About two years ago, Thomas J. Barrack Jr. acquired a gaming license. That might seem odd, considering Barrack's position as chairman and CEO of Colony Capital LLC, a Los Angeles-based real estate opportunity fund manager. In addition, the process of acquiring a gaming license requires an individual to open up every aspect of his or her life to official scrutiny. Why would Barrack take on that kind of inconvenience?

“No other financial players are licensed to own gaming companies,” Barrack said. “No one wants to go to the trouble.”

In fact, Barrack welcomes inconvenience in matters such as these. He considers it a way of stacking the deck in his favor. License in hand, Barrack and his Colony Capital opportunity fund purchased an operating casino company, including its casino properties, reorganized the company, and sold it to Harrah's for $700 million.

The wildly successful transaction involved a lot of work and just a little bit of gambling — which is just what opportunity fund managers like.

Managing an opportunity fund is like wandering between cracks in the financial and asset class markets and searching for inefficiencies, according to Barrack. “When you find inefficiency, you find opportunity,” he explained.

Unlike core and core-plus real estate funds, opportunity funds, in search of high returns, tend to buy and sell real estate like stocks. The mantra is buy low and sell high, just like an aggressive equities investor.

But that doesn't mean taking elaborate gambles. Unlike stock pickers, real estate opportunity fund managers don't search for public companies whose value might rise. Instead, they look for properties with unrecognized existing value and find a way to tap that value. It's a risky business, but far less risky than a simple roll of the dice.

The role of opportunity funds

By exercising flexibility far above and beyond what traditional real estate fund managers have at their disposal, opportunity fund managers have given investors a new angle on real estate.

For example, opportunity funds now appear in two different pension fund investment categories. Some institutions perceive opportunity funds as real estate, but others view these funds as private equity and place them in the same category as leveraged buyout funds and venture capital.

Traditionally, real estate comprises only 5% to 10% of an institution's investment portfolio. And about one-quarter of that amount is dedicated to opportunity fund investments, according to Carol Broad, director of real estate research with Russell Real Estate Advisors, a wholly owned subsidiary of the Frank Russell Co. of Tacoma, Wash.

Then again, opportunity funds might not show up in a real estate allocation at all. “We have a couple of clients that have moved their opportunity fund investments out of the real estate portfolio and into their private equity portfolios,” Broad said.

The reason for this movement toward the private equity category lies in the nature of the returns generated, or at least promised, by real estate opportunity funds. Instead of the 8% to 15% returns typically sought by core and core-plus (sometimes called value-added) real estate funds, opportunity funds reach for the brass ring and aspire to double their investors' money in three to five years by generating annual returns in excess of 20%.

Clearly, opportunity funds represent a different category of real estate investment. They promise extremely high yields and come with the risky potential for extremely high losses. As a result, some institutional investors do not want these funds in their real estate portfolios.

Whatever portfolio a pension fund assigns to handle its opportunistic real estate investments, fund managers can choose from dozens of opportunity funds that have sprung up in the last 10 years. While little published data delineates the opportunity fund industry, analysts estimate that the market includes between 50 and 100 fund companies.

Perhaps the most comprehensive study ever conducted on opportunity funds was issued in April of this year and is titled, Real Estate Opportunity Funds: The Numbers Behind the Story. The study's author, Nori Gerardo Lietz of the Pension Consulting Alliance Inc. of Portland, Ore., examined 187 opportunity fund limited partnerships formed by 55 firms between 1988 and 2000.

Equity commitments to opportunity funds grew from $750 million in 1990 to approximately $71.4 billion in 2000, according to the study's findings.

Formerly known as vultures

Opportunity funds emerged in the aftermath of the savings and loan (S&L) and banking crises of the late 1980s. In the early 1990s, the Resolution Trust Corp. (RTC) — a federal agency created in 1989 and later disbanded — seized the assets of failing financial institutions.

A handful of firms recognized opportunity in the mess. Those firms included Goldman Sachs, Morgan Stanley, Apollo Real Estate Advisors, Colony Capital and six or seven other companies.

In 1990, Colony Capital created a partnership with Stamford, Conn.-based GE Capital and purchased West Coast Acquisition Partners, or W-CAP, the first pooled RTC portfolio. The face value of the real estate in that portfolio was $1 billion.

Over the next four years, the RTC sold $400 billion in real estate to other opportunistic investors. “It was a basic idea: Buy when everything is down and sell when it goes back up,” Barrack said.

The vulture funds, as they were called at the time, bought real estate portfolios for 20 cents to 30 cents on the dollar. Frustrated bankers accepted the deals because no one else had any capital.

