The spiralling US-China trade war and a shock drop in local property prices effectively killed Chinese entrepreneur Chen Chang Wei’s bid to finance the HK$15 billion ($1.92 billion) purchase of two Hong Kong office towers, according to people familiar with the deal.
Enter Gaw Capital Partners: the private equity fund has agreed to buy 49% of the two skyscrapers according to a filing on November 2 without disclosing the price it paid. The move is the latest in a decades-long track record of moving in on distressed sellers who are struggling to make payments on property loans or secure funds for acquisitions.
“Oftentimes when companies are in distress that’s the best time to invest,” Gaw Capital’s president Kenneth Gaw told FinanceAsia in an interview.
Gaw Capital is on something of a run. Since the brothers Kenneth and Goodwin Gaw founded the firm in 2005, it has grown into Asia’s second-largest property fund manager according to data collated by trade publication PERE, and it has made spectacular profits by snapping up dilapidated hotels and run-down office blocks from bankrupt sellers in California all the way to Osaka.
Based on this success, Gaw Capital has been able to raise its biggest fund yet at $2 billion. And it has wasted no time in putting the capital to work.
On Wednesday, Gaw Capital led a consortium including Goldman Sachs to buy 12 properties in Hong Kong for HK$12.01 billion ($1.54 billion). It is using equity from its latest fund, according to a filing with the Hong Kong stock exchange.
Gaw Capital also used some of this equity to buy into Chen’s Hong Kong towers deal, another filing shows.
Chen had been trying to arrange financing at a punchy 80% loan-to-value (LTV) ratio for the Grade-A office towers ‘Cityplaza Three’ and ‘Cityplaza Four’ owned by Swire Pacific. However, the bank declined the loan and he found little support among bond and mezzanine debt investors, one of the people familiar with the deal said. A Gaw Capital spokesperson declined to comment.
In terms of affordability, Hong Kong tops investment bank UBS’s global property bubble index. While a bubble is hard to identify before it pops, cracks have started to show; prices of private homes across Hong Kong dipped in August for the first time in nearly 2-1/2 years shortly after interest rates on mortgages rose in the city.
“Almost nowhere offers good value,” Kenneth said. Of his hometown, Hong Kong, he says: “Prices, no question, are in bubble territory.”
Property broker Jones Lang LaSalle has calculated that Hong Kong office capital values were 171% above their last peak in 2007, way more stretched than 80% in Sydney and 6% in Singapore. While there has been no softening in capital values thus far, leasing demand and rental growth have slowed after a decade-long bull run, its analysts said.
Chen was caught in this downdraft. To boot, he was offering investors less attractive terms than on a similar transaction across town last year. Then, a consortium of property investors bought The Centre, a skyscraper located in the heart of Hong Kong’s business district, from tycoon Li Ka-shing for HK$40.2 billion. It was the highest price ever paid for an office building anywhere in the world. The consortium offered investors debt with a weighted cost of capital of 10%, while Chen was gunning for about 8.5%, the person said.
In a test of its support among the financial community, Gaw Capital is seeking to bring in investors for its own debt financing with an LTV of around 60% to 65%. The fund has until April 11 to complete the deal, an unusually long time in the world of property investment the same person added. Gaw Capital declined to comment on the transaction.
To garner support, the Gaw brothers can boast a long track record of high returns to show investors: their five funds have had an internal rate of return (IRR) of between 10% and 25%.
They cut their teeth on distressed US properties, including the $10 million acquisition in 1995 of the Hollywood Roosevelt Hotel from its bankrupt Japanese owner. At the time, Kenneth recalls, Hollywood looked like something out of the 1990 film Pretty Woman as drugs and prostitution was rife. The hotel was a shadow of its glory days when it hosted the Academy Awards and guests included Marilyn Monroe.
Shortly after Gaw Capital acquired the hotel the surrounding area was revamped and the hotel became a Hollywood A-list party hot spot.
“Now just the liquor bill is $40 million a year,” said Kenneth, whose family still owns the hotel. “Overall revenue is about $50 million.”
He and his brother have used that same formula of seizing on a distressed situation time and again around the world.
The brothers turned their attention to Asia after the 1997 financial crisis, picking up distressed assets at cents on the dollar. Signs are, Kenneth reckons, that the property cycle is peaking once more and defaults on repayment loans are rising.
BRACED FOR A CRASH
Gaw Capital, which invests across the capital structure of property deals, could make a killing by inserting itself into more overleveraged transactions by Chinese investors as Beijing tamps down on debt. Mainland Chinese companies such as HNA, Anbang and Wanda borrowed billions of dollars to buy overseas property between 2014 and 2017 and this year all three are selling off assets at firesale prices.
