Blackstone seeks gold in 'core' offerings

Real Estate Alert, May 5, 2004

Blackstone Group is adopting an unusual strategy to help achieve the 20% targeted return for its opportunity funds.

The New York investment firm is increasingly competing against core and core-plus players for large properties that--on the surface, at least--don't appear to have the kind of substantial upside potential required for high returns. Blackstone is betting that its ability to spot hidden potential, together with rising property values, will make the investments pay off.

The company has completed at least two such acquisitions over the past year. Last month, Blackstone bought the 834-room Hyatt Regency Washington from Strategic Hotel Capital for $180 million. In September, it bought a roughly 50% stake in Philadelphia's Verizon Tower from Dana Commercial Credit of Toledo, Ohio, for about $100 million. Both are considered stable, top-line properties.

Meanwhile, Blackstone has competed unsuccessfully against core and core plus investors on other large properties. Just last month, it made a play to gain control of International Place, a trophy office complex in Boston. Tishman Speyer, a conservative player, won the bidding with a $600 million offer, which is expected to produce a 7.5% initial annual yield.

To be sure, Blackstone continues to target the traditional kinds of investments made by opportunity funds. But it is increasingly looking at properties that would appear to be geared toward core and core-plus investors. For such investments to pay off, rising property values in the local market can be just as important as hands-on operations.

Opportunity funds usually shy away from such deals because they see limited potential for high yields and because they want to avoid bidding contests altogether. But Blackstone, because of its sheer size, does not want to rule out large transactions without examining them.

The firm's fourth fund recently closed with $2.2 billion of equity, which will be leveraged to provide almost $9 billion of buying power--an amount that would be virtually impossible to invest via $20 million deals, given the high degree of competition at that pricing level. The fact that Blackstone is willing to run such a large fund reflects confidence in its ability to find suitable investments.

Sometimes Blackstone participates in offerings in the hope of identifying upside potential during the bidding process, only to exit when it fails to discover a way to achieve high returns. For example, it was in the running for a portfolio of luxury hotels offered by KSL Recreation, but ended up dropping out. The properties wound up going to CNL Hospitality, a conservative REIT.

But the strategy paid off with Verizon Tower. The 1.2 million-square-foot trophy, at 1717 Arch Street, is almost fully leased to Verizon through 2012--which attracted conservative investors. But Verizon has an unusual lease under which a disproportionate amount of the rent is not due until the later years. Because REITs and pension funds generally cannot afford to own properties that go long periods without generating any return, they wound up walking away from the offering. But Blackstone snatched it up. It plans to undertake a complex debt and tax restructuring.

John Kukral, a senior managing director of Blackstone, said the strategy is a logical extension of the firm's main philosophy of investing in properties with inherent quality, rather than ones needing extensive renovations. For example, in one of its early investments, Blackstone took over the 1.6 million-sf Worldwide Plaza in 1996 after buying a defaulted mortgage from Deutsche Bank for $370 million. It leased up the Midtown Manhattan property and sold it two years later to Equity Office Properties for $578 million.

"We felt there was more value to be created in buying the best assets you can, because when the market came back, you'd get more lift," Kukral said. "But often, assets [such as Verizon Tower] have some flaw in them that make them not attractive to the broader investor market."

Other large opportunity-fund operators, such as Lubert-Adler Partners and Walton Street Capital, tend to spend more time going after investments whose risk levels--and potential returns--appear to be higher.

"We need a deeper value-creation story to get comfortable with it," said one major fund manager. "I think [Blackstone has] shown a tendency to make a little more of a bet on cap-rate compression [rising property values]. And they've done well with it."

Beacon Capital Partners, a value-added player, is the firm that Blackstone is most compared with these days. But Boston-based Beacon, which promises mid-teen returns, sticks to big office buildings, whereas Blackstone has tried its hand at many property types.