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The Blackstone Group L.P. (NYSE:BX)

February 13, 2013 12:15 pm ET

Executives

Jonathan D. Gray - Global Head of Real Estate for New York, Director and Member of Executive Committee

Unknown Analyst

Hope you had a -- welcome to day 2 lunch. We are really, really lucky this afternoon for today's keynote lunch speaker. I'm really honored to welcome Jon Gray, Global Head of Real Estate at Blackstone. Jon spent his entire 20-year career at Blackstone. Since joining the firm in 1992, he's helped to build a preeminent -- the preeminent global real estate investment franchise. John's a member of the board and sits on the management and executive committees.

Under Jon and team's stewardship, Blackstone has become the largest U.S. owner of hotel properties, the second largest landlord of commercial properties and the third biggest owner of shopping centers.

Over the past 2 years, the firm's also made a really fast and agile move into the U.S. residential housing through invitation homes. I'd be remiss not to add that along the way, with that scale build has come fantastic returns for their limited partners in an asset class, where, frankly, many of Blackstone's competitors before the financial crisis are, quite frankly, gone.

Outside of the office, Jon is highly active on the philanthropic front. He and his family recently established the Basser Research Institute at the University of Pennsylvania School of Medicine, focused on the prevention and treatment of certain breast and ovarian cancers.

So Jon and I are going to do a bit of a fireside chat. We're going to keep it open-ended and leave plenty of time for all of your questions. But before we do, please join me in welcoming Jon Gray to the stage.

Jonathan D. Gray

Thanks a lot.

Question-and-Answer Session

Unknown Analyst

So Jon, 20 years of Blackstone, your only job out of school. So maybe at a really high level, Blackstone to you, what's it all about?

Jonathan D. Gray

Sure. It's obviously changed quite a bit, the number of people at the firm versus when I joined in 1992, the number of offices that are out there. Certainly, the AUM, when I joined the firm, there was less than $1 billion under management, one private equity fund. Today, $210 billion of equity under management. But I think what makes Blackstone special is that the DNA of the firm has remained constant over that entire period of time. The commitment to serving our clients well, to delivering great returns for them, for operating with integrity, for being entrepreneurial, for hiring the very best people, that has stayed the same, even as the business has grown. And I think you see that in the returns we've generated over time for our investors. So if you look across the firm, in Private Equity, we've produced 15% net returns over 20 years, in Real Estate, 16% net returns, in our mezzanine funds run by GSO, more recent vintage, but 19% returns, and in our Hedge Fund Solutions business, we've produced in our equity funds 400 basis points over the S&P with 1/3 volatility. So the DNA has allowed this business to deliver great returns, and that's led to success in raising new funds. In the last year alone, we raised over $34 billion of equity. That's not from acquisitions but organic growth. And that's a reflection of our investors' confidence in us. And when I look out going forward, my confidence in the firm is very high because a couple of things have happened, one is that there's a hunger for yield. All of you know that, as investors. But if you're a large pension fund and you have a target of 7.5% in a 2% 10-year treasury environment, it is very hard to generate those kinds of returns. And that's leading more capital around the globe, both in the U.S. but also sovereign wealth funds, to look at alternatives in order to generate higher rates of return. And that's good for the industry overall. And then specifically to Blackstone, I think our competitive advantage is that there aren't many folks who can do this across 4 different verticals: in real estate, in private equity, in credit, in hedge fund solutions. There aren't many who can do it for investors in the U.S., in Europe, in Asia. And there are very few who managed to ride through the crisis, particularly the last few years, and not lose significant amounts of capital. And so that, combined with the fact that the banks have also had to exit many of these businesses, I think, has positioned the firm very well. But at its core, it's that DNA, that commitment to excellence of our people and to our underlying investors that has held constant, and that's the reason I feel pretty good going forward.

Unknown Analyst

And we're going to spend the balance of the next hour really focusing in on Real Estate, one of the 4 verticals that, obviously, you and the team have helped build into this great business over the last few years. And maybe just to set the table, philosophically, Jon, I think about heading into the financial crisis and all of what Blackstone Real Estate did, selling EOP, going into the depth of the crisis. And then after that, whether it be on the commercial side and then, more recently, on the real estate side, sort of skating to where the puck went and being a really early mover. Philosophically, how do you identify being a first mover, and how do you do that?

