The 1980s savings-and-loan crisis, in which hundreds of thrift institutions, staggered by bad mortgage loans, were taken over and bailed out by the federal government, came to a head when that era's real estate boom petered out.

Terrell Gates, a third-generation real estate investor, owner and operator, witnessed the havoc up close. "My family lost it all in the 1980s during the real estate S&L crisis here in Texas," he says. "That experience is indelibly printed on my mind to say the least. My experiences from the past inform what's going on today."

What's going on today is a much happier scenario. Virtus Real Estate Capital, which Gates founded in Austin, Texas, in 2003, is raising its 35th private equity fund. The firm has bought 127 commercial properties over the past decade, some $1.7 billion in acquisitions, and divested itself of 24 of its partnerships. The majority of its assets have been sold.

"We've been fortunate and blessed to have a very strong return profile and track record," Gates says.

Early on, Virtus invested in commercial real estate deal by deal, with most of its capital coming from family offices and institutions, according to Gates. Eventually, it moved into blind pool investing through discretionary funds. In 2008, it entered the retail channel. Today, Virtus's client base comprises high-net-worth accredited investors, some of whom come through broker-dealers and others through RIAs; traditional institutional investors; and ultra-high-net-worth foreign investors who come mainly through an offshore note structure.

The firm employs 35 people in its corporate office and oversees another 120 or so who work for its property management companies.

Bracing For The Storm
In late 2006, Gates and his team met to review the firm's success during what he calls "the rising tides of all rising tides of commercial real estate," and to look ahead. Since opening, Virtus had posted "ridiculous returns" and rewarded clients handsomely. Now, they wondered how they were going to replicate the success of the past going forward.

"We had no idea 2008 was coming, but we did perceive storm clouds on the horizon," Gates says. The majority of their assets had been in "basic food groups": mainly multi-family assets. But when they could no longer "buy right"-for the right valuation among other things-they figured things were probably going to change, and not for the better.

"Our challenge became, how to insulate ourselves from capital market, economic and real estate market cycles-none of which we control," Gates says. "If we could find non-correlation, we could have more insulation during the downturns."
The upshot of this strategic brainstorming was a decision to focus on four demographic trends and the specific types of commercial real estate these would demand. "Our thesis," Gates says, "was that if you could figure out the real estate needs of these major demographic trends-which are going to happen whether the S&P is up 50 points or down 50 points-that would provide you some of the insulation you were looking for."

The demographic trends in their analysis:
  The leading edge of the 78 million Americans born into the baby boomer generation was moving into retirement and had growing health-care needs.
The 74 million offspring of boomers, the Echo Boomers or Millennial generation, was coming of age.
The Latino market in the U.S.-46 million and counting-was growing, and constituted the largest minority group in the country.
The U.S. population was highly mobile, owing to the transitory nature of employment, among other social forces.
The Virtus team identified investment opportunities in four sectors that would directly benefit from these trends. Aging and longer-living boomers were going to need senior housing and medical offices to meet their accelerating health concerns. Echo boomers would require student housing as they headed off to college. And individuals following the job market would increase demand for self-storage facilities, as would empty nesters and boomers downsizing their households.

In Search Of  'Opportunistic Scenarios'
Gates describes Virtus's investment strategy as "income plus growth," and its methodology as "opportunistic acquisition through value-add upside." He says this combination distinguishes it from other private equity real estate managers.

"Most opportunistic or value-add private equity real estate funds typically have little to no cash flow," he says. "They're more if-you-build-it-they-will-come strategies-in other words, much higher risk. We, on the other hand, are income plus growth; so even though we have a private equity return profile, we want half or more of our total return coming from current cash flow."

Virtus's approach is to get in, buy right-acquire most properties off-market or through opportunistic scenarios involving some kind of liquidity-constrained seller-then put in place best-in-class institutional-quality operations through its different operating partners. It strives to grow the net operating income through five different value-adding techniques, and either does a cash-out refinancing or sells the asset individually or in a portfolio. The process takes three to four years.

Virtus buys most of its assets off market, usually from smaller or regional operators. It has very specific criteria for underlying properties; for example, at least 20,000 people must live within a three-mile radius of a self-storage facility to ensure there's sufficient traffic in front of the property.

Gates says that over the last two years, Virtus has been making more opportunistic acquisitions, involving liquidity-constrained sellers. Some are lenders, others are owners who face a maturing loan or have broken through a covenant. In these cases, Virtus will recapitalize the opportunity. "We're very creative about how we go about getting to these," Gates says. "Maybe we'll get a discount on the note and then bring them back in in a joint-venture partnership."

Virtus's overall guiding investment strategy is the same across all four property types. The investment concept and property type have to be viable in all parts of the cycle-whether the year is 2004 or 2009.

In addition, there must be a way to mitigate structural risk. "We want multiple ways of getting our money back out of a deal," Gates says. The firm's favorite one is current and sustainable cash flow. "If I can buy an asset today that's throwing off strong current-preferably double-digit-yield at the property level and there's upside through value-add operational efficiencies, then to me that's the best of both worlds."

Returns need to be commensurate with risk because commercial real estate ultimately is an illiquid asset-"something I learned very well here in Texas during the 1980s," Gates says. Virtus seeks to generate at least 20% returns per annum from each of the properties it buys, with half or more of that coming in current cash flow.

The firm executes each property's underlying business plan through an operating partner, a domain expert in the particular niche who will take the property from where it is at acquisition to where it needs to be from an income perspective at sale.  
Last year, Virtus bought a large Class A self-storage asset in a major urban area that was overbuilt and overlevered. The firm had previously dealt with both the lender, who wanted to get rid of the note, and the borrower, who simply wanted to get out from under the recourse loan. Virtus executed a deed in lieu of foreclosure with the borrower and purchased the note at a discount-"a very cooperative situation," Gates says.

And a profitable one. Virtus bought the property for about $2.9 million, a significant discount to fair market value. After the closing, a new appraisal valued it at $5.3 million, an 87% increase in fair market value and a 141% unrealized equity ROI. "That was before we actually improved the operations," Gates says. "Now, we've taken it over and plugged in one of our institutional operators, who has already enhanced the net operating income fairly meaningfully in just the last six months."

Another recent acquisition, with one of its operating partners, was an off-campus student housing property across the street from Georgia Southern University. The Class A 2006 construction was an attractive investment because the university had had a 22% enrollment growth rate over the past five years that was expected to continue, Gates says.

Virtus recapitalized the existing equity, then converted its equity into preferred equity, which would give it both priority on cash flow and liquidation preferences in the event the property had to be liquidated. The firm underwrote a 12% yield in the first year, but has been generating closer to a 15% yield, according to Gates. It is now improving the property and increasing rental rates in order to grow the net operating income. It will ultimately exit the property sometime in the next couple of years.

The firm's newest fund, the $500 million Virtus Real Estate Capital LP, will invest in all four property types. For the RIA share class, the targeted yield is about 9%, and the targeted IRR for a five-year hold is in the high teens to low 20s. The new fund is unusual, Gates says, in that it's a limited partnership and provides public reporting. This structure is intended to be attractive to both high-net-worth and institutional investors.

"It's still private equity real estate, but by providing public reporting, it gives greater transparency, and that allows us to have an unlimited number of investors in our retail share class," Gates says. In addition, he adds, the investors, as limited partners, ultimately own the underlying real estate, so they get all the pass-through benefits of depreciation and accelerated depreciation.