Trading Up

(Bloomberg Wealth Manager)

by Kieran Beer

June 1, 2005 - Time was when wealthy individuals and their advisors couldn't access the kinds of investment opportunities available to large institutions. But now that more individuals are beginning to act like institutions--that is, striving to invest in a wide range of assets for the long term--some institutional asset managers have started to pitch to retail customers, albeit exclusively to the carriage trade. One such manager is Ted Gamble Jr., founder of The Prescott Group, a real estate investment firm in New York. Gamble, who served in the real estate group at Morgan Sanley for 10 years before launching Prescott, spoke with Bloomberg Wealth Manager about how he views the real estate market today.

Why the push to serve wealthy individuals?

The private investor has a wide range of investment opportunities in fixed income, public equity, and even in some of the alternative asset classes, like private equity and hedge funds. But real estate has frequently been done outside of the coordinated wealth management process, without he discipline or rigor that is applied to the other parts of the portfolio. We've developed three types of investment vehicles for the high net worth marketplace. The first is for significant family groups with $50 million or more to invest in real estate, which suggests an overall net worth of $400 or $500 million. They have the capital to create a diversified portfolio using their own equity, and for them we offer what’s really a separate account program and serve them in much the same way that an institution would be served. We examine their objectives in the real estate sector and help them design their program, whether debt or equity, domestic or offshore. The result can range from low risk, lower yielding core investments to higher risk but much higher yielding properties.

Stepping down a notch, for someone with $5 million to $10 million and all the way up to $40 million to invest, we offer what we call targeted fund investments. When we see a particular opportunity, perhaps an anomaly in the market that we can take advantage of, we partner with various financial institutions--a wealth management firm, for example, on a co-branded basis. We contribute some capital to a targeted fund, and they contribute the remainder of the capital. These funds are anywhere between $50 million and $75 million, and that fund will make an investment in a niche—for example, special situation retail or a specific segment of the residential multi-family market. The idea is to have a small pool of equity dedicated to a very specific strategy that we think appropriate and that requires quick deployment to take advantage of an opportunity.

While the separate account objectives range from core to opportunistic investments, the idea with the targeted fund investments and the next area that I’m going to talk about—diversified portfolio investments—is to target the middle range of the return and risk spectrum. An investor likes to see a relatively attractive current return, and that’s anywhere between 6 and 8 percent in the current market and an overall investment return in the mid-teens.

Individually, the funds don’t offer diversification across sectors—hotel, residential, and office, for example—but by investing in several you do achieve diversification.

We focus on one area with one operating partner because it’s very unusual in the real estate business to have a partner equally good at managing different types of real estate—for instance, both apartments and office buildings. We manage the assets and they manage the property.

The third tier, as I mentioned, is diversified portfolio investments, which are typically focused on property types, maybe an office group or a prortfolio of residential properties and typically, with one operating partner. Unlike blind pools or large open-ended funds, these will generally be made up of three or more properties that all together have a purchase price of about $100 million. That being said, we’re looking at a group of properties that is half that amount and another that is about $300 million. In these funds, diversity is important, and we achieve it in a number of ways, including geography. In an office building, we look for diversity among tenants, so that they aren’t all from the same industry and no one company dominates the credit profile. We also like lease diversification so that leases expire over several periods.

When private clients and their advisors look at this, the underwriting is quite transparent. They see the properties that have been identified, the cash flows, and can review in detail our operating strategy for the properties before they invest. The advisor and the client can get a good idea whether the properties are a good fit with their investment strategy. The minimum unit size is typically $250,000.

What are the fees and the structures for the three vehicles you’ve talked about?

We operate more like a private equity fund than a real estate syndicator. We charge an acquisition fee up front and an annual asset management fee, which are dramatically lower than the loads in many real estate investments where there can be a total load at the front end as high as 15 or 18 percent. Some of the European offerings, particularly those from some of the Swiss banks, have a fee load approaching 24 percent. In a compounding business like real estate, if you’re that far behind on day one, it’s not likely you’ll be in good shape on the other end.

Our specific fees vary by transaction, but in terms fo a general range, a 1 percent acquisition fee and an annual asset management fee of approximately 65 basis points is typical. The quid pro quo is that, like private equity finds, we'll typically take 25 percent of what’s left, after investors have received all of their money back and the next tranche of capital up to a certain specified return, which varies by deal and product type. We do well only after the client has done well.

What about lockups?

They vary according to the individual investment, and in the tier two and three types of investment funds, they range from four to seven years. But we’re working on an office transaction that we’re projecting a 10 year investment period in order to capture certain tenant rolls, and we just closed on a transaction in the residential sector in Atlanta that has about a four year horizon. Of course, we periodically review the capital markets and real estate environment to determine whether we can take advantage of a profit opportunity and liquidate the investment sooner than we’d anticipated.