At 48 years old Kenneth has already invested through property cycles. He fully expects real estate to be at the centre of the next global financial crisis, given it is the world’s largest asset class and banks find it the easiest form of collateral to lend against. As central banks globally raise interest rates, there is likely to be a spike in the number of distressed sellers looking to sell property fast.
“Every crisis presents itself differently but when you look back you see it is always about too much leverage. The next crisis will be no different,” Kenneth said.
In mainland China, Gaw Capital is betting that Beijing will resume its efforts to deleverage the world’s second-largest economy once the strain of its trade war with the US has eased.
Gaw Capital finds distressed assets via relationships with domestic companies such as co-investor China Great Wall Asset Management (Great Wall), and it has set up a joint venture with Guangdong-based developer Country Garden to buy non-performing loans directly backed by assets.
The brothers can also use their family contacts and cultural affinity with China. Their father Anthony, was born in Myanmar after the family emigrated from the coastal southern Chinese province of Fujian before World War II and their mother, Rossana, is from pre-Communist Shanghai. Together, their parents developed a property empire called Pioneer Global and listed it in Hong Kong. Forbes Asia estimated the family's wealth at nearly $3 billion in 2017.
Gaw Capital also needs to be careful it is not caught in the same debt trap.
Its portfolio of real estate has swollen to north of $17 billion of assets under management since 2015. Gaw Capital’s rule of thumb is to use no more debt than a loan-to-value ratio of 50%. However, it occasionally breaks its own guidelines, such as in Japan, where banks offer property investors seven-year debt for as little as 20 basis points above the benchmark floating interest rate.
A key risk for non-Japanese investors like Gaw Capital in Japanese real estate is if the yen rapidly appreciates in value, it makes it harder to pay off yen-denominated debt.
GROWTH NICHES
To buffer itself from a possible property crash, apart from limiting the amount of debt it employs, Gaw Capital is looking to invest in growth niches. It is buying hotels in destinations increasingly frequented by Chinese tourists, gentrifying downbeat areas of Asia’s burgeoning cities, building student housing to cater for the offspring of Asia’s expanding middle class as well as logistics warehouses to house the regional e-commerce boom.
“We invest in the sweet spots of these trends,” said Kenneth, a former Goldman Sachs banker.
A leap in Chinese tourism to Japan was a major factor in Gaw Capital’s turnaround of the Hyatt Regency hotel in Osaka. The Gaws bought the 480-room hotel from construction company Obayashi Corporation in 2014 for about ¥3 billion (about $31 million at the time), or around 5 cents on the dollar. The hotel was built in 1994 and made a loss for the next 20 years.
“The operating inefficiencies were quite obvious – the owner knew it but couldn’t do anything about it because of [the local] culture,” Kenneth said.
Within a year under the Gaws’ ownership, the money sinkhole went from a $2 million operating loss to a net operating income of $4 million. The Gaws sold the hotel in 2016 for ¥16 billion, or about five times the money invested. About half of that turnaround came from cost savings and the other half from an increase in Chinese tourism in Japan.
Afterwards Gaw Capital was able to raise an Asia hotel fund and a European hospitality fund. In Europe, Gaw Capital is focusing on the hard-hit property markets of Spain and Portugal and has already made two purchases: a renovated 18th-century palace, the five-star InterContinental Porto - Palacio das Cardosas, and a 50% stake in the Spanish boutique hotel brand Hospes Hotels, alongside Spanish investment company Omega Capital.
Hong Kong-based brokerage CLSA forecasts that Chinese tourists will make 191 million outbound trips by 2021, up from 57 million in 2010.
GENTRIFICATION
In pricey Hong Kong, Gaw Capital’s biggest-ever deal was the November 2017 acquisition of 17 shopping centres in lower-income areas from Link Real Estate Investment Trust for HK$23 billion, alongside state distressed debt investor Great Wall and investment bank Goldman Sachs.
The auction was fiercely contested as bidders felt that shops, where people go for their daily necessities, are unlikely to be disrupted by the rise of e-commerce and that there was potential for gentrification in crowded Hong Kong. Gaw Capital thinks it got a bargain. “We value the retail shopping spaces at around HK$7,700 per square foot – when was the last time you saw commercial real estate [in Hong Kong] at below HK$10,000 per square foot?” Kenneth asked.
Gaw Capital is already reshuffling tenants after taking control of the portfolio in March. Kenneth said just moving a supermarket from the ground level to the first floor and opening up space for food and beverage hawker stalls can generate a 40% to 50% uplift in rents.