Successful vulture or opportunity funds don't — and still don't — buy anything without having a good idea of who will take them out of their investment and provide the profit. In this case, desperate original owners took the vultures out.

The vultures sold the real estate back to the original owner/developers at something like 60 cents on the original dollar. “We also loaned about 70% of the purchase price to the developers,” according to Barrack.

The circular transactions carried prices low enough to ensure that owners could pay the debt, plus interest, to the funds handling the finances. “In that period, we were making incredible returns, north of 70%,” Barrack said.

Other funds sprang up. Most produced massive returns. Starwood Capital Group LLC of Greenwich, Conn., for example, completed 38 transactions in its first two funds in the early 1990s. These included RTC portfolios, bank portfolios and non-performing loans also purchased from banks. Multifamily housing was the property of choice, and the returns were astronomical.

“The average internal rate of return (IRR) for both of these funds was 96%,” said Jerome C. Silvey, executive vice president and CFO of Starwood.

After a year or two, institutional investors that had avoided the vulture funds wanted to enter the business. Vultures interested in new capital promptly gave their real estate category the more elegant moniker of “opportunity funds.”

The next evolution of opportunity funds

By 1994, the RTC era crisis had ended, and the opportunity funds sought new opportunities. “In the early days, the value-add was on the buy side,” said Silvey. “As the market recovered and assets increased in value, we began buying into markets where you had to increase value yourself. It was no longer a case of the rising tide that floated all boats. You bought a property that needed to be bailed out.”

During this period, opportunity funds bought real estate that needed repositioning. The more stable market meant that opportunity funds had to pay more to buy real estate, while also spending more to manage assets. Fees rose accordingly, as asset managers came on board.

Like the vulture funds, opportunity funds targeted a market that would take them out of these value-added investments. REITs provided the take-out solution.

REITs have no interest in carrying “negative capital” on their balance sheets, explained Barrack. “A property in need of repositioning is a bad investment for a REIT. Properties that yield no income drag down yields on funds from operations (FFO),” he said.

But stabilized properties drive FFO higher for REITs. During the mid-1990s, opportunity funds supplied REITs with a steady flow of repositioned properties, generating returns of 25%-plus for investors. REITs, in turn, profited from the acquisition of these large stabilized properties and saw their stock prices climb ever higher as investors plunged into REIT stocks. REITs and opportunity funds fed off each other until 1998, when high-tech stocks lured investors in another direction.

While everyone made money, Barrack conceded that this repositioning phase produced lower returns than the original crisis phase of the opportunity investing business. “We did pretty well,” he said. “But real returns during the [repositioning] period were around 17% to 20%.

Opportunities abound

The next opportunity market arose in Western Europe and the United Kingdom in 1995, as the property markets there developed problems similar to those of the RTC era in the U.S. According to Barrack, the returns on those investments rose accordingly with the level of inefficiency in the marketplace. “In these funds, returns rose 25%,” he said.

The modus operandi once again involved the purchase of distressed property, with the comfort of knowing there was a take-out market in which to sell. In Europe, a take-out opportunity arose when large German funds were formed following a change in German tax law, which created incentives for those funds to buy real estate in other countries, Barrack said.

“These funds were buying property at cap rates around 4%,” said Barrack. In effect, that meant the German funds were willing to spend a very high sum to purchase real estate.

Despite the existence of a buyer, doesn't European real estate take the risk associated with opportunity investing to unacceptable extremes?

“To be sure, there are more issues to confront in Europe,” said Barrack, who emphasizes that at its core the opportunity fund business is one that capitalizes on inefficiency. “When a particular market, for one reason or another, fails to work effectively, we try to take advantage of that inefficiency. In the mid-1990s, Europe had lots of inefficiencies, and we did very well, along with a number of other firms, including Goldman Sachs and Morgan Stanley.

“Why did we go to Europe? Because others wouldn't,” continued Barrack. “It was too difficult. But once we got there, we had an unbelievable competitive advantage in an inefficient market.”

But history shows that the window of opportunity is brief and that markets usually return to efficiency in short order. “This happened in the U.S. in the early 1990s and in Europe in the mid- 1990s,” according to Barrack.

The same will inevitably happen in Asia, where property markets are rife with inefficiencies. Today, opportunity funds are moving into Asia. “I would say that about 40% of our current funds will go international,” said Starwood's Silvey. “About 25% will end up in Europe, while 15% will go to Asia, and Japan in particular.”

Starwood Capital has entered into a joint venture with Nomura Real Estate Development in Tokyo, according to Silvey. “We plan to focus on all asset classes. This might mean buying loans and distressed assets from banks. Nomura has a large number of people on the ground in Japan, and they provide us with good access to the markets, the culture and the expertise, especially in the recent J-REIT legislation.”

