MORGAN STANLEY REAL ESTATE FUND PROBLEMS

The December 14, 2011 issue of the Wall Street Journal contained an interesting article about the problems facing the Morgan Stanley global real estate fund. The article points out that Morgan Stanley (MS) was forced to return about $700 million to investors and to reduce fees in order to persuade investors to stick with them after a lack luster performance. This, in and of itself, is not newsworthy. Morgan Stanley did what it had to do to retain the management (and management fees) of its $4.7 billion fund. What is noteworthy is the fact that, as part of the deal, the investors gave the fund (Msref VII) an additional year (to June 2013) to invest instead of being required to return billions to investors. The fund, apparently has invested only $2.5 billion of the committed funds leaving $2.2 million un-invested with a deadline of June 2012. This leads one to question the sanity of the investors in imposing a deadline.

There is no indication as to who the investors are but it is possible that a large number, if not the vast majority, are institutional investors managing other people’s money OPM) such as pension fund managers, rather than being representative of individual investors investing their own money. In any event, the imposition of an investment deadline does not appear to be a decision, or strategy that a knowledgeable, sophisticated individual investor would make.

The reasons for failing to invest the money should be carefully examined. There is no question that conventional wisdom suggested that there would be unlimited buying opportunities to acquire high quality real estate arising out of the collapse of worldwide investment real estate values. However, conventional wisdom appears to have been wrong. Even though many superior properties went into default due to the inability to be able to refinance or because of a drop in value attributable to reductions of rent, these properties were not offered to the market at “bargain” prices because the institutions controlling them made a decision not to sell into a falling market and instead to hold and manage the assets through a turn-around. Real estate is not a highly liquid asset and the key to successful investing is one of timing. Real estate professionals know and understand that the profits are made on the “buy side” of the transaction and not the “sell side”. In other words, if the property is acquired at a “good” price the ability to profit is more certain. On the other hand, if a property is acquired at an over-market price, the investor is dependent on luck for a profit at the time of sale.

The investors in the MS fund seem to be punishing management for acting prudently by refraining from paying over-market prices for available offerings. Action might be justified if MS were not making all reasonable efforts to place the money. But, if a substantial effort was being made but was thwarted by unwilling sellers, then the question of time limits or punishment were probably not appropriate strategies for the investors. Instead, the investors, along with MS should have examined the market and determined when and under what conditions would buying opportunities begin to surface and whether or not it was worthwhile waiting for those opportunities. Imposing an investment deadline makes no rational sense.

Why is an investment deadline an erroneous strategy? To start with, a fund manager, operating under a deadline, will be highly incentivised to buy something – anything even if the long term outlooks for the acquisition(s) are questionable. The fund manager, by failing to invest will lose the contract and all that goes with it. Thus, the fund manager may feel forced to make questionable acquisitions and pray that, by the time sale is indicated the market will have improved enough to override any overly aggressive buying decisions. It is also probable that others like MS, who raised money for opportunistic investment, are having similar problems. If they too feel investor pressure, the result can be a “herd mentality” resulting in many making overly aggressive purchases for fear of being subject to investor criticism. When this happens, property acquisition becomes a very competitive sport where “getting the deal” becomes more important than the economics of the deal. This “herd mentality” was evident in the period leading up to 2008 when the frenzy of activity pushed real estate prices beyond the outer edges of the envelope.

There is substantial uncertainty in the investment markets today. Much of the uncertainty is attributable to global economic problems as well as domestic problems. The volatility of the stock market indexes underscores that uncertainty. Unlike stocks and bonds real estate cannot be traded on a daily basis. It takes a substantial amount of time to either buy or sell a large piece of real estate. Real estate investors can’t hedge against adversity by placing “stop loss” orders. Once a property is acquired it becomes subject to the vicissitudes of the market, whether good or bad.

The bottom line for investors should have been whether or not MS was best qualified to execute an opportunistic purchase strategy when market conditions were conducive to acquisition and then deciding whether the timing was going to be within their anticipated time horizon. If the answer to either of these questions had been NO then, a return of the uncommitted money in the fund might have been a good decision. But, putting intense pressure on MS to invest the money was probably not the best or wisest decision.