Nothing could be sweeter to a wealth manager's ears than the words "dislocated markets," and no sector has suffered more dislocation in recent years than real estate.

Developers, syndicators and other real estate mavens who made killings buying foreclosed commercial and residential properties from developers and banks in the 1990s are again on the prowl, soliciting institutional and wealthy individual investors to participate in still-distressed real estate markets that began unwinding three years ago.

Investors can participate in numerous ways-by investing in private partnerships and funds that buy loans, by investing in mortgage-backed securities or by investing in property that comes directly from delinquent borrowers or banks or from the Federal Deposit Insurance Corp.

Since the start of 2009, 71 funds have raised $42.5 billion from institutional investors to buy distressed real estate or real estate debt, according to Preqin, a London-based alternative investments research firm, and several feed funders are now available for wealthy individual investors and family offices to participate in these portfolios.

Starwood Capital Group, whose founder Barry Sternlicht built a hotel empire on the back of the 1990s real estate recession, persuaded investors to put about $950 million into an initial public offering for a blind real estate pool last year, and this year raised $2.8 billion from high-net-worth and institutional investors in two new "opportunistic" funds. Brookfield Properties and its majority owner, Brookfield Asset Management, in July announced plans to amass $4 billion to buy distressed real estate firms and portfolios.

Individual investors, not surprisingly, are clamoring for action. They've bid up publicly traded real estate investment trusts to become the year's hottest stock fund sector, and wealthier investors and their advisors have followed the smart institutional money into small private pools aimed at distressed real estate.

They're also pouring billions of dollars into wrap vehicles. Thirty-three real estate funds of funds have raised $6.1 billion since 2008, according to Preqin; that includes $900 million raised through six funds in the first nine months of this year.

With so many vehicles available, dare advisors resist operators' whisperings of 20% returns or more in the distressed market, or the pleas of yield-hungry clients eager to shop in the bargain basements of commercial and residential real estate?

It's irresponsible to ignore such opportunities, many advisors say. But then they must also quickly learn that real estate demands more homework about the quality of managers and the liquidity needs of clients than perhaps any other asset class.

"There has been dislocation on a massive scale, and significant disruptions in any market are going to lead to capital being raised and opportunities pursued," says Benjamin Dickey, the director of wealth management services at Reinhart Partners Inc., a Milwaukee-based RIA with $3.2 billion of assets under management for institutions and wealthy individuals. "But that doesn't make this appropriate for everyone."
Investors in distressed real estate must be comfortable tying up what can be a significant percentage of their taxable investment assets in illiquid vehicles, he says, and have the patience to wait at least five years-and perhaps as long as ten-for the investment sponsor to make good on the returns they seek.

After scouring the distressed real estate scene since 2008, Dickey has put three vehicles on his approved list. One is the Michigan Avenue Real Estate Opportunity Fund, which is affiliated with Chicago's Reinsdorf family. The fund has raised $10 million to date and invested in two condominium buildings and a rental apartment complex in the Windy City. The second vehicle Dickey likes is a private placement from Dallas-based Macfarlan Capital Partners LP that invests in southwestern commercial properties. The third is the American Realty Capital Trust, a non-traded REIT that buys debt and equity issued by owners of properties leased by well-known retail chains. (The REIT is distributed through RIA custodial platforms and brokerages.)

The common thread among these funds' managers, Dickey says, is their financial and operational experience and their predilection for investing in local markets that they know well. These managers also avoided the inflated prices that prevailed just before the 2008 real estate meltdown.

"In any asset class, we look for managers who have strong convictions but know they don't have all the answers," Dickey adds.
One of the core problems facing advisors in the market is that distressed real estate spawns hordes of so-called experts in local markets who think they can rehabilitate, rent and flip properties purchased with other people's money.

"It's an amateur hour production," says Rick Ashburn, the founding principal of Creekside Partners, a Northern California RIA that manages almost $69 million of assets for 45 families. Ashburn, who's based about 75 miles from Sacramento-what he calls the foreclosure capital of the west-has been deluged with pitches to buy distressed debt and foreclosed homes through private placement offerings.

"Operators are coming out of the woodwork, but real estate isn't like stocks," he says. "It's a really complicated investment and the decision isn't about the asset class but about whether the guys know what they are doing."