How do you find the properties you invest in? How much do you rely on the operating partner?

From our perspective, the operating partners are very important. In a difficult market for finding deals in the past couple years, we’ve actually seen a lot of transaction volume that we like at pricing that makes sense. The reason is that we don’t go to an auction where 300 other people are bidding for the same asset. Many of the things we look at are on an off-market basis, where an operating partner comes to us with a portfolio in which they’ve created a lot of value after taking significant risk. After two or three years, a typical holding period for many of the opportunity funds, they’re ready to move on, and we act as replacement capital for the fund and get to invest without standing on line at an auction. Also, an operating partner may tell us they’re watching a portfolio owned by a competitor and ask us to move quickly to acquire it jointly prior to it being broadly marketed. We like situations like that.

Can you give some specific examples of the properties that you buy?

The Atlanta transaction I mentioned closed two weeks ago. It’s a portfolio of rental apartments. We’re doing it with an operating partner that we've know for a number of years and with whom we’ve done a number of deals.

Currently, we’re working on a larger portfolio—a group of almost 2,000 units in the Gulf Coast area of Louisiana and Texas. Both of these transactions were off market. We’re also in negotiations to acquire an office building in Connecticut that wasn’t broadly marketed, but was brought to us by another operating group. We’ll be closing on that transaction shortly. Another deal in process involves retail properties throughout the country—it will be between a $100 million and $200 million transaction.

And how are these investments structured?

Most often, when we’re dealing domestic investors, we’ll structure it as a limited partnership, and we’ll have our own interests as the general partner organized as a limited liability corporation. But the structure depends a lot not only on whether we’re dealing with domestic or foreign investors, but what states the domestic investor resides in, since state laws and requirements can vary and impact which structure works best.

And of course the deals vary based on where we see opportunity. One investment involved buying a large office building in Atlanta from a subsidiary of Hartford Insurance and then re-tenanting that building and selling it after the occupancy had been brought up. Another investment involved a building in Coral Gables, Florida, that served as Latin American headquarters for a large U.S. corporation. The company stayed in the building while we tenanted the space they weren’t using—bringing in a large bank as well.

So much real estate investment is concentrated in New York, Washington, D.C., and Chicago. You haven’t mentioned any of these markets.

We focus on those gateway cities, but also on other areas that we like. For example, we like South Florida and Southern California. Even if they tend to be cyclical, both have good long term growth prospects because of migration and the economic engines that drive each region. And we like strong secondary and tertiary markets. They may not have the dramatic growth of New York City or Washington, D.C., but cities like Cincinnati, St. Louis, and Minneapolis, with the right assets, can offer tremendous opportunity because they have less capital entering them. You can often get 200, 300, or 400 basis points of additional yield compared to yields generated by similar assets located in a prime gateway city like New York.

In the real estate business, people spend a lot of time arguing whether you make money when you buy the asset at an attractive price or through active management. What do you think?

Like a lot of rhetorical questions, the answer is clearly both. A very in-depth due diligence process conducted up front is a part of getting comfortable with an investment. We are broad based in that we see opportunities in a number of property types, and we have good relations with many different operators because we look at things in the hotel, office, industrial, residential, and retail areas.

We believe you must have a broad view of the economy, the markets, and the dynamics of a particular product type. Then you have to go down to the regional or local level and understand how that asset competes with comparable properties. How is it likely to evolve over time in terms of its competitive position? What’s the real income generating capacity of that project likely to be with capital improvements?

How important is geography?

The properties in the Northeast are very different from those you’d focus on in the Sun Belt. In the Northeast, for example, we’re looking at very attractive B-plus and A-minus assets in suburban markets outside the major cities that have performed remarkably well—even in the downtown of a few years ago when many of the cities showed dips in occupancy and rental growth.

By contrast, Atlanta in the past few years has seen a dip in its traditionally robust job growth. There are so many real estate professionals in places like Atlanta or Dallas, that the second things start looking good again, everybody starts building. That’s exacerbated the traditional cyclicality of those markets. Still, if you look thoroughly at the economic statistics for Atlanta—not just the metropolitan area but the region or submarkets like Cobb County where we bought a recent deal—you’ll see there’s been a de-emphasis on multi-family housing growth in favor of single family, making it more difficult to get construction permits for multi-family. So if you’re buying an existing multi-family project, it gives you a layer of protection you don’t see in some other Atlanta investments. It’s a minor example of the texture or fabric you have to look at.

Another example is St. Louis, which is a market that has certainly seen its challenges, especially in the downtown area. A major investor bought Metropolitan Square, a large office building in the downtown area, from Met Life and recently sold that asset at a discount to their original expectations. It’s still an excellent building, but the downtown market had not performed as well as they had hoped.

The lesson is—when you buy an asset, you have to ask yourself, "When my investment period is finished, who am I going to sell it to?"