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Property Perks

The following article is from Financial Advisor Magazine written by Jerilyn Klein Bier

High-net-worth individuals scrounging for yield in a low-interest-rate environment and financial advisors seeking to differentiate themselves from the competition are increasingly knocking directly on the door to commercial real estate.

According to global research firm Real Capital Analytics, investment by private investors in commercial real estate in the U.S.—which sank to $31.6 billion in 2009 from a pre-crisis $172.2 billion—approached $176.9 billion in 2014. This applies to multifamily, industrial, retail, office, hotel and senior housing properties worth more than $5 million, and includes investments by high-net-worth individuals, family offices and developers/owners/operators who aren’t institutional investors, says Ben Thypin, director of market analysis at RCA.

Dani Evanson, a managing director with California-based RMA, a private real estate investment and advisory firm that serves the ultra-wealthy, says all its clients are interested in exploring and adding real estate to portfolios. As investors search for current cash flow, she says, “real estate is sort of the new darling in providing that.”

Meanwhile, a 2014 poll from Morgan Stanley Wealth Management found that among investors with $1 million or more in financial assets, 36% see opportunities over the next three years in commercial real estate (for non-residential purposes) while 53% see opportunities in rental real estate (apartments and single-family homes rented for residential use).

In 2011, Bill Militello launched Leesburg, Va.-based Militello Capital as a spinoff of his RIA firm after clients and prospects repeatedly expressed interest in real estate and private equity. That’s not surprising, he says, considering that most millionaires amassed their wealth through real estate and private operating companies. “Every high-net-worth client we talked to said we weren’t doing things differently than their current advisors,” he says—so he saw real opportunity in focusing on private alternative investments.

Over the last three years, Militello Capital, which partners with operators of properties, has been involved in nearly $400 million in commercial real estate transactions. Clients initially helped him develop a due diligence process, which he refined over time. “They would understand the investments better than I did because that’s how they made their millions,” he says. Today his clients are mostly RIA firms. “Our goal is to help advisors bring their clients closer to the deal,” he says.

Like others, he prefers not to focus on the lofty returns properties racked up during the recent real estate rebound because he feels it could mislead investors. But going forward, he thinks it’s reasonable to see cash yields in the high single digits and annual returns (cash yields plus appreciation) in the low teens.

Apartment communities are Militello Capital’s specialty. “No matter the economic climate, people always need a place to live,” he says. It invests in supply-constrained secondary and tertiary markets in the Carolinas, Tennessee, Georgia and Florida, which are seeing heavy migration from other U.S. regions. “We believe population drives rooftops,” he says, “and additional rooftops drive economic vibrancy.”

He favors properties that are “tweener-sized,” he says. “Too big and expensive for a couple of rich guys to buy on their own and too small for REITs to get out of bed and convene investment committees.”

His concern about REITs, he says, is they often rely upon short-term financing and the imprudent use of leverage. Instead, Militello Capital invests in properties that use leverage very modestly and fixes interest rates 10 years out so it can get through a full cycle despite what might occur in the capital markets. “It lowers yields in the short term,” he says, “but it means surviving rising rates.”

The firm likes to develop five-year exit plans for properties. It typically focuses on renovations and repairs in Year 1, raises rents in Year 2, and looks to refinance properties and return as much invested capital as possible to investors in Year 3. Investors continue to receive dividend checks during Years 4 and 5, he says.

Militello Capital recently closed on a 160-unit apartment community in Charleston, S.C., for $8.8 million and is investing an additional $1.2 million to renovate units and improve amenities. Charleston is where aircraft maker Boeing is building its Dreamliner plane, which Militello says is creating jobs and housing needs.

Militello Capital’s four-step due-diligence process includes doing background checks on deal partners and intermediaries, reviewing private placement memoranda, seeking well-articulated investment strategies and supporting data, and evaluating the frequency of reporting and audits.

Militello also conducts unscientific research. “If you observe construction cranes and lots of young people,” he says, “jobs and a fertile economy are likely to exist.”