Jonathan D. Gray

Well, what I'd say is we keep it really simple. That's the most basic thing, which is we try to buy income-producing properties at a discount to physical replacement cost. Sometimes, we do that through debt, sometimes, we do that by buying public companies, but at the end of the day, we're trying to get into that $500 a foot office building for $300 a foot. And then when we get at that asset, it may be over-leveraged, it may need new management, it may need a different -- may need capital. Whatever it is, we want to go in there and fix that, whatever's broken, and then sell it to the long-term owner. And I think sticking with that philosophy for us over a very long period of time is what has kept us out of trouble. I'll talk about why we deployed a lot of capital, also, and it goes back to my earlier comments, we've had a lot of consistency. So in our Real Estate group, we've got 19 partners who've been there an average of 13 years. And I think in an investment business, particularly when you're operating on a global scale, that's really important. And we've had the exact same process. So every Monday morning, at 10:30 in the morning, on the Real Estate side, we go through every investment around the globe that we're evaluating, every potential disposition. We have all 240 real estate professionals on the call, very tough for my colleagues in Asia, timezone-wise. Steve Schwarzman, Tony James, Joan Solotar, Byron Wein, everybody's there. And that discipline of having people out in the field looking for transaction but centralized investment control has served us very well. So it doesn't matter if the deal is in Dalian, China, Dusseldorf, Germany, Dallas, Texas. It's coming back to the same room. So those have been the basic tenets. In terms of why we went out and deployed capital, we sold a lot, obviously, going into the crisis, and that was really a function -- the market was so heated. To get into hard assets at a discount, we had to buy big companies like Equity Office and then sell a lot. And that turned out to be a good decision. When the crisis occurred, we looked out at the world and said, gosh, there's an awful lot of pain out here and distress. Now people focused on the fact that economic growth was very weak, which is -- it's continued to be. People focus on the fact that financial institutions had to pull back, that unemployment was quite high and new employment growth wasn't very strong. And so people were very conservative and nervous. What we looked at and said gosh was look at this great opportunity to buy hard assets at a discount, really, around the globe. And so we went out and helped do the recapitalization of General Growth. We bought back Extended Stay, which was a business we sold in '07 for $8 billion. We bought it back with some partners for less than $4 billion. We bought a big senior living business, Sunwest. This distress has continued. We just bought one of the largest hotels in Dublin. We're doing quite a bit in Europe, generally under stress, which I can talk about. We just bought up one of the larger malls in Sydney. But we looked at the world and said the distress is creating a great opportunity. And oh, by the way, our biggest competitors, who are mostly financial institutions, who did opportunistic real estate on balance sheet and in funds, they're no longer in business. And so we looked out at the world, and we were really the only large opportunistic check writer for a period of time. Now it's starting to get more competitive, but we had a very favorable dynamic out there. And when we looked out also, we saw not only are there not a lot of competitors to help clean up these over-leveraged assets, but the debt markets had cooled quite a bit. So whereas the CMBS market had been issuing $230 billion at the bottom of the crisis, it was basically 0. And even last year, it was in the $40 billion-ish range. It's starting to pick up now, which we can talk about. So lots of distressed assets, not a lot of equity out there to buy these assets, limited debt availability, that created a very good environment for us to get low basis. So when we bought Centro's, an Australian over-leveraged company, their shopping centers in the U.S., we bought 600 shopping centers for $9 billion, we paid $98 a square foot, which we thought was almost half of replacement cost. And so having the courage to believe in your tenets even in a tough time, which is hard assets will revert to physical replacement cost, served us really well. In addition to that, the other thing that gave us confidence was that the credit crisis also stopped the threat of new supply. So the thing that undoes real estate, then, like most industries, is excess supply comes out and then, of course, fundamentals deteriorate. Well, obviously, rents have fallen. Occupancies had fallen. But also, banks are trying hard to shrink their balance sheet. So if you look in the retail space in the United States, in 2006, there was 200 million square feet of shopping centers that were delivered. In 2012, that number had fallen to 8 million, a 95% decline. And across the commercial real estate landscape, it's about an 80% decline in the United States. And so what we said was, wow, we can buy assets because of the distress and competitive dynamic at a favorable basis. And even though growth is slow, 1.5%, new supply is running effectively 0, net of obsolescence, and so we can still see decent fundamentals. And so what we've seen over the last couple of years is a nice recovery in commercial real estate. If you didn't read the newspaper and you just looked at hotel same-store sales, RevPAR, they're running up 6%, 8%. Our office buildings have seen occupancy increase 1,000 basis points from the bottom 3 years ago. Centro, which I mentioned, the shopping center portfolio is almost up a couple hundred basis points in occupancy. So, not because we have robust economic growth, we all know that's not the case, but a lack of new supply. So the credit crisis created a great investment dynamic for us and a favorable supply picture. That gave us a lot of confidence. We went out, deployed a lot of capital, held onto those things we hadn't sold, and as a result, today, as values are rising, fundamentals are improving, we find ourselves in what we think is a pretty good spot.

Unknown Analyst

Great. And fast forwarding to today, right where you left us, Jon, if you look not only within the core U.S. business that you have but all of what you're doing globally and abroad, can you just give us a -- paint us a picture of what the global real estate investing landscape looks like today?

