Private Equity Real Estate Update

April 13, 2017

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 Investments

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’s three Exchange funds did well (these are non-liquidating funds that defer capital gains and provide periodic valuations).
    • Prana Growth Fund I, Prana’s largest fund, returned 15% during 2016. The fund has experienced a major makeover of its portfolio recently; 39% of its portfolio was purchased in the last two years. About a third of the fund’s equity is held in four old, large Manhattan properties that Prana believes have large imbedded gains. They expect to sell these buildings over the next two to three years. They also plan to market and sell the majority of the fund’s other older holdings this year. This group of buildings constitutes just over a quarter of the portfolio’s equity. More than half were recently in contract to sell.
    • Prana Growth Fund II returned 11.3% last year. This is a smaller fund with a 10-building property portfolio. Similar to Growth Fund I, Prana management expects a high level of sales activity this year and three buildings are already in contract to sell. The two funds have identical objectives.
    • Prana Realty returned 9.9% in 2016. This is a private REIT fund designed for retirement plans, foundations, and other tax-exempt entities. About half the fund’s portfolio was purchased in 2008 with most of the rest purchased in 2016. The older buildings are throwing off very high cash flows and Prana management expects to sell them over the next 18 months. The fund continues to pay an 8% cash yield and over the next year or so returns are likely to be in line with the yield.
  • Prana Current Yield Fund I sold the last of its buildings in the first half of 2017. The annualized return to investors over the life of the fund was 27.7% (significantly beyond our expectations). (Note: the annualized return for any specific investor can vary slightly based on when they entered the fund.)
  • Prana Current Yield Fund II sold three buildings during 2016 (out of a portfolio of 11 buildings). They have now sold four buildings since the fund’s inception at an average annualized return to investors of 31% (the lowest single building return was 24%). The building returns along with income distributions resulted in an investor return for 2016 of 28.3%. The fund also made distributions of capital in 2016 from the building sales. As of early this year, the fund’s largest holding is in contract to sell at a sizable profit and is expected to close shortly. Prana expects to sell the fund’s remaining properties over the next two years. So far returns have significantly exceeded our initial expectations, and we believe that is likely to continue. We believe the remaining buildings in the portfolio have material imbedded gains.
  • Prana Current Yield Fund III is now fully invested, mostly in Bronx properties. The building portfolio includes a group of troubled/grossly mismanaged properties the fund bought from an institutional investor at a very attractive average multiple (the price Prana paid relative to the rent roll). The attractive price bodes well for the fund’s ultimate returns. Prana has fixed the management problems and expects to begin selling some properties this year. The cash yield on the fund was 8% in 2016. The average rent increase through the end of last year on the fund’s properties was 8% (most of the properties were purchased in 2015). Though we don’t believe this fund will generate returns as high as Current Yield Funds I and II, we believe it is well positioned and could capture a return in the mid-teens.
  • Prana Current Yield Fund IV is still in its acquisition phase. It owned 10 properties in the Bronx and Los Angeles at the end of 2016, and management expects to complete its acquisitions in the first half of 2017, including one Manhattan building. The fund is paying a 4% cash yield, and it should grow over time. Prices on building purchases have moved higher (though borrowing rates remain low), and for this reason we expect this fund to deliver a lower return than prior Current Yield funds. Nevertheless, we believe the fund will likely deliver a low double-digit return that will compete well with most financial assets.
  • (Prana) City Finance Company notes made their 9% interest payments. These notes have never missed a payment and are expected to mature over the next year. Prana is unlikely to issue more notes.

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.

  • They often seek out broken and dysfunctional ownership structures where their ability to help fix the problems can lead to outsized returns.
  • They are willing to look at niche markets and smaller deals where bigger players are less active.
  • They are a partnering organization. Their ability to contribute capital (alongside the deal sponsor), their high-level problem-solving skills, their speedy decision-making, and their deep network allow them to partner with skilled real estate operators, often participating in back-end and other deal-related fees in addition to the direct real estate returns. Many of their investments are partnering opportunities.

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.)

  • ERI Fund 2009 had a strong year in 2016 and has already delivered a sizable return even though a meaningful portion of the fund’s portfolio is still invested. The fund had profit and income distributions equal to 19.9% of remaining investor capital in 2016 and made additional distributions in January of this year. Since the fund’s inception through this January, investors have received distributions of $434,000 for each $250,000-unit investment (amounting to 174% of the original investment). The annualized return (IRR) since inception is 16%. And with a third of investor capital still invested, this return will increase over time as more investments are liquidated.
  • ERI Fund 2015 has now called almost all its investor capital and has made 37 investments encompassing 225 properties. The portfolio is geographically diversified, with an emphasis on multifamily properties. Investments include a focus on niche areas that ERI has capitalized on in the past, such as low income housing and tenancy-in-common portfolios. The fund’s investments are consistent with ERI’s focus on niche markets and opportunities, complex situations, broken ownership structures, special situations, and opportunities to joint venture and share in sponsor profits. The fund expects to call the last 15% of its capital by the end of 2017. To date the fund has committed 96% of its capital to specific investments. Most of the fund’s investments are underwritten to target a minimum annualized return of 20% (at the fund level, so this is before ERI’s fees).

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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