Opportunity fund managers look first for a buyer who will take them out of the market once asset values rebound. That's the hope for J-REITs.

But analysts fear that Japan may prove to be a more difficult challenge in this regard. Silvey is confident that the J-REIT model will catch on, but perhaps not for a while.

“Our approach has been to identify assets that will generate a cash-on-cash return of 20%-plus on a dollar basis for two or three years. We don't expect to lose money this way,” explained Silvey. “To lose money in the aggregate with this plan, there would have to be a devastating blow to the real estate market in Japan, which is already at a 12-year low.”

As time goes buy and J-REITs filter into the market, opportunity funds will begin to identify their exit strategies.

Intellectual freedom

Are there any opportunities left? Opportunity fund managers face this question every time they approach potential investors. The answer, of course, is that inefficiencies are everywhere. Sometimes national economies fall out of balance and create massive opportunistic inefficiencies. Sometimes individual properties grow inefficient and create micro opportunities.

The Mayfair hotel in New York City serves as an example. In 1999, while the U.S. economy and real estate market were at their peak, a business dispute occurred between the owner, lender and the restaurant manager of the Mayfair. The property went into decline.

Colony Capital recognized a micro opportunity and purchased the property for $60 million. “Remodeling the hotel would have cost $120 million,” said Barrack. “Instead, our plan was to convert it to condominiums. While negotiating the transaction, we pre-sold 20% of the units. We tripled our investment in an 18-month period. An opportunity fund has the intellectual freedom to do these kinds of things,” according to Barrack.

Unlike other types of real estate funds, opportunity funds retain an almost unlimited amount of flexibility to steer capital in one direction or another.

“Core and value-added funds define their goals in great detail for their investors,” said John Roberts, president of AMB Investment Management Inc., San Francisco. “You say what you are going to target, and you don't stray. Opportunity fund agreements, however, allow their managers to buy virtually anything.”

The opportunity fund innovation of co-investment makes potentially risky deals palatable to investors. During the real estate crash of the early 1990s, pension funds watched as the properties in their portfolios decreased precipitously in value. But the fees earned by their fund managers remained constant.

When opportunity funds stepped into the fray, they committed to the concept of co-investment. According to observers, opportunity funds contribute 1% to 5% of the capital in their funds. In a $1 billion fund, the co-investment portion could total $50 million. While small in percentage terms, a $50 million co-investment ensures that the opportunity fund manager's interests are aligned with those of the clients investing in the fund.

The co-investment concept has proven so popular that funds at the core-plus, or value-added, level have copied it. “When we went public and formed our value-added fund in 1997, our clients said they wanted this co-investment idea,” Roberts said. “We like that idea so much that we co-invest a minimum of 20% in our co-investment funds. We have a 50% interest in some of our ventures.”

According to Roberts, perhaps 15% of core-plus, or value-added funds, now practice co-investment.

Another opportunity fund technique involves cross-collateralization. In forming a fund, opportunity fund management firms solicit commitments from as many as 20 to 30 pension funds and endowments.

If these commitments total $1 billion, for example, each contributor will own a percentage of each deal equivalent to its contribution. For example, a pension fund contributing $100 million will own a 10% share.

When the fund decides to make an investment, calls for capital are placed, and each contributor ponies up its share. “We also promise a preferred return,” explained Barrack. “Investors will receive, say, the first 10% as a return on their money. As the promoters, we want a 20% promotional interest in the profit above 10%.

“Now, suppose we do four deals under this plan, and the first three earn 25% returns,” Barrack continued. “The investors receive their share, as do we, on each of these deals in turn. Then deal four collapses, and we lose $20 million. At that point, we still have the profit from deals one through three.”

When opportunity funds first began raising money, institutional investors feared they would be stuck with bad deals, according to Barrack. “The way we address this issue is through cross-collateralization. In other words, no one can cherry pick deals. All partners invest according to their commitment in each deal. Yield is calculated deal by deal. Overall, losses offset the gains. This is cross-collateralization.”

Opportunity funds typically follow a 6- to 10-year cycle. Promoters raise funds by soliciting commitments for two or three years. The next two or three years focus on the search for deals. Finally, the cycle ends as the opportunity funds sell and close out deals, taking in their final profits.

Since 1990, private real estate equity funds that are of the vulture-opportunistic ilk have run through this cycle three to four times. Each effort has begun with a promise of surprisingly high returns.

In many cases, though certainly not all, funds have made good on their promises by ferreting out inefficient markets, stimulating those markets with targeted investments, taking large profits, and leaving behind a more efficient and productive market.

Mike Fickes is a Baltimore-based writer.