Litman Gregory has incorporated private equity real estate investments in client portfolios since 1988, and for many years Prana Investment funds have been our primary investment option. In 2009, we added Equity Resource Investments (ERI), a Boston-based real estate investment firm, as a second investment option. We have conducted extensive and ongoing due diligence on both organizations.
In considering private equity real estate, our investment philosophy is to emphasize value-added investment firms that can take advantage of market inefficiencies in specific real estate markets and find creative ways to enhance potential return and mitigate risk. More generally, we want more than just real estate market exposure. We want to find ways for Litman Gregory clients to benefit from market inefficiencies so we are not overly dependent on uncertain market trends to drive returns.
We view both Prana and ERI as highly skilled, creative, high-integrity real estate investment firms. Both have a long track record of success that Litman Gregory clients have participated in.
Prana primarily invests in inner city, multifamily real estate in Manhattan, the Bronx, and Los Angeles. A typical investment is a mismanaged building operating below potential that Prana can buy at a below-market price.
Prana can execute this strategy because of their deep knowledge of their markets and their significant operating and negotiating expertise. In addition, most of the buildings in these markets are owned by small operators, many of whom are not experienced investors. The result is a fragmented market where similar buildings sometimes sell at very different prices. This market dynamic presents opportunities for Prana given their expert knowledge of their markets. Over time Prana also relies on their property management expertise as they seek to improve their buildings, grow rents, and position them for sale at a price that will result in a healthy profit. They execute their approach while maintaining positive and respectful relationships with their tenants.
Litman Gregory first invested with Prana in 1988, and over the years we have captured strong annualized returns for our clients in many Prana investments. Returns have typically been in the teens and occasionally higher. Several Prana funds did struggle in the aftermath of the financial crisis period, and returns were much lower and temporarily negative in some years. These struggles were largely driven by structural factors that exacerbated liquidity problems. Prana has made structural changes that should materially mitigate this type of risk going forward. More recently, Prana’s building returns have experienced a strong rebound. To date, no completed Prana fund has had a negative inception-to-date return in almost 30 years of fund management. Nineteen of 25 completed funds have delivered double-digit annualized returns with a median return of 15%.
Prana investment funds generated very strong returns in 2016, and all the funds appear well positioned going forward. Returns on the individual funds will vary from year to year, though all Prana funds are now being managed based on the same objectives and strategy. Here are brief highlights of the individual Prana investments:
Prana Current Yield Fund V is a new fund launched this month.
Equity Resource Investments (ERI)
ERI is a deep-value, often activist, real estate investment firm that has been around for over 30 years. Unlike Prana, they are not a real estate operator. ERI leverages their extensive industry network built over 30 years to pursue significantly undervalued real estate opportunities in inefficient and specialized segments of the real estate market.
ERI funds are well diversified geographically and in terms of number of properties. They mostly focus on multifamily real estate (55% to 70% of most funds) but also tend to have investments in most other types of real estate. We believe that their investment approach is unique. It incorporates factors that mitigate risk and enhance return by (1) applying demanding criteria that include bargain pricing and 20% gross hurdle-rate returns based on conservative assumptions, (2) seeking out and negotiating joint venture deal structures that give their funds preferential returns and multiple sources of return, and (3) focusing on opportunities to add value, often in niche markets and/or complex situations that are a deterrent to other investors.
Over its long history, almost all completed or nearly completed ERI funds have generated annualized returns in excess of 20%. Their worst return is likely to be in a fund that invested just before the financial crisis. This fund is still in progress and looks likely to deliver a return of just over 10%.
Litman Gregory clients are invested in ERI Fund 2009 and ERI Fund 2015, and just recently new investments were committed to ERI Fund 2017. (Note that ERI funds have higher minimum investments than Prana funds and are not practical for investor portfolios of less than $5 million. Whether a client is in a particular fund is a function of various factors specific to their investment portfolio, goals, and circumstances.)
The Real Estate Private Equity Opportunity
Over the life of Litman Gregory, our private equity real estate investments have added materially to our clients’ investment returns, though there have been some relatively short periods when this was not the case. Going forward, we believe realized returns for new investments and for funds invested more recently are likely to be lower than they have been on average in recent years because markets are selling at higher valuations. However, based on our analysis, we believe low double-digit returns are still attainable and likely. Funds invested in the first half of this decade may deliver higher returns by the time they fully liquidate their portfolios. Of course, there is no guarantee, and we can imagine scenarios where returns could be lower. But an important consideration is that we believe both Prana and ERI invest in a way that skews the odds in investors’ favor and, more specifically, they seek out investment opportunities where there is an opportunity to materially impact the realization of value and return. This enhances their ability to deliver returns in any environment.
The primary risk to this outlook is a severe recession—something worse than the run-of-the-mill recessions Prana and ERI have successfully navigated prior to the financial crisis. We also believe the funds would be competitive with financial assets in a rising interest rate environment though absolute returns could be lower. There are more challenging scenarios (rising rates without rising rents) that would not be good for Prana and ERI, but these would likely be difficult environments for other equity-oriented investments. A catastrophic earthquake would also pose a risk to Prana’s Los Angeles properties, though these properties make up much less than 50% of most funds.
The context of our analysis is the 28 years we have been investing with Prana and the almost 10 years investing with ERI. We believe that our ongoing analysis and familiarity with their investment models and capabilities gives us a deep understanding of the opportunities in their markets and their potential and risk in different environments. The potential is materially impacted by the expertise, execution skill, and strategies employed by the two firms.
Importantly, we are always comparing investment opportunities, and while we believe prospective returns in these specific private real estate investments are lower than in the past, we also believe they continue to stand out compared to what we expect from stocks and bonds over our investment decision horizon.
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Actions to Take in Uncertain Times
In a volatile environment like the one we find ourselves in today, and experienced just two years ago in 2020, we recognize that some investors feel as though they should make changes in their portfolios—even if just to take action.
Research Update on Market Volatility
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Commentary from Our CIO—First Quarter 2022
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