Jonathan D. Gray

Sure. Well, I'll start here in the United States, and what I'd say in the U.S. is the markets are healing and the fundamentals have been healing, really, now for 3 years. The capital markets have begun to heal, I think, really, in earnest over the last 3 or 4 months. It's been a gradual process, but all of you know what's happening to credit spreads out there. And so what's -- one of the challenges in commercial real estate is we've been in a very low interest rate environment, and you would have thought with improving fundamentals that the values on the private market would've gone up really quickly. And they have, for very stabilized core assets in the best markets. So investors, REITs and sovereign wealth funds and institutions said, I'm really scared, but I'll buy the very best, safest stuff. I'll do it on a lowly leveraged basis. I'll pay relatively low yields. That's what I want. But the great mass of real estate, particularly in the middle of the country, people found uninteresting. So we tend to like the things most people find uninteresting. So we bought a bunch of strip shopping centers and warehouses, suburban office buildings, limited-service hotels because there was this capital vacuum. And one of the reasons was -- primary reason was debt just hasn't been out there. So you had low base rates but really no debt availability. Or if there was debt, it was at very high spreads. So we're now moving into a world where debt capital costs are coming down over very low base rates, and I think that's going to fuel a significant increase in asset prices in commercial real estate. And it had happened, really, just on the coast in the best core stuff, but it's starting to spread out. Now at the same time, there's still over-leveraged, underleased, troubled assets from the '05, '07 period. It doesn't get cleaned up overnight. There's still, I think, 40% of the $600 billion of CMBS issued in that vintage is in some form of workout, REO, watchlist. So there's still a lot of stuff to work out. And the capital hasn't made that leap yet, and the debt markets aren't there on that. So we still think it's a pretty good time to deploy capital. I just got a call today on a legacy portfolio that a big institution had bought, with a local operator, the institutions marked it down 70% or 80% on their equity, wants liquidity. It's a holdover from the past. And so I think there's still a good investment environment, but obviously, it's not as compelling as it was over the last few years. That's the U.S. And I do think, for stabilized assets now, you'll see better valuations. And we can talk about our disposition plans because I know people here are curious. But the market for that is definitely getting better. As you move around the globe, Europe is in a different place. I think everybody knows that. The banks have been much slower to address the fundamental over-leverage problems in Europe. There's still EUR 2.4 trillion of commercial real estate debt on the bank balance sheets in Europe. They've just started to sell some of the loans. By the way, they don't really have a CMBS market. They don't have a lot of public companies with access to unsecured debt. And so you're seeing the oxygen come out of the commercial real estate market, with the exception of core London and Paris, where global buyers, sovereign wealth funds, in particular, are showing up using very little leverage and want to own these assets, I think, rationally, given the threat of inflation over time and the yields they get on 10-year treasuries or bonds or other things. But overall in Europe, there's a fair amount of distress and there are not a lot of buyers. And the competitive dynamic for us there has been very good. Last year, we put out $3.6 billion of equity in Europe, which was, by far, our busiest year. Most people, of course, have hated Europe. We're not bullish about European growth prospects. We're bullish about the basis we're buying assets. So I mentioned this hotel in Dublin. It had sold in 2007 for EUR 280 million. We bought it for EUR 67 million in the last couple of months. So distress is creating some very interesting opportunities in Europe. There aren't a lot of pools of opportunistic capital, so we're spending a fair amount of time there. But I think you have to be wary that the fundamentals in Europe are going to be tough because they not only have the same fiscal headwinds we've got, obviously, their union is more difficult than what we've got. But their banking system's in a much different place. And over here, and many of you invest in bank stock, particularly, larger banks have dealt with most of their troubled issues in commercial real estate. Over there, it's a very different story. And we're now beginning to see almost everything we bought last year was from a bank. We've been buying now. We're actually buying some things from Spanish banks. We bought some things from Italian banks. The Irish have been going at it in earnest, and credit to them, I think they're going to come out of the crisis first as a result. The British banks will be selling more and have begun to sell. So I think Europe, as I look as an investor, is very interesting for distress. If I go to Asia, it's hard to paint Asia with one brush. I should mention, by the way, in Europe, there are other places like Poland and Turkey that have good growth, but sometimes have Western European owners who may be distressed themselves, but the underlying market fundamentals are still pretty good. As you go to Asia, each country is a little bit different. So Australia, we've been quite active. We've probably been the most active foreign investor in Australia. And we've been buying NPLs. We bought a big shopping mall, I mentioned. We bought a distressed public company. Australia feels a lot like the U.S. to me. The fundamentals are coming back. It's better growth than the U.S. now, but they just used too much leverage back '05, '07, and that's created some opportunities. Japan is more like Europe, even more challenged on fundamentals, and as a real estate investor, with population declining, that's a tough dynamic. So there are opportunities. We've done some things in the logistics space we like it there, but Japan is a truly distressed market. And the question is now that policymakers have made some changes, will we see some of the banks there sell some things? It's been a long wait in Japan. I don't know the answer to that. India and China -- I'll start with India. I like India. Not many people in the world like India from an investment standpoint. People are concerned about corruption, infrastructure, rule of law, getting sick when they visit. There are all sorts of things that make people unenthused about going to India. But I would tell you all those things existed in India 5 years ago, when it was one of investors' favorite places. And India, if you look at the demographics, if you look at the cost differential for U.S. multinationals to do some things there, demand is still growing. So in a city like Bangalore, office absorption is 7%, 8% as opposed to 1% New York or London. And we've been buying good-quality office parts in Bangalore for less than $100 a foot at double-digit unleveraged yields in place, 10% 11%, and 15% mark-to-market cap rates because the rents in place are below where the market is. There's definitely issues about the rupee. There are all sorts of questions on exit, but we just see it again as good fundamental value. And the underlying tenets are some of the best multinationals in the world. So it's a place where -- in India, there's not distress from a debt standpoint, but there are developers who are long buildings, long land and short liquidity. And so we think that's interesting. China is not as extreme. There's more pools of internal capital in China. There's been more construction in China, but it has cooled a bit. And there are some folks who face issues, capital markets-wise. Just to give you a sense, in China and India, public equity issuance of real estate stock is down 85%. And that's creating opportunity. We just bought a large building in Shanghai from a distressed Taiwanese owner. They needed to sell in a hurry. High-quality building in Puchi. It's creating real opportunities. It's not as capital-starved as India, but we think it's interesting, and I would just comment because many of you are probably curious on the residential side. I think China will continue to grow. It'll grow at a slower pace, just given its size. And maybe it's overinvested in terms of physical improvements and so forth, but urbanization is a real thing there. Competitiveness is real there, and residential housing -- forget speculative housing for investment purposes in Shanghai or Beijing at $1,200 a foot. We're doing a project in Nantong, which is a secondary city outside of Shanghai. We're building at $100 a foot, we're selling at $200 a foot. And today -- in the old days, the public markets would have fueled almost everything, and they're not today. So for us, as you can tell generally, I've got a constructive outlook because the credit crisis has sucked capital out of a capital-intensive business. And so debt is not out of hand in real estate generally around the globe, and cranes are not out of hand. Now it's a cyclical business. That will change. But right now, it's in a pretty good part of the cycle.

