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."