There could also be a hidden value in the portfolio’s 9,000 car parking spaces. Link Reit’s valuation was around HK$500,000 per space, whereas Gaw Capital priced each space at between HK$700,000 to HK$800,000.
Gaw Capital could sell down the portfolio piecemeal as the area gentrifies, according to a property dealmaker familiar with the fund’s plans.
The company has since doubled down on the strategy by leading a consortium that includes Goldman Sachs to buy another 12 properties from Link Reit. Blackstone is also in the consortium, according to a person familiar with the deal.
Gaw Capital also has a knack of spotting lucrative fixer-uppers in up-and-coming areas.
“Their asset management team is exceptional at repositioning property, anything from a fresh coat of paint to a new [global distribution system] for a hotel,” the property dealmaker said, singling out Christophe Vielle, the head of Gaw Capital unit GCP Hospitality, as “the best in the business”.
Hong Kong tycoon Richard Li struggled for years to find a buyer for a dejected department store and a virtually empty retail podium in Beijing’s fashionable Sanlitun neighbourhood. After several bids fell through Gaw Capital stepped up. In under four years, the Hong Kong-based fund had turned the money pit into a thriving business hub, with tenants such as co-working firm Naked Hub, luxury car retailer Infinity and global technology brands including Fujitsu and Hewlett-Packard-owned Aruba Neworks.
The deal was obscenely profitable for Gaw Capital. After buying the property, Pacific Century Place, for Rmb5.5 billion ($928 million) in August 2014, the private equity fund spent Rmb600 million to Rmb700 million on renovations, then sold it for Rmb10.5 billion earlier this year to Yuanjing Group which is controlled by Chinese property billionaire Zuo Hui, according to people familiar with the deal.
“Investors have been very happy,” said a smiling Kenneth.
Investors see value-add strategies as representing the best opportunity in real estate over the next 12 months, above core funds in second place, according to a June poll by data provider Preqin.
For now, though, Gaw Capital looks to have a Midas touch and has hit some of the most profitable themes in property, such as co-working. Gaw Capital bought the Shanghai-based network of coworking spaces, Naked Hub, in 2016. The firm was subsequently bought by New York-headquartered WeWork in April, which paid in cash and shares.
Gaw Capital still has exposure to WeWork, which last year raised $4.4 billion from SoftBank, valuing WeWork at about $20 billion.
While Kenneth is nervous about the swift rise in valuation it sees WeWork’s trove of data as key to value add.
“Whether they can justify this valuation in the future depend a lot on whether they’re able to use technology to monetise data from their very large membership. If they can do that, then yeah, maybe it is worth that much,” Kenneth said.
BETTING BIG
Gaw Capital has plenty of firepower to deploy if property prices do go sideways. Based on its turnaround credential, Gaw Capital has been a capital-raising machine since inception, having drummed up $9.6 billion of equity from investors since inception across five funds.
In a filing to the US Securities and Exchange Commission in July it said it is targeting $2 billion for its sixth fund called Gateway Real Estate Fund VI. The fund has not closed yet although it is deploying capital rapidly, said a person familiar with the matter.
This latest capital-raising effort, spearheaded by Kenneth’s sister Christina Gaw, has secured commitments from sovereign wealth funds, government pension funds, insurance companies as well as US state pensions and endowments. Some investors in Gaw Capital’s previous funds have signed up again, always a sign of confidence in the money manager.
Fund I had an IRR of about 25%. Gaw Capital is in the process of exiting and distributing Fund III and IV and investors are looking at returns in the high teens to low twenties.
One concern for investors is that Gaw Capital tends to bet big, as with the renovation of Pacific Century Place in Beijing, which took up a large chunk of Fund IV and is the biggest single-asset transaction by a foreign real estate private equity fund in China to date.
That gamble turned out great for investors, but the firm is not always right.
Gaw Capital’s worst-performing fund so far is its $800 million Fund II, partly because of another big bet when the brothers invested $200 million in a joint venture with a big developer in Chengdu, the capital of Sichuan province, just months before the 2008 Sichuan earthquake.
Work on the project stopped for two years, relates Kenneth. The developer was stressed and could not meet its obligations to the joint venture so Gaw Capital ended up having to take full control.
“Those years were very stressful as we were staring at a very big hole,” Kenneth said.
Eventually Gaw Capital made money on the deal but it took four years longer than expected. Gaw Capital is wrapping up Fund II this year and it will likely have an IRR of about 10%, which is still a handsome return.
“The last eight to nine years has been a straight bull market, so it’s easy to get things right,” Kenneth told FinanceAsia.
Investors in its latest $2 billion fund are betting that Gaw Capital made its mistakes when prices were rising and can carry off similarly remarkable turnarounds now that markets look set to become more volatile.
