Pay dirt

Executive Summary
Company. TerraCap Management Industry. Private equity Key. Follow the population growth when investing in commercial real estate.

Stephen Hagenbuckle doesn't buy into the conventional wisdom that all the great commercial real estate deals are gone now that the recovery is underway.

Hagenbuckle and co-manager Robert Gray at TerraCap Management plan to prove people wrong with the launch of a third fund for which they're raising $250 million to invest in more commercial real estate.

Bonita Springs-based TerraCap has made a name for itself by buying distressed commercial real estate in Florida for pennies on the dollar during the downturn with its first two funds, closing on 47 deals and now managing more than 4 million square feet of commercial space. That's enough to fill more than 69 football fields.

For example, the second fund it launched with $102 million in December 2011 so far has delivered an internal rate of return of 32%, they say. The life of the fund was originally eight years, but early successes means the fund already has returned 42% of invested capital to investors.

TerraCap's thesis was that Florida's population growth would rebound as the economy recovered, driving commercial real estate values up from depressed levels. “It seems like sometimes the trend is your friend, as they say,” says Gray. “People keep moving to Florida, as we expected.”

Hagenbuckle and Gray launched the first TerraCap fund in January 2009 during the depths of the downturn with $25.9 million from high-net-worth individuals. They acquired residential land and focused on properties located on the best commercial corners. “We saw that as the first wave of opportunities and deep discounts,” Hagenbuckle says.

The success of their first fund drew institutional investors such as pension funds. “They've delivered almost everything they've talked about,” says Raymond Depelteau, the chief investment officer for the city of Holyoke Retirement System in Massachusetts.

The second fund focused on acquiring commercial buildings at deep discounts from banks and distressed sellers, turning them around and filling them with tenants before selling them at a handsome profit. Buildings included warehouses, hotels and offices. Now, TerraCap plans to use money it's raising for its third fund to continue the strategy of seeking out undervalued commercial buildings, modernizing them and boosting rents and occupancies.

Time is on its side. It takes years to permit and build new office buildings, for example, and no banks are financing any speculative commercial buildings. That creates an economic moat. “It buys us three more years with no competition,” Hagenbuckle says.

Investor expectations are more tempered now that the recovery is underway. “I think a lot of the easy money has been made,” says Depelteau, who remains confident the market can continue to improve. “It seems that Florida is still an attractive market where 15% to 20% returns are reasonable,” he says.

Great deals out there
There will be no shortage of opportunities to invest, says Hagenbuckle. For example, TerraCap recently acquired a 160,000-square-foot office building in Maitland near Orlando for $57 a square foot and will spend $5 million to build a parking garage and spruce it up to improve its appeal to prospective tenants. Even with all the improvements, Hagenbuckle estimates the building's worth the equivalent of half its replacement value.

“A lot of people think deals are gone. We would challenge that wholeheartedly,” Hagenbuckle says. “There's a good two to four years of buying at deep-value prices.”

Here's why: Nationally, Hagenbuckle says $1.2 trillion worth of 10-year commercial loans made during the latter stages of the boom that will be maturing in the next few years, and about $216 billion worth will not be refinanced. Of that sum, $90 billion of commercial mortgages are for properties located in the region that stretches from Texas to Florida and up to Washington, D.C. “Our regional focus has expanded outside Florida,” Hagenbuckle says.

More than 80% of TerraCap's deals are done before a property is officially listed for sale. Often, distressed sales can be embarrassing to the sellers, especially if a public auction doesn't deliver the price they expected. “If it doesn't trade, then it looks bad,” Hagenbuckle says.

And some buyers of distressed buildings take advantage of sellers by throwing last-minute negotiating problems that can derail a deal. “Certainty of transaction is more valuable than maximum price in the eyes of a distressed seller,” Hagenbuckle says. “We have a good reputation as a credible buyer.”

Although the first two funds didn't use much debt, the third fund will be permitted to boost debt to 65%. Private-equity funds use debt to boost returns, but that can be risky if an investment turns sour. “You can't put on debt on unstabilized properties,” Hagenbuckle says.

But the third fund will buy buildings with more tenants and that will make banks more willing to lend to TerraCap. These include office buildings, warehouses and limited-service hotels. “Wells Fargo is our biggest lender,” Hagenbuckle says.

Property values may decrease when interest rates rise because the cost of ownership is higher as a result, but Hagenbuckle isn't concerned about the prospect of interest rates increases. “If interest rates creep up, that means the economy is getting stronger, companies are more profitable and they can pay higher rents,” he says.

Besides, Hagenbuckle says he remembers double-digit interest rates in the 1980s, and even if interest rates rise now they're still relatively ultra-low. “We're so spoiled right now,” he says.

Institutional investors notice
TerraCap's success hasn't gone unnoticed by sophisticated investors. The funds now have more than 300 investors and about 75% of them are institutions such as pension and retirement funds.

Initially, the size of an investment in TerraCap funds averaged $180,000. Now, it averages more than $1 million as more deep-pocketed investors participate, Hagenbuckle says. The average real estate deal size increased from $2 million in 2009 to $20 million last year. “We invest capital as we raise it because deals don't wait,” Hagenbuckle says.

TerraCap doesn't disclose revenues, but it recently made the Gator 100, a contest sponsored by the University of Florida and managed by accounting firm Ernst & Young to identify the fastest-growing companies founded by graduates. More than 600 companies applied, and TerraCap ranked 21st on the 100 list because it posted 65% annual revenue growth over the last three years.

As is typical of a private-equity fund, TerraCap keeps 20% of the profits after returning capital to investors. Its third fund will charge a 1.5% management fee.

“We always look for good investments, especially in that alternative space,” says Dan Owens, a trustee for the Holyoke Retirement System. Owens says he likes TerraCap's strategy of scouting deals in the $20 million to $40 million range that it can manage itself. Those prices are too high for individual investors but too low for the big real estate funds. “They've found a nice niche and they've done a nice job,” he says.

Home run investments
TerraCap Management's first two investment funds have successfully acquired distressed properties on the Gulf Coast and turned them around. Here are three deals that highlight the winning strategy:

Deal 1
Property: Hampton Inn, Fort Myers Beach
TerraCap acquired the 120-room Hampton Inn hotel in Fort Myers Beach in October 2012 for $4.35 million. The fund spent $1.8 million to upgrade the hotel and boosted customer satisfaction and cleanliness to the top 10% among its peers. Nearly two years after TerraCap acquired it, it sold the hotel for $9.43 million.

Deal 2
Property: Westlinks Corporate Center, Fort Myers
Westlinks Corporate Center was part of a 15-building acquisition in three deals in the Gateway area of Fort Myers for a total of 515,000 square feet for $20.5 million in late 2013. The industrial and office “flex” space rented for $3.50 per square foot, net of expenses, when TerraCap acquired it and it has doubled since then. TerraCap was recently under contract to sell the properties for $40 million.

Deal 3
TerraCap acquired the former Lakeview Office Park in Tampa's Westshore business district in October 2013 for $22.50 a square foot. At the time of purchase, only 7% of the six buildings there were occupied. After sprucing up the office park and renaming it Tampa International Business Center, TerraCap says it has had recent offers from prospective buyers for $100 to $110 per square foot. The buildings are now 55% full.