Ashburn has resisted investing in residential deals, and has not yet found compelling ways to exploit the acres of distressed office buildings, apartment complexes, industrial parks and other commercial real estate littering the landscape. "We'd love to buy something, but there isn't any major play on distressed commercial property," he says.

Several of his clients are commercial property developers that have been searching for opportunities but have yet to find banks or troubled property owners willing to sell at realistic prices. "Yields are still just 5% to 6%," he says.

The weak supply isn't limited to the retail market. One of the great ironies of the property-induced recession and its lingering effects on the economy is that even the largest and most experienced real estate managers haven't been able to put their money to work.

"There's almost nothing for sale," Sternlicht told an audience of high-powered investors and financiers at a panel on commercial real estate at the Milken Institute's global conference in Beverly Hills last April. Banks or their regulators are reluctant to sell deeply impaired loans and foreclosed properties at deep discounts, and other troubled assets are trapped in complex commercial mortgage-backed securities.

"A huge amount of money was raised to invest in distressed opportunities," Richard LeFrak, chairman and chief executive of the LeFrak Organization, a huge residential apartment developer, said at the conference. "I'm not sure that we're gonna see [those] opportunities until such time as the gridlock that's inside the banks ... inside these complex structures, start unhinging."

When distressed assets do become available, these managers say, yield-hungry neophytes overpay for them in bidding wars. Sternlicht, for example, says he bid 57 cents on the dollar for a pool of assets being offered by the FDIC that turned out to be 42% below the winning bid.
Any strong properties or loans that are up for sale are being seized by publicly traded REITs, which have easily been outbidding private competitors, LeFrak said. Part of the public funds' strength is that they've been able to raise capital cheaply from investors who have become satisfied with dividends of 3%.

With so much money chasing so little supply, funds are returning money. At least 19 distressed funds have returned more than $6 billion of total equity to their limited partners since 2008 (or made plans to return it), according to the newsletter Real Estate Alert, reporting in April. Other funds have released investors from their capital pledges in return for extending investing deadlines on money already committed, the newsletter added. (The publication has not updated those April findings, however.)

The good news, says Michigan Avenue President Thomas Meador, a former executive of American Express' Balcor Co. realty group, is that bank regulators in some regions are beginning to pressure more lenders to take capital hits and unload some of their distressed assets. As more supply comes into the market, Michigan Avenue-which takes minimum investments of $250,000 and touts targeted internal rates of return of better than 25% over five to six years-plans to raise more money from advisors and develop custom funds for family offices, says Jonathan Reinsdorf, a senior vice president of the firm.

Private distressed real estate funds generally charge the standard limited partnership management fee of 2% of assets raised and 20% of realized profits, advisors say. Lower-yielding non-traded REITs take investments as low as $10,000 and charge management fees of 1% to 1.5% while keeping about 15% of the performance gain.

Experienced real-estate operators, ranging from giants such as Starwood Capital to niche managers, say that opportunities today go beyond direct investing in properties. These managers are also being approached by delinquent borrowers to design custom solutions. Such solutions might allow borrowers to find ways to repay bank loans and maintain at least a small interest in their properties.

"The product today is with existing borrowers who have defaulted on their loans but still control the assets," says Mark Bolour, the 38-year-old chief executive of Bolour Associates, a family office in Los Angeles that expects to make $200 million of bridge loans and other financings in exchange for a majority stake in the borrowers' properties through 2012. Bolour, who invests his family's capital as well as money for other family offices, says many investors prefer direct financings to passive investing in funds. "Since the meltdown, they don't trust many fund managers and they're not interested in owning a tiny percentage of a fund that's invested in 50 different properties," he says.

Bolour targets 10% to 12% returns on debt and internal rates of return of 25% or higher on equity.

Fund managers say the problem isn't trust as much as it is persuading investors to emerge from the lingering shell shock induced by the 2008 meltdown. "Their biggest concern is liquidity," says Reinsdorf, noting that his Real Estate Opportunity Fund plans to begin paying dividends early next year to limited partners out of the rents and other cash flow generated by fund properties.

Alexander Haverstick, whose New York-based firm Boxwood Strategic Advisors specializes in improving cash flow for wealthy investors, isn't convinced. The wealthy clients he works with are concerned about the weak economy and are generally loath to lock up money in workout situations.

"Real estate used to be about location, location, location," he says. "Now it's about liquidity, liquidity, liquidity."