Unknown Analyst

And a recurring theme that we always talk about when we discuss Blackstone is the global scale that you all have built. So when you identify an opportunity like India or China, Jon, can you just talk about all of the infrastructure, the people and the talent that you have and what it took to kind of get you where you are today if someone else were try to build and replicate that?

Jonathan D. Gray

Sure. First, it's awfully expensive. In Asia, for instance, unlike the U.S. and London, where you can operate pretty much out of New York and London and cover these regions, in Asia, because of the distances and the language issues, we've got 6 offices in Asia. So just physically, it's very difficult. And then putting people in place who you have confidence in is a real challenge. So what we've done -- Chris Heady, who runs our Asia business, was in both New York and London prior to this. Alan Miyasaki, who runs Japan, was in New York. Stuart Grant, who was in London for us, now runs our asset management. So we've got people who've been with us 10, 15 years, who've been trained and sort of understand how we look at the world, and that's really important to us. We also have the benefits of being part of Blackstone. And we've got Anthony Leung, who's the former Finance Minister of Hong Kong, who's our Chairman of Greater China, and Akhil Gupta in India, who ran development at Reliance Industries. We have all sorts of -- Paul Costello in Australia, who ran the Future Fund. So we've got the benefit of that, plus Blackstone's insights in private equity and credit that we get, too. So when we're talking about investment opportunities, it's not narrowly focused in real estate. We get the benefit of sort of the whole firm, which is hugely important, plus the benefits of the firm's relationships with big financial institutions or corporates. So almost anywhere we go where there's an underlying tenant issue or something, we can call somebody at Blackstone somewhere to help us. And I think that's a big competitive advantage. But building these businesses is very difficult, and maintaining the discipline is really hard. Look, the banks built these businesses very quickly. They didn't have a great investment culture in retrospect. They didn't communicate particularly well. I think one of the real challenges folks have asked, which is "Blackstone, you've grown your Real Estate business very rapidly, can you still maintain the standards?" We think you can, but it's hugely important that you're totally integrated. So last week, we had 100 folks in around the globe to go through all our assets around the globe. Everything we've got, because we want people to understand the issues we're facing around our logistics properties or our office properties, development issues, what works, what doesn't work. We want everybody to have the benefit. We want everyone to communicate and really create one global culture. And that will give us what we think is sort of an enduring advantage over time.

Unknown Analyst

Great. And shifting over to the residential side of things, I know there's a lot of interest in terms of all of what you're doing with invitation homes and the REO to rental market. So maybe you could just set the table and talk about the investment spend that you all have made in recent years to kind of penetrate that market, and what your current thinking as we hear now others and fresh pools of capital considering becoming more aggressive players.

