Excerpts: Morgan Stanley: Investing in Distressed Real Estate
- Certainly, if you take Japan and China as a total and look at the rest, it is inconsequential. That is a dramatic statement, and I cannot tell you that we have completely shied away from everything else, but this is how we spend our time.
- This is why Tim Collins and Lou Forster and many of the players that we compete against have focused so much of their time on Japan. It is where the action is.
- In terms of the focus of our business, our strategy, it is really simple. We spend 80% of our time and energy on Japan, and it is very comprehensive. A third of what we do is non-performing loans (NPLs), about 60% is real estate assets, and less than 10% is operating companies.
- What the Japanese banks have been able to do thus far is ignore the problem by basically saying, “Look, this borrower is continuing to pay interest on their loan.” In a low interest rate environment, many people can pay interest on their loans. In the United States, the notion of the ability to repay the principal is a critical criterion in determining whether a loan is non-performing, sub-performing or not. In Japan, it is not.
- So, first you have to find unique situations where you can buy assets on an off-market basis. You have to look for complicated situations, where you buy a company, for example, you strip it apart, you pull the assets out of it, and because you are buying the entire package (and if you are willing to put up with the difficulties associated with stripping the assets out of it), you can get better pricing.
- A third part is to borrow as much money as you can possibly borrow. That is probably the scariest part of the thesis. It is not uncommon for us to be able to borrow 80% or 90% of our purchase price on anything we buy at interest rates of about 1.5%–2%. You look really smart, as long as things work out, if you can buy something for 100 that has a 6% or 7% current yield and finance 80% of it at 2%. That is a great cash-on-cash equity yield, and, in fact, we have had a number of assets that we have bought on that basis, held for three years, sold for what we have bought them for, but because we made such a big cash-on-cash equity yield, we did very well. The targeted IRRs (internal rates of return) are 20%, plus leveraged internal rates of return. You can do that, but it is a tricky business. It is the reason we have a team as big as this.
- To sum up our business, there are four components. One is the real estate advisory business, which is raising equity capital through J-REITs for clients, or providing M&A advice. The second is we are also the largest foreign, non-recourse lender in Japan to real estate. We have an aggressive loan position there. Third, we also have the MSREF program, which is our real estate fund, which again, from a focused standpoint, is about 60%–70% of what we have done. Finally, there is asset management, which is managing the assets that we own together with some third-party assets.
Source: Columbia Business School, Investing in Distressed Real Estate