Investing in private equity partnerships with direct on-site research into properties is a cornerstone of Spruce's approach to real estate. The firm doesn't use REITs because, Bailey says, he regards them as real estate-related equities, making them overly correlated to stock market swings.
As the global economy continues its recovery, Bailey sees plenty of opportunities to invest in distressed properties in the U.S. and Europe. "We think that between spin-off situations, between asset sales and between collateralized mortgages, you will be able to buy very attractive assets at attractive valuations," he says. "The trick is to come into these assets with unencumbered capital."
Eric Bruck, principal of Silver Oak Wealth Advisors in Los Angeles, doesn't claim to be a real estate expert. Yet he agrees with Bailey that distressed debt has merit. "It's somebody else's problem that we see as something to capitalize on," he adds.
Bruck has invested his clients in two real estate investment companies. One, he says, has run a nontraded REIT that produced roughly a 7.5% return, fully sheltered from taxes, since last year. Recently, it went public and provided an additional bump in valuation. Bruck says now he is investing in the same company's next nonpublic REIT, which focuses on the health care sector. His second real estate investment is a mortgage pool Bruck discovered in 2003. He remained invested in it - before, during and after the real estate bubble burst.
"It's a private bridge loan mortgage pool," Bruck says, which provides close to zero correlation to the stock market. "These are first position, 12- to 18-month loans, with most durations typically a lot less than 18 months. They are what I call a soft-hard moneylender. The credit requirements are higher so their rates are lower and their positioning is much more disciplined. They won't take anything but a first position. If there is a first in place, then they will get it to move to second position and guarantee the debt service on the first in order to make the loan."
Unlike REITs, the mortgage pool is taxable, so Bruck uses it mainly in his clients' retirement plans. "Although in some cases, because the yield right now at 8% is higher than in taxable bonds, it can make sense to use it in taxable portfolios," he says.
Silver Oak's path to the mortgage pool began with a client who wanted to invest. "My knee jerk reaction was, 'That's the kiss of death; don't go near it,'" Bruck recalls thinking at the time. But after investigating on the client's behalf, Bruck and his partner decided to invest with other clients' money. Because the pool is based near Silver Oak's offices, Bruck says, they've had breakfast together with the pool principals each quarter for nine years.
"They've been very smart,'' Bruck says. "No single loan is more than 1% to 1.5% of their entire pool, so the diversification has been excellent. Whatever defaults they have has been made up out of their cash flow.'' Those benefits are "the kind of thing we are looking for in this environment."
Of the $120 million in assets Silver Oak manages, up to 15% is in the pool at any one time. Initially comprised of commercial real estate, the pool began to move into residential real estate as well after the crash, he says. These days, it is adding distressed properties. Returns have ranged from 6.5% at the low point to more than 9% in the early 2000s. While there were defaults from 2007 to 2009, the losses have never exceeded the managers' ability to use cash flow to cover them, Bruck says. "They've managed to keep it whole and strong," he says.
Although there are risks to investing directly in mortgage pools and non-public REITs, Bruck says, he prefers that strategy to trusting assets to some of the huge public REITs. "The lessons of the 1980s were these huge public programs that sold through B-Ds," he says. "They were black boxes. The general partners had all the control. The fees were high. If it's not simple enough for me to understand, for a client to understand I'm not going to go near it."
By contrast, the due diligence in his mortgage pool "ran circles around what the banks were doing," he says. "And some of these borrowers could not get qualified with the banks."
THE BANE OF BAD LOANS
Some clients found themselves on the wrong side of the real estate crash. Parker, the advisor in Torrance, Calif., says some of his clients bought California vacation homes near Mammoth Lakes or in the desert near Palm Springs. Joe Graziano, a partner at FFP Wealth Management in Bayonne, N.J., says up to 10% of his clients bought second homes in Florida at the market's peak.