Going Private

Donald Jay Korn

http://www.financial-planning.com/

May 1, 2008- Saying real estate has been a good investment lately is an understatement. Real estate mutual funds have returned more than 31% annually over the past three years (through the first quarter of 2006), according to Morningstar, and nearly 22% over the past five years. The category's 16% annualized return for the past decade leads all fund categories and tops the S&P 500 by more than seven percentage points a year.

So now what? Financial planners might advise clients to keep buying real estate stocks and funds while momentum is on their side, but this path may lead to a repeat of the real estate downturn of 1998 to 1999. A more cautious approach is to stop investing in what might be an overpriced sector, but then investors would miss out on the potential benefits of the asset class.

There is a third approach, fortunately--to buy real estate the old-fashioned way, in private transactions. A private placement is the sale of a security in a manner that is exempt from the registration rules and requirements of the SEC.

"Real estate in general is an inefficient asset class," says Chris Hauswirth, chief operating officer and director of research at Wetherby Asset Management in San Francisco. "The potential exists for talented real estate investors to find inefficiencies and thus earn excellent returns. We've recommended private real estate to some of our clients for the past few years, and these investments have performed very well so far."

Advisers often become aware of private real estate when clients ask them to investigate a particular deal they have been offered. Sponsors or organizers might also come to planners with deals, and advisers can also ask local real estate developers, accountants, attorneys and other professionals for leads to private placements. In addition, groups such as the National Association of Personal Financial Advisors may refer planners to syndicators, which offer private real estate funds for individual investors.

Occasionally a financial planner will put together a transaction just for the firm's clients. Bob Bolen, an adviser in Franklin, Tenn., found a property for sale, with the potential for developing residential lots, in the Florida panhandle, close to the Gulf of Mexico and a major highway. "I arranged for several clients who had expressed interest to make all-cash investments in this property, using money in their IRAs," he says. "They put up $25,000 to $50,000 apiece. We did the deal last year, and it's going fine so far. I might do something like this again."

Bolen's experience notwithstanding, advisers generally have to find the best private real estate deals today, advisers generally must go beyond residential properties in coastal America, where price appreciation has been well publicized. "A lot of advisers read articles about real estate being overvalued," says David Bourne, chairman of Equastone, a San Diego-based real estate investment firm and syndicator. "They're a bit surprised to hear that office markets have done poorly, in certain areas, so good values are available. You might be able to buy at a price per square foot that's well below replacement cost."

In addition to seeking overlooked market sectors, planners may have to screen properties that are still works in progress. "We are generally not investing in stable assets that are fully leased and can provide income right away," Hauswirth says. "Those properties tend to be very richly valued, so the opportunities are modest. Instead, most of the private real estate investments we recommend to clients are in the value-added' category. These transactions involve buying the property, improving or repositioning it and then selling."

Such real estate investments pose problems for planners trying to evaluate, however. A stable property can be judged by its capitalization rate, which is determined by dividing its net operating income by the purchase price. A property with a cap rate of 10%, for example, is usually a better buy than one with a cap rate of 5%.

"When buying value-added properties, cap rate is irrelevant," Bourne says. "There might be no income for the calculation." Therefore, financial planners may have to devote more effort to assess the appeal of a private real estate deal.

"Judging private real estate investments on a case-by-case basis allows me to become more comfortable with the assumptions supporting the valuations," says Sammy Grant, a financial adviser in Sandy Springs, Ga. "On the other hand, we can pass on specific deals that don't make sense."

Private real estate can be risky, especially when property development or renovation is involved. These investments are illiquid, too, so the potential return at the end of the day must make the effort seem worth the time and effort. "Using reasonable projections of cash flows and taking the expected time frame into account, investors should be looking at possible annualized returns north of 20%," explains Frank DiFerdinando, president of Keller Wealth Advantage in Irvine, Calif. TYPES OF DEALS

There are two main kinds of private real estate deals: buying a single property and buying a pool of properties. Single-property deals are typically easier to research, and it may even possible to check out the property personally and get an idea of the payoff. It does help if the property is close to home.

Recently, for example, Grant looked at a shopping center under development just outside of nearby Atlanta. "The organizers provided estimates for purchase price, construction costs and expected future cash flow," he says. "In addition, they also highlighted benefits unique to the property such as favorable zoning. Because this investment was in my backyard, I was able to verify many of the assumptions in the offering independently, through my connections in the local real estate industry."

To verify those assumptions, Grant went to local sources for the answers to several questions: How important is the fact there is a sewer moratorium in the area, preventing competing development? Were the projected rental rates reasonable? "After getting answers, I was able to make a more educated recommendation than I would have been on a competing deal in some other real estate market that I am not as familiar with," he says.