Tangible and Transparent

Darryl Poisson, founder of DJP Wealth Management LLC, a Tampa, Fla.-based RIA, has been successfully introducing alternative investments to clients—the majority of whom have created wealth through real estate and their own operating companies. “They’re not stock market gurus,” he says. “They understand tangible assets.”

Poisson, who in his former career underwrote commercial real estate projects, says it’s difficult to research such deals because transparency is often lacking. Partnering with Militello Capital provides transparency and access to good deals, he says, and gives him ideas on how to position commercial real estate to clients.

He conducts extra due diligence on projects vetted by Militello, such as studying capitalization rates—annual net operating income divided by the value of a property. “As a fiduciary, I feel it’s my duty,” he says. He likes undervalued commercial properties with little leverage, good occupancy rates and strong management. “Cash flow tends to be very predictable,” he says, “and investors like this.”

Some of his clients prefer to invest in private commercial real estate funds, which enable them to own a variety of properties, while others prefer individual projects. When helping clients decide how to allocate to real estate, he considers their liquidity needs, their stage in life and their net worth.

“As a generality, real estate is a singles and doubles type business,” says Poisson. “We’re not attempting to hit home runs, but we never want to strike out.” Currently, he has investments in projects yielding 6%-plus. He doesn’t suggest deals to clients unless their anticipated total return—dividends and ultimate exit event—is at least 10%.

Secret Sauce

Pacific West Land LLC, a fund sponsor and real estate operator based on Bainbridge Island, Wash., seeks internal rates of return in the low teens and normally buys properties with all cash, says Martin Stever, president of the 35-year-old firm.

“The temptation when debt is really cheap is to pile it on, but that’s a good way to get killed,” he says, pointing to 2007 and 2008. He also thinks it’s important to work with private operators who have weathered a couple of down cycles. “When it comes to real estate,” he says, “having some gray in the beard really matters.”

Approximately 40% of Pacific West’s investors come through the two dozen fee-only RIA firms it works with. Its 65 properties, most of which are shopping centers, are valued at approximately $250 million, says Stever. They are largely located in secondary markets in the nation’s Southeast and Southwest, such as Phoenix, Atlanta and Orlando.

“We’re value buyers,” he says. “Our secret sauce is, we only purchase one out of 100 properties that we look at.” Pacific West looks at income potential, including occupancy rates and rents. It also studies demographics and traffic at intersections.

Based on the current stage in the real estate cycle, Stever thinks the correct strategy now is to buy properties for operating income, not capital gains. Pacific West is holding on to properties for 10 years. Investors must have “patient capital,” he says.

As a rule of thumb, high-net-worth individuals should have no more than 5% of their invested portfolio in commercial real estate, he says. He also feels they should have at least $2 million in investable assets. “If someone has $1 million in investable assets and a house,” he says, “their largest exposure is already in real estate.”

Stever says pooled investments, which allow investors to own a piece of multiple properties, are becoming more common as real estate transactions have gotten much faster. People also like the diversification they offer, he says.

Mike Ling, founder of Berkeley Inc., a fee-only RIA in Boise, Idaho, has used Pacific West for about a decade. His clients also have private placements in Capitaline Advisors’ U.S. Farmland Fund LP, which buys and leases crop farmland, and an equipment-leasing fund from SQN Capital Management LLC.

With interest rates and bond yields so low, properties that offer lease income are more appealing to him than raw land, which does not. He likes investments that avoid leverage and fee splitting and offer transparency. “With a lot of companies, it’s a black box,” says Ling. “We feel we can’t do that for our clients.”

Berkeley generally recommends that clients allocate 5% to private placements. When it tells clients about particular investments it would like to add to their portfolios, says Ling, “Nine times out of 10, they say, “This sounds good.”

“In a world that’s hard to differentiate yourself, it’s worth exploring alternatives in general,” says Poisson. “Commercial real estate is not a silver bullet, but it helps to diversify a portfolio.”