Jonathan D. Gray

Yes. So I'll start with my basic worldview, which is we like to buy hard assets at discounts to physical replacement cost. And it was pretty clear over the last few years that the largest asset class in the world, U.S. single-family housing, was going to have a lot of homes sold at big discounts to physical replacement cost. Why? Because there was too much leverage, financial crisis, asset prices ran up too much, and banks were going to be foreclosing. Now we're buying only post-foreclosed homes, after the banks have done the foreclosure. And so we looked at this asset class and said, gosh, we can buy homes that sold for $300-plus thousand for $150,000. And then just like in commercial real estate, there's a lack of new supply. So if you looked at the long-term average and you looked over the last 3 or 4 years, we've built 65% or 70% below the long-term average on housing. Forget where we were, 2 million homes, we're down 80% versus '05, '06 levels. So the same dynamic: distress creating opportunity to get favorable basis and hard assets, limited new supply. That means with just modest economic growth or just population growth -- remember, the U.S. is adding 3 million people a year, 1 million-plus household formations. If you weren't building that number of homes, you should see a recovery as hard assets revert to physical replacement cost. So that's what gave us confidence. The problem, I will tell you, was execution, which was how were we going to do this? We're used to moving very large amounts of capital efficiently, and we couldn't figure out how to do that. So we started on this probably 2 years ago. And I'd like to say we kissed a lot of frogs. We met with a lot of people, trying to figure out how we could crack the code. Originally, we thought there were going to be huge sales from the banks. We ultimately figured out that wasn't the case. We built our 17,000 homes, $3 billion of homes we bought onesie, twosie. It's been at foreclosure auctions and short sales. But we ultimately stumbled on partners who had experience in the U.K. in the buy-to-let crisis of the early '90s, where they started a buy-to-rent business there, and then had bought a very large apartment management company in the United States, Trammell Crow's old apartment management business called Riverstone. And they had 170,000 apartments they manage and people on the ground in all the markets where there was going to be a lot of distressed home sales. And so roughly a year ago, we got this all set up, and we started buying. And what we saw in the premise, of course, was, a bit like the buy it, fix it, sell it we do in the commercial real estate business, we would buy these homes. They've been foreclosed state. They're vacant. We've got to go in there, spend capital, roughly 10% of the purchase price to fix up the homes, lease them out and then create a steady stream of income that we think investors will want to pay for in a very low interest rate environment. So we went out there. I will tell you it was a bit of sort of riding the bike and building the bike at the same time. We didn't really know. There was a lot of skepticism internally. We didn't know if we could really manage this efficiently and lease it, but the Riverstone organization gave us a lot of confidence. And so today, I will say what we did as the year went on is we saw the markets moving. And if you wanted one takeaway on what's happening in the U.S., you read about it, but housing markets are recovering, I think, much faster than people realize, in places particularly West of the Mississippi, in Phoenix, in California. Homes in many places are moving up 20-plus percent year-on-year. It's much slower in Chicago and Atlanta, but we're seeing, overall, a lift in housing prices. And as we saw that on the ground, we started accelerating our purchases because our theory was -- originally, we thought we were going to buy them, fix them, lease them, and do it in a gradual way. But then we came to the conclusion. Gosh, you know what? We're better off stockpiling the homes today, even if we can't renovate them all at one time because if we do that, that will create the opportunity to have low basis in the assets. So we started accelerating purchases. At this point, we've renovated a fair number, but we still have a lot unrenovated. Of those we've renovated, we've leased almost 70%. So the leasing demand, because of the shortage of housing in the U.S., is pretty good, and what we're offering tenants, we think, is pretty compelling. There are 14 million homes in the United States that are rented out, and they're virtually all by mom and pops, and they don't necessarily get very high standards in terms of customer service and the physical quality. Our view was if we could fix up these homes to a higher standard, give real customer service, call-in center, website, all that, that we could attract tenants over time. That's starting to happen, but a big portion of it is just the shortage of housing that's out there. We also believe that the public markets will like these companies over time because I think the tenants will prove stickier than what you see in the apartment business. Traditionally, in the apartment business, you have 50% turnover. A family that moves into a home, we think, is much more likely to stay longer once they enroll their kids in school. And so we think that will reduce capital expenditures and potentially give you additional pricing power over time. And the thesis in terms of where the return comes from in this business is threefold. And obviously, the markets are changing, so we should talk about this. But one is you buy a distressed home at a discount to the market price because you're buying it vacant and it's at a foreclosure sale, and you're buying all cash as opposed to a regular MLS listing. So that discount used to be as much as 20%. Today, it's maybe 10% or lower. The second thing is you get a current return once you lease up. People talk about a lot of numbers. I would say on average, it's about 6% unleveraged yield today. That's down probably 100 basis points maybe from where it started. And in places like California, it's as low as 4%. And then if you borrow against that, you can get an 8% or 9% current return. And so you have the discount, you have current yield, and then the third piece is HPA, home price appreciation. And when we started on this, we believed very little on home price appreciation. That's obviously moved up a lot. The challenge today, and as you look at other folks who are entering this business, is the yield I described is going to be going down as prices go up because the rents are not growing as fast as the home prices are, and the discount is going down as well. And the investment bet is now much more home price appreciation-oriented. So I would say for us, we think the investment window is this year. We don't see it -- we don't know, but it feels sooner rather than later, particularly to generate the kind of opportunistic returns we want. But I think the recovery in housing is a multiyear cycle because of the imbalance of the low household formation we had that sort of pent up, as well as population growth and the low construction. So I think housing comes back here. It'll take some time, and I think these companies will make a lot of sense in the public market, most likely in REIT format.

