The changing role of the private investor - real estate investment - Mid-Year Review and Forecast

It is axiomatic that investment activity has increased and that equity capital is readily available today for real estate investments. With increased competition for attractive real estate transactions, it is proving to be more difficult today to find the opportunistic real estate deals that were available over the past few years.

As a private investor, Intertech Corporation engaged in acquiring distressed properties in what was customarily described as a down market: the years between 1991-1995. Because of the shortage of both debt and equity capital for real estate assets during this time, our acquisition strategy benefitted from asset pricing discrepancies and capital inefficiencies. We were purchasing hotels, commercial buildings and residential developments at deep discounts to replacement costs, and at attractive double digit unleveraged cash-on-cash yields.

In addition, developers, strapped for capital, could not demand a significant amount of sweat equity. Between 1991 and 1996, which reflected the trough in the real estate cycle to increasing recovery, Intertech achieved, on an annualized basis, an exponential return on equity for its real estate investments. Certain real estate assets that were purchased during this time were not looked upon as a long-term hold in our portfolio, but were viewed instead as a mispriced commodity suited to be traded and sold when the disequilibrium between supply and demand stabilized.

Today, with a flood of equity investors and the perception that real estate is an attractively valued asset on a risk-adjusted basis, the cost of acquiring real estate is rising sharply. Generally speaking, across particular real estate asset classes, there has occurred an equalization in the supply/demand equation, whereby the overhang of properties, due to the overbuilding in the 1980's, no longer exists. Indeed, vacancy rates have gone down in most markets and there is a perception that the risk is quantifiably removed. This is in sharp contrast to what the real estate pundits believed would occur when they wrote their predictions just five years ago. The buyers today are not the institutions of the 1980's, and since supply always rises to reach demand, there are plenty of deals to support the ever-increasing cheaper sources of equity capital.

The public Real Estate Investment Trusts and "opportunistic funds" created in the last couple of years are the acquirers, and they are buying these assets at close to or at replacement costs. Their cost of capital is much less pricey than for entrepreneurial capital since they have continuing access to the public markets to raise funds at more attractive rates than the private borrower. Therefore, we, as a private investor, are constantly looking for niches where there are inefficiencies in the market.

Evolving economic environments call for investment flexibility, as well as discipline. As the market has recovered, the nimble private investor looks to new development or redevelopment opportunities, but only where the exit strategy is clear, notably, a sale to a REIT or attractive refinancing opportunities. Thus, the financing of real estate assets, once thought to be uncorrelated to the public equities market, is now heavily dependent on the REIT stock market environment. And private investors, who traditionally have treated real estate as a hedge against inflation and as a long-term hold, are now focusing on a shorter term holding period.

The importance of a clear exit strategy is central to an effective investment strategy today, so as to avoid the pitfalls of having a continuous illiquid investment. Furthermore, the structure of REITs has made it very advantageous for private owners - for estate and income tax planning purposes and with the proper planning - to sell their real estate portfolios to REITs, since they can avoid capital gains tax with the sale. For these reasons and with the consolidation of the REIT industry, there will be greater and greater shifts of real estate assets from the private to the public sector.

So what has been Intertech's activity in 1997? In early 1997, Intertech made headlines with the sale of HEI Hotels LLC, a Connecticut-based hotel operating company in which it held a major interest, and 10 hotel properties that it owned in joint venture with PRISA II, an institutional real estate fund managed by Prudential Life Insurance Company. That package was acquired by Starwood Lodging Trust, the nation's largest public hotel real estate trust, for $327 million. (Intertech had begun buying full-service hotels in 1993 at deeply discounted prices and sold its portfolio to PRISA II in May 1995; it then re-invested some of its profits into the joint venture with PRISA II and HEI Hotels and acquired the interest in the operating company that was ultimately sold in 1997 to Starwood Lodging Trust, along with the assets.)

Intertech is slated to start construction on a new 260,000 square-foot speculative of rice building during the fall of 1997 in Reston, Virginia. This building is the first phase of a 960,000 square-foot office portion of Plaza America, a mixed-use project. Intertech successfully developed a 165,000 square-foot community retail center in late 1995 as part of the Plaza America project. The decision to start a speculative office building at this time was based upon strong absorption rates and a vacancy rate of 4 percent in the Northern Virginia market.

In New York City, Intertech has begun the redevelopment of the retail portion of its 475,000 square-foot building known as Times Square Plaza at 1500 Broadway. When completed, Times Square Plaza will have approximately 70,000 to 90,000 square feet of retail space developed for various retail users that are unique to Times Square. In addition, Intertech hopes to maximize the value of its building through the creative and strategic placement of super signs on various parts of its building.

Although Intertech's capital can service opportunities, especially in overlooked and developing niches, we do not expect to achieve the same significant returns going forward as we have achieved during the past seven years, during the early stages of the real estate recovery. The market has matured, whereby real estate valuations have increased and the equity, coming substantially from the public markets, is very competitively priced. Intertech hopes to continue to apply the discipline to avoid entering into real estate transactions where the reduced returns do not justify the risk.

Currently, we see opportunities in the senior living arena because, like hotel investments, they both have day-to-day operational characteristics, as well as a real estate component. More important is the demographics and the economics of the aging population that indicate to us that the high-end of the senior living facilities support investment and development.

The entrepreneurial and opportunistic investor/developer will take on the risks for zoning and site selection that the large operating companies may not. Hence, there is a classic opportunity here for significant added value.

COPYRIGHT 1997 Hagedorn Publication
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