How to cash in on cheap real estate

By Philipp Harper

If your agenda for 2008 includes investing in distressed real estate, keep this in mind: Just because you buy low doesn't mean you'll be able to sell high.

The "buy low" part seems easy enough. Historic oversupplies of inventory, the subprime-mortgage mess and the possibility of recession have created a perfect storm of declining value in once-hyperinflated real-estate markets. Condo shoppers in South Florida, for example, can expect discounts of 40% to 60% off the previous sales prices.

Think you can't go wrong at those prices? Think again. Investing in a declining market is tricky business. What looks like a discount today may look like something else entirely when the market finally reaches bottom.

Depending on your investment goals, it may make sense to jump immediately into the distressed-property market, or you may be better off waiting a year or two. Either way, investors who do their homework and are honest about what they can afford -- and for how long -- stand to profit during this period of market deflation.

A collapse of historic proportions

Nationally, according to the 10-city composite index tracked by the S&P/Case-Shiller Home Price Indices, prices of existing single-family homes fell 8.4% in November compared with the same month a year earlier. Declines were most pronounced in such formerly red-hot markets as Miami (15.1%), San Diego (13.4%), Las Vegas (13.2%) and Phoenix (12.9%).

November's decline, the largest in the 20-year history of the index, marked the 11th consecutive month of falling prices. The downturn has seen the U.S. housing market shed $1 trillion of its value, according to Yale economist and index co-founder Robert Shiller, who says additional trillions could be lost in the event of a recession. What's particularly unsettling about the index is that it doesn't take into account condominiums or new single-family homes, sectors that have been losing value far more rapidly than the market as a whole.

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The greater Miami market is glutted with a 35-month supply of condos and town houses, and an additional 26,000 units are due for delivery in the next two years, according to Jack McCabe, the principal of McCabe Research & Consulting in Deerfield Beach, Fla. He doesn't expect the oversupply to be erased until baby boomers begin to retire in earnest in 2010 and beyond.

McCabe, who saw trouble looming in South Florida as early as mid-2004, when the boom still was going strong, advises private investors and hedge funds looking to cash in on the caving market. Where a year ago he saw one or two potential deals a week, he says, he now sees one or two a day and expects the pace to accelerate.

Following the vultures

The action is being dominated by large so-called opportunity funds, or "vulture funds," that seek annualized returns of 18% to 25% on deals ranging from $20 million to well more than $100 million. Major players include Blackstone Real Estate Partners, Apollo Real Estate Advisors, Fortress Investment Fund and Contrarian Capital Management.

The type of investment -- raw land, single-family tracts, condo construction, condo conversions -- depends on the expertise of the fund managers as well as opportunity. Exit scenarios, almost always part of the investment strategy, include flipping property immediately to domestic or overseas buyers, renting it out before reselling it or some combination.

Opportunity funds seem like an ideal way for unschooled investors with limited resources to dip a toe in the distressed-property marketplace. There's only one problem: The cost of entry generally is in the millions of dollars.

Even when a relatively small deal is being put together, it's usually not open to the public, says Norm Radow, whose Atlanta company, Radco Development Solutions, specializes in resurrecting multifamily and commercial projects. It's too time-consuming and expensive to clearly explain the "risk-reward intricacies" of highly speculative deals to inexperienced investors, says Radow, whose company completed $340 million in projects in 2006.

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For a small deal -- valued at less than $5 million, with minimum subscriptions of about $100,000 -- Radow simply enlists colleagues in the development business.

Whether such opportunities will become broadly available is unclear.

"Everybody is telling me they're putting together a fund for distressed real estate, but I haven't seen it on the street," Radow says. "It makes perfect sense to put together a contrarian real-estate fund. It's the right time."

Deals for the individual investor

Even without access to vulture funds, individual investors can make money in the distressed-property market. But they must be cautious and willing to do their homework.

First, says McCabe, it's important to have an exit strategy that realistically weighs the cost of holding the investment until it can be cashed out. Loan payments, insurance, taxes and maintenance costs or fees must be part of the calculations.

Continued: 'Quality goes first'

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