Opportunity funds shift tactics, goals to maintain returns - Focus On: Banking & Financing

OPPORTUNITY: "An appropriate or favorable times" says one venerable dictionary. And nothing could better fit that description for astute real estate investors than the year 1991. As the Resolution Trust Corporation prepared billions of dollars of assets for bulk sale in the ensuing few years, there were "opportunity funds" that purchased deeply discounted mortgages and properties, some of which proved to be huge bargains.

As a result, some opportunity fund investors are accustomed to annual returns in the range of 15 to 20 percent, and the opportunity funds themselves have become an established real estate industry segment and a significant capital source.

However, as the real estate market continues its sustained recovery, where will the opportunities be found to keep investors happy? The answer begins with recognition that the modus operandi of the funds has changed. Since it is no longer possible to snap up promising assets at 40 or 50 cents on the dollar, most of the funds are re-examining their strategies for maintaining appealing yields.

Rather than searching for the best fire sales, the basic goal now is to work with the inefficiencies between the real estate and capital markets. A common approach is to buy assets and maximize their value. No doubt, this falls into the category of "easier said than done." But in fact, it is being done, because today's complex market environment presents many situations in which sellers do not - or cannot - exploit full market potential.

Some of the reasons are: A financial institution held on to a foreclosure to recover its loss and now wants out of the real estate business; an owner lacks the wherewithal to tackle zoning issues for redevelopment; a property needs re-tenanting or re-positioning; or perhaps environmental remediation is necessary or a note requires re-structuring. All of these situations offer the opportunity to enhance returns by adding value.

It is also important to note that opportunity funds use leverage as a means increasing returns. The use of leverage is unrelated to the pre-1986 tax strategies that were abolished by tax reform legislation, and which encouraged unneeded real estate development almost solely to generate tax losses. Equally important, the leverage is applied to acquisitions with a shorter time horizon. Value enhancement and defined exit strategies are two of the characteristics that distinguish today's opportunity funds from their predecessors.

An option undergoing active evaluation today is the formation of strategic relationships with private operating companies. The appeal of this idea is that a real estate operating company would provide a fund with an alternate access to transactions and local market expertise. In return, the operating company strategically aligned with a fund would likely enjoy expanded access to the capital markets and reap the benefits of the fund's expertise. It could also offer a means of retaining the firm's identity in an era of intensifying consolidation.

Realism dictates the recognition that circumstances have changed, and the opportunity funds must prove their mettle by working smarter to maintain above-market returns. This is a good sign for the entire industry because it means the word "distressed" is slipping ever farther into disuse in the real estate lexicon.

COPYRIGHT 1997 Hagedorn Publication
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