Unknown Analyst

Jon, I want to shift to the really important topic of exits and monetizations. I think in covering this sector's public companies, I mean, one of the challenges for the investment community and for the analyst community is the predictability and the visibility of monetization activity and not, frankly, having seen a full cycle as a public company, as you and your investment team and partners have over the 3-decade life of the firm. So maybe to kind of start the conversation, one, you've got a significant amount of money accruing value in the ground. Two, 57% of the firms that accrued performance fees are within your business. How do you decide to sell something, and how do you think about the potential pool of what's in the ground that can come back to your LPs and your public unitholders?

Jonathan D. Gray

Well, I'd start with your earlier comments, which is I understand the skepticism on performance fees, right? We went public. We said our business would have a steady earnings because of the long-term management contracts we have in place, and then we would pay out incentive fees as we generated this carried interest. And we really had a 4-year drought with very little in the way of realization. So there's been a sort of show-me attitude from the markets, which is totally understandable. I think it's clear from what happened last year with our firm and some of the other firms that, that is beginning to shift. So in Real Estate, for instance, we had less than $2 billion of realizations in 2011. We had close to $4 billion in 2012. And we have said on our earnings calls that we expect a material acceleration in dispositions in Real Estate in 2013 and '14. Now exactly how that happens, I don't know. There tends to be a lumpiness in our business, but we do have significant accrued value on the balance sheet. It's possible. Historically, we've sold things at higher values. When transactions occur, you never know if that's the case or not. But our expectation is as our assets and investments get mature, both the assets we had prior to the crisis and even some of the newer things we invested at, at deeply discounted prices because of the distress, you could see a pickup. And obviously, improving debt capital markets, the strength of the REIT market, the interest of sovereign wealth fund buyers who are looking for yield, all of that is coming together, I think, to be a positive sign, in particular, for commercial real estate. So I would stick with the idea that I think you will see a pickup. We don't want to speak to time, but it just feels like the market seems to be heading our way. Europe could blow up tomorrow, debt crisis in the U.S., everything blows off, and then things are delayed. But under current market conditions, I feel fairly confident about realization pace picking up.

Unknown Analyst

And back to the scale, Jon, of you and your business, when you think about what's the right form in which to exit, there's so much optionality that you could sell through a strategic, that you could form and build a REIT, that with all these new money coming into the market from the financial community that you could exit that way. How do you think about all that optionality of realization?

Jonathan D. Gray

Well, I would say there are 2 very positive forces for us as it relates to our exits. One is I mentioned sovereign wealth funds, particularly in places like London. In the U.S., it's a little harder because of the FIRPTA laws that limit them to 49% ownership. But they're staring at a world of low interest rates and potential inflation. And if you were given a choice between owning a 10-year treasury at 2% or an office building in New York City at 5%, where you've got a hedge against inflation if it really starts to turn up, I think that looks like a better investment. So I think for some of our highest-quality shopping malls and office buildings, I think that will be a potential exit. The other thing I would point to is the public markets. Commercial real estate debt, in particular, that mechanism we've talked about has broken down. Banks want to shrink their balance sheets. They do not want to hold real estate debt on their books. And not only is that holding to maturity, but in some cases, just the CMBS market has become quite challenging because they inventory a bunch of loans for 6 months, something happens in Europe, and they lose a lot on a mark-to-market basis, and it makes them nervous, so rightfully so. So what's the way for bondholders who want additional yield, real estate debt, to get without forcing the banks to take balance sheet risk? Well, the unsecured market that the REITs can access, public real estate companies, really, in the U.S. and I think, over time, Europe as well. And if you look out in the REIT unsecured market today, their borrowing costs are 2.5%. So if you think about that, and they have access to a lot of equity capital out there as well, I think much of what we own will end up in the public markets. You've seen it. We own a stake today in General Growth, but we owned stakes in the past in Brandyline, in Sunstone, in DiamondRock, where we sold assets, we take cash, we take stock. We believe in the recovery in the commercial real estate cycle. So we're fine taking REIT shares, but I think these companies will grow in market cap, and they will continue to have a meaningful competitive advantage because of their access to low-cost unsecured debt.

Unknown Analyst

And while no one can predict the timing of when exactly you can exit these, Jon, how should we think about, tactically, the timeline for you all in terms of -- are there certain size investments that are sold first or certain geographies or certain quality of properties that come before others as we watch this unfold over the next 1.5 year?

Jonathan D. Gray

Well, we have been, and people have seen it publicly in our office portfolio, selling some of the lower-quality assets in order -- when we do go to exit some of these markets to have exactly what the buyers want. But overall, I would say I think a lot of it will happen sort of co-terminus. I think about the toys along the beach, and when the tide comes in, it could take a lot back. And we have a fair amount of stuff that's at a maturity phase, some of the older stuff we own, even some of the newer stuff. And so I don't see it as some order that this is supposed to come first, then that. I think it's a function of each investment's life cycle, and we've got a fair number that are in a mature phase, combined with where the markets are. And right now, the markets feel pretty good for that. I don't want to get expectations ahead of themselves because as fiduciaries, we want to get the right value for these assets, we think -- particularly the stabilized assets, as they get stabilized, we can get closer to physical replacement cost and sort of intrinsic value. And so we're not pushing the button. On our office portfolio, we didn't sell buildings, even though we could have gotten a low cap rate on our office buildings. We were 80% occupied. They wouldn't pay us for that 20% vacancy. Now they're 90%-plus. It becomes more interesting. So I think it's a function of -- given the maturation phase, as I said, if the markets stay conducive as they are today, I would expect to see this acceleration of sales.

