Redwood Market Commentary, Q3 2011

Recently, we participated in an interview for an industry publication. While answering the questions, we thought that the interview would also provide a good market commentary for our first investor report for our new Redwood-Kairos Real Estate Value Fund III, LLC. We have targeted $100 million for the Fund and we started raising capital on June 1 of this year. Currently we have $23 million in commitments signed and are well on our way to our goal. We will raise capital until September 1, 2012. Below is an excerpt from the recent interview.

What are the largest challenges to raising capital for an investment fund that buys non-core real estate today?

Having a track record people can feel good about from the last cycle. Many fund managers more than failed to protect equity let alone make a profit. We did well comparatively on both counts and have a good set of relationships with existing investors that appreciate our track record and our perspective of protecting equity.

What strategies has Redwood employed to overcome these challenges?

Conservative underwriting, niche strategies that were honed in times of competition, and tactical execution skills that helped our firm out-position and out-work the average investor.

The anticipated wave of distressed property offerings from lenders and troubled owners has been slow to come. Do you see that changing in the near future? In the meantime, where can investment firms with high risk appetites find opportunities?

There will be more distressed property offerings. It will slowly leak out of banks and special servicers over time. Over the last few years it has become apparent that lenders will first try to work with borrowers for up to a few years and then hold REO for another couple of years. I am sure the special servicers will get some legal advice that stretches the “held for sale” REO timeline for even a few more years to benefit the CMBS bond holders (the trust). Supply of investment properties will increase slowly as leasing velocity increases. For those of us that are patient, that will mean better buys with less risk.

You have to understand that the FDIC, bank special asset departments, and special servicers look back at the early 90’s and see a wealth transfer to the opportunity funds by the RTC. They have decided to service the assets the best they can for their stakeholders instead of enriching someone else by selling cheap. Banks will be the first to change that attitude as they make money in their primary business, but the FDIC and special servicers will perpetuate their portfolios longer. This, in the pursuit of self-interest, if for nothing else.

Does the current economic uncertainty – both in the U.S. and abroad – have the potential to create more buying opportunities? Or is now the time to hold back on acquisitions?

There is no way to call the bottom of a market, particularly a slow to move illiquid market like real estate. The way we mitigate that risk is to buy assets we are happy holding for cash flow. If things get worse we will get better deals and live happily with the strong cash flow assets that we bought near the bottom even if we missed the timing a little. If things get better we bought some great assets at the bottom. Either way we are happy investors and not gamblers trying to pick a bottom.

What makes a property a compelling “value-add” buy in today’s market?

Generally the more challenged properties in good locations are the most compelling. Lenders managing leasing problems are going to extract value first then sell. Or worse they will sign a lease to create value that encumbers the longer term value and cash flow capacity of the real estate. We have seen that many times. So if it is a problem property on many levels, property management, leasing, capital improvements– particularly ones that effect leasing, borrower issues, design, then our firm can usually get ourarms around it and execute. Also, smaller deals are off the radar screen for special servicers. It is not worth their time to fix these problems, even simple problems. It takes the same effort to sign a big lease for a $50mm deal as a big lease on a $15mm deal so the time is spent on the larger deals. Better deals are below the radar screen of institutions, but require expertise in execution when they are problem assets.

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