of 2013, you will see a major disposition program out of Blackstone,” said March of Eastdil Secured, a unit of Wells Fargo & Co.

This presents its own challenges as debt financing for large purchases remains hard to come by and economic growth is slowing, tempering the rebound in real estate values.

Blackstone has said it expects to exit Equity Office and Hilton in the next few years. It might sell Equity Office’s buildings in chunks to various buyers. Hilton probably will have an initial public offering in the next two years, Joan Solotar, a Blackstone senior managing director, said on the company’s July 19 earnings conference call.

The firm has accelerated payouts from real estate so far this year. Blackstone returned $1.35 billion of cash to investors in its property funds in the first half, double the $667 million it distributed a year earlier.

Before Crisis

Investors are watching for the dispositions from Blackstone, partly because it proved so adept at cashing out before the credit crisis. The buyers of the assets fared far worse. Developer Harry Macklowe had to give up his flagship General Motors building in Manhattan because he personally guaranteed $7 billion he borrowed from Deutsche Bank AG to buy seven office towers from Equity Office. Morgan Stanley and MPG Office Trust Inc., formerly known as Maguire Properties, also relinquished assets after they couldn’t refinance.

“In the back of our minds there is the fact the last time Blackstone sold $20-odd billion of real estate, there was a worldwide economic collapse immediately thereafter,” Chris Kotowski, an analyst at Oppenheimer Holdings Inc., said jokingly on the July 19 conference call.

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