Unknown Analyst

Maybe ask then one final question on this, Jon. But what would you need to see in the marketplace in terms of growth expectations or the competitive landscape that would change your trajectory and maybe we're going to hold onto some of this stuff for another year or 2 beyond what we originally thought?

Jonathan D. Gray

I think it's a function of markets. If the debt markets trade off significantly and the equity markets trade off in sympathy, as we saw last year, we could have a debt crisis here. We could have stuff in Europe. Who knows? If that happens and confidence sort of goes away from the marketplace, we own hard assets that should have a certain value. And if the markets pull back, we'd say, you know what? We don't have any pressure under our capital structure. We were fortunate we've had less than 1% realized losses over 20 years, which we're very proud of. We have the right -- we're not pressured to sell, and we want to do what's best for our investors because our business begins and ends with delivering great returns for our investors. So if the markets pull back, capital markets gets scared, then I would say, okay, it's less likely Blackstone sells. If the market continues to heat up, there was $11 billion of CMBS issued in January, that's generally a good sign for Blackstone's likelihood. Now how it happens, in some cases, we could take things public. We can merge with public companies. We could get stock. I just think you'll see more assets heading in that direction over time.

Unknown Analyst

Great. With that, let's take some questions from the audience. We'll have a microphone coming up, but please raise your hand, and we'll get to you.

Unknown Analyst

What's the unlevered cap rate that you guys are getting on those buy-to-rent properties or resi real estate in the United States, if you take all your reserves for CapEx and so on and so forth?

Jonathan D. Gray

So the gross yields are 8% to 12%, and it's about a 2/3 margin, maybe lower, it depends. So I would say 4% to 8% is the net, depending on the part of the country. So net unleveraged cap rate in California, let's say, is 4%, and a lower-end home in Atlanta is 8%, and I'd say on average, about 6% today. But that feels like it's heading lower as prices move up because the rental market is not moving, obviously, as fast. Growth in rents is not moving as fast as capital values. So if people are saying it's higher than that, it's maybe in certain parts of the country or at lower-end price points. But on average, I'd say 6% is probably a decent number, but my expectation is it will continue to move down as the year goes forward.

Unknown Analyst

One other question. When you calculate your replacement value, do you use the current value of land, or do you use the value of land when people actually build, which is not at the bottom?

Jonathan D. Gray

Yes. It's a great question. The good news is in the U.S., land represents -- in most of the U.S., outside of New York, in L.A. and San Francisco, land tends to represent a relatively small piece. So if it's an Atlanta suburban office building, it can be 15% of the value, 20% of the value. Obviously, when you get to places like London, Tokyo, it's as much as 80%. So I think we take sort of a reasonable guess. We look at -- today, land, in a lot of place, commercial land has very little value because it doesn't make sense to build. We'll maybe take a longer-term view and say, okay, it's a suburban office building. It's $30. I don't know if I can sell it today, but we look holistically -- most of it, we're buying below the physical cost of the asset, the improvements as opposed to the land. But it's a good question.

Unknown Analyst

Jon, one topic we didn't get to talk about yet was the competitive landscape. So yesterday, we heard from David Rubenstein, who was speaking to interest from his limited partners, in core, core-plus type of product. This morning, I asked Harold Marks what he saw as the most out-of-favor asset class, and he said opportunistic real estate. So I mean, Blackstone has such a large competitive advantage in terms of, really, any metric that you could look at. How do you see the competitive landscape evolving today?

Jonathan D. Gray

Well, I would say that where we sit today probably won't be the case forever because today, with $60 billion of equity, $57 billion of equity, a $13.3 billion global fund, we're 3x or 4x larger than competitors out there. Capital is in such that new entrants, and you talked about some very well-run firms, who will grow, I'm sure, their real estate businesses over time. So I think we will see more competitors. In the near term, however, raising large scale commingled opportunistic funds is really hard because most investors lost enormous amounts of money in it. And so it's not what they want. So our ability to raise capital for that particular area seems like a pretty big competitive advantage today. And even some of the other very good alternative shops who've gone out there, so far, have not had great success. My guess is at some point, they will, but we feel like we've got a pretty meaningful advantage in the U.S. and, frankly, even larger in Europe and Asia because people just don't have teams on the ground to compete with us. So we feel like for the next 3 or 4 years, the competitive dynamic, particularly in what we think is a good investment environment, should stay positive. But we recognize over time other competitors will emerge. I will say overall for our business, because we've done a great job for our investors, haven't lost their capital, delivered good returns, innovated maybe more than other folks have, our investors are really looking to us to do things, and we're really focused on areas where we can deliver them great returns. So we won't necessarily take capital because it's available. We could take capital for lots of things. We want to take capital where we can deliver them favorable risk-adjusted returns. And we think if we keep doing that, we'll keep generating carried interest, we'll raise more funds, we'll have more room for our people. So I think the dynamic overall today is pretty good, but my guess is it will get more competitive over time.