Grant learned that this particular shopping center is going up in a rapidly developing neighborhood. "A new residential area is right behind it, providing hundreds of potential customers. The developer has a good track record for leasing this type of property to tenants," he says. The plan is to lease up the storefronts and then refinance or sell the presumably appreciated property, hopefully in about three years. Grant wound up recommending the property to clients, several of whom went into the deal.

Not every private deal is so conveniently located, though. "At a client's request, we recently evaluated an investment that asked for $250,000 to buy into a ski resort in California," says Robert Hockett, president of Cambridge Southern Financial Advisors in Atlanta. "We didn't fly out there, but we did investigate it pretty thoroughly. We read the 400-page appraisal, for example. This arm's-length appraisal put the property's value at far more than the debt that would be incurred, so there was a lot of collateral."

Hockett says that the deal was put together by a well-known group. "I spoke to the company's attorney and its CFO," he says. "The plan was to partition the property in 10 months so that investors would own individual lots. Therefore, the positive aspects were impressive management, possible liquidity and an encouraging valuation."

On the negative side was a lack of control. "We typically don't recommend limited partnerships or limited liability companies to clients," Hockett explains. "Instead, we'd prefer that our clients go into an investment where they can either buy the whole property or have majority ownership so they can exercise control."

Hockett explained the advantages and disadvantages to the prospective investor: "Our client could afford to lose the entire $250,000 if the deal fell apart, and he was willing to assume the risk. He made the investment a few months ago and seems to be happy with it."

Other private real estate funds seek to raise equity capital to buy a dozen or more properties. In the lingo of real estate offerings, this type of deal is a "blind pool"; investors don't know what their money will be buying.

"We will consider blind pools in some circumstances," Hauswirth says. "That depends on the people involved and the strategy they're following." What's more, in the time it takes to complete fund raising, some of the initial capital may be used to acquire specified properties. Therefore, latecomers might have a better idea of how their money will be invested. EVALUATING DEALS

As the above examples illustrate, analyzing a private real estate transaction involves time, effort and knowledge of the industry. Although each deal is unique, there are several common principles to keep in mind, including the track record of the sponsor and of course the terms of the deal.

"The track record of the sponsor is the most important thing," says Sheila Chesney, a planner in Beaufort, S.C. "We like to see a history showing that someone has previously made money for investors."

What's more, the current deal should be similar to those that have paid off in the past. "Equastone is one of the sponsors we have recommended to clients," Chesney says. "Those clients went into an offering that intends to buy properties, fix and sell them. The company has a track record of doing this for a long time, which is what we like to see. When we asked management about the company's past performance, we were shown projections from prior deals and how the results matched up."

The way a deal is presented counts, too. Advisers should beware of high-pressure offers. "If the sponsor says that he must have an answer within 24 or 48 hours, we always pass," Hockett says. These transactions are complex, and more time is necessary to check into the people and the property involved.

It's also important to scrutinize the deal terms. "I look to see how much the organizers are putting in," Grant says. "If 30% of the capital is coming from their own pocket, that's better than no contribution at all."

Examine the terms of the payout, too. "These deals typically pay a preferred return to investors," Grant explains. "As soon as there is free cash flow, investors get this return. After investors get their money back, plus the preferred return, there's a split between the investors and the organizers." Often, the preferred return is 8% to 10% a year; the subsequent split might be 50/50, although that will vary from one offering to another.

Collateral is also important. "In addition to having control, through complete or majority ownership, we like clients to have some degree of collateral," Hockett says. "With proper collateral, if a deal blows up, the investors usually can get back 60 to 90 cents on the dollar."

  THE RIGHT CLIENTS

Because private real estate deals are risky, they aren't right for every investor. "You usually have to be an accredited investor," Grant says, referring to individuals with a net worth of over $1 million or income over $200,000 ($300,000 in joint income with a spouse).

High-net-worth investors don't have to invest huge amounts of money into a deal, however. "My clients often invest the minimum in each deal, which might be only $20,000 or $25,000," Grant says. "Even if the price per unit is $100,000 or more, it may be possible to split a unit among several investors."

Chesney also suggests that clients invest the minimum in each fund so they can participate in more funds. "We like to see them diversify by geography and by the time different deals are expected to pay off," she says. "Private real estate also can be diversified by the type of offering: income-oriented, value-added or opportunistic."

High-net-worth clients may pay planners a percentage of assets under management; planners compensated in this way can carry private real estate holdings at the original cost. That's not the only possible approach, however.

"If I know the firm that appraises the property, I'll feel comfortable with the reported value," Grant says. "Then I can justify the values I use on my quarterly reports to clients. I treat these private real estate investments as portfolio items for purposes of determining my asset-based fees." Considering the effort needed to analyze these deals, advisers may want to get a real return if they help clients find ventures that are literally wealth building.

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