Unknown Analyst

How is Hilton doing?

Jonathan D. Gray

So the question is how is Hilton doing. Hilton is doing very well. We bought Hilton in 2007, and everybody thought it was the poster boy of wrong time, over-leverage, all this. The good news is that the fundamental thesis in buying Hilton was that the potential to grow the brands of Hilton outside the United States was enormous, and we have grown the company. We've gone from 3,000 hotels to 4,000 hotels over the last 5 years, during the greatest downturn since the Great Depression. Hilton puts up virtually no capital. Third parties do that. We have another 1,000 hotels in the pipeline at Hilton. Most of that is outside the United States. And so to give you numbers, when we bought the company, it had 5,000 rooms under construction outside the United States. Today, it has 70,000 rooms. And so what you see in China, in India, in Turkey, in the Middle East, even in Europe -- because when we bought Hilton, it had been, for 40 or 50 years, separated from Hilton International. And so really, only the core Hilton brand and a few comrades were outside the United States. Today, if you go to Europe, Double Tree, Hampton and Hilton Garden is coming nearer, even in slow-growth Europe. And then in the emerging markets, the whole range of brands is coming. So we have a terrific CEO in Chris Nassetta. We smartly bought a bunch of debt at the bottom, which turned out to be a very good investment, when people were nervous, but we still thought this was a great company. And then the RevPAR cycle, the industry has turned, and, as I mentioned before, is running up 7%, 8%. So at some point on the disposition discussion, Hilton will obviously be a company that will look to the public markets. I think because it's so well-positioned and growing so quickly, I think it will get a very good reception when it happens. We're not there yet, but my expectation is over the next year or two, that will happen.

Unknown Analyst

Final question for you, Jon. As both a lifelong Blackstone employee and, 2, as a really active participant in the real estate investment business, what's your greatest concern?

Jonathan D. Gray

Well, I think interest rates today have to be most investors' concern, right? Where the fixed income market, where base rates have gone, it's hard to imagine. You look at that graph from 1981, the 10-year being 15% down to 1.5% or 2%, it doesn't seem like that's going to go much lower. And in real estate, the risk is, well, if that happens, what's going to happen to your portfolio? And I'd say a couple of things. One is there's a little bit of a cushion there because the spread between cap rates and interest rates is probably as wide as it's ever been because I think people anticipate, so there's some buffer built in there. But I would say, to me, the next factor is what causes those rates to go up? If rates go up because U.S. economic growth finally accelerates, that's not as troubling, because that means that rents will go up and you'll have $30 rents in place in your office building and the market rents $35 or $40, and that can keep cap rates low. So once again, you would have a buffer. If rates go up in connection with a loss of confidence in the markets, like we saw in Italy or Spain, that's problematic. It would be problematic, obviously, for equities and other fixed income things as well, but that would be the thing that keeps me up at night, which is why I'd love to see a long-term sort of grand bargain and so people felt like the U.S. was on a good fiscal path. But I think you have to watch rates. And back to your question on dispositions, once we finish the mission, once we fix whatever it is, stabilize the asset, if you think you've now converted something that was broken into a, safe, more bond-like instrument, what you should do to hedge is sell because -- and focus on over here, where you're getting more spread, more margin, you're more cushioned. So my overall feeling is self-stabilized assets to mitigate interest rate risk and value, and hopefully, over time, rates move up more because of economic growth, but I think a shock to the system, like occurred in 1994, just given how low rates are, seems to me pretty likely at some point. I just don't know when.

Unknown Analyst

And as a partner of Blackstone, your greatest concern?

Jonathan D. Gray

Oh, as a partner of Blackstone, my greatest concern. Yes, as the firm overall. I would say my greatest concern is as the business grows -- I've said over 20 years, in my earlier comments, we've kept the DNA. And when I think about this business and its potential because of the brand, the people we've got, the relationships we've built with investors, I think it has great potential. But we have to maintain the quality, and we've managed to do this since Pete and Steve started the firm in the mid-'80s, but during my time, as I look forward, that's the thing I worry the most about, that our investment standards in Tokyo or India or London, New York, everywhere, that we understand that we're stewards of capital and have to do a terrific job and have to be very thoughtful. And then we maintain the same discipline, the same processes as we grow. As a lot of places get very large, they lose that. They become more siloed. What made them great, they lose. They lose the entrepreneurial spirit that had allowed them to innovate, and over time, they start to fade like this. I think to me, that's my biggest fear. Do I think we can overcome it? Yes, because I think the people who run the firm are very focused on that, but it's something you have to be very vigilant around.

Unknown Analyst

Is there any more questions? Please, warm thank you to Jon and the Blackstone team.

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Source: The Blackstone Group LP Presents at 2013 Credit Suisse Financial Services Forum, Feb-13-2013 12:15 PM
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