The Property Funds World interview - David Michelson, Three Arch Investors: "We expect the property meltdown to move quickly beginning in 2009"

David Michelson, an advisor with Three Arch Investors, says the California Distressed Land Fund, which is being launched by sponsors and managers with experience of the last US residential property crisis in the 1990s, is perfectly placed to capitalise on the ongoing fall in the value of real estate to more affordable levels.

HW: What is the background to your company and fund?

DM: The sponsors of the California Distressed Land Fund together with its managers have more than 25 years experience each of local residential developments throughout California, Arizona and Nevada, and collectively have developed more than USD1bn in properties.

This group was very active in the last major meltdown of the 1990s when the massive liquidation was done by the Resolution Trust Company, an agency set up to dispose of real estate assets on behalf of the Federal Deposit Insurance Corporation.

The sponsor is Three Arch Investors of which David Michelson is the general partner. The fund manager is Gary R. Emsiek, who was previously president of PhD Homes and Polygon Homes in California.

A non-levered physical real estate fund, the California Distressed Land Fund is buying risk-adjusted assets primarily from financial institutions that are motivated to remove these assets from their balance sheets. It is currently open to professional EU investors with a minimum investment of USD5 million. The fund's closing date is October 15.

HW: Who are your service providers?

DM: The fund is a Jersey private company with Vistra Jersey as its administrator. Its UK Counsel is Katten Munchin Rosenman Cornish and the Jersey counsel is Howard Law. The cash manager and custodian is First American Companies and the auditor is Deloitte & Touche.

HW: How and where do you distribute the fund? What is the profile of your current and targeted client base? What are the advantages of this fund for European investors?

DM: Through its London office, IGS Group is the placement agent and marketing consultant. IGS is an FSA-regulated entity that primarily targets family offices and pension funds. The fund has been set up to maximise its net earnings through a Jersey domicile, which provides a tax-efficient structure for EU investors.

HW: What is the investment premise of the fund?

DM: The fund intends to acquire around 15 per cent of its assets in 2009, with the majority of its acquisitions to be carried out in 2010-11. The premise is rather simple, in that we look to purchase major land banks and other improved real estate from motivated sellers, and to hold or improve the assets until the market experiences strong demand.

The average acquisition price will be 50 to 75 per cent less than the peak values. The classic asset bubble caused homes to increase in value to a point where only 7 per cent of families with two incomes could afford to buy averagely-priced homes in the targeted areas.

Past cycles have shown that when home prices drop to a level where 30 per cent of dual income families can afford averagely-priced homes, demand significantly increases. To achieve this level of affordability prices will need to drop to 40 per cent below peak valuations. We are currently about 25 per cent off peak values.

HW: How do you make investments for the fund?

DM: We have been in this marketplace for more than 25 years and have very strong contacts with the banks, brokers and even the regulators who will look to experienced operators to liquidate these assets. Because of our existing relationships we will benefit from a wide pool of assets to choose from.

HW: What is your approach to managing risk?

DM: We limit the acquisitions to land banks or properties which have discretionary entitlements and for which there is a clear exit strategy. We buy the assets for at least half of what we believe we could sell it for, and we aim to sell the asset in three years or less. We have also limited the fund size to USD150m to allow us to be very selective in the assets we purchase.

We manage risk by knowing our markets, limiting the areas to major markets where there is good transportation and centres of employment that are close to the assets, so that buyers will not have to spend significant time commuting.

HW: How do you expect your performance to be affected by ongoing market developments? When do you expect the market to turn?

DM: We are in a great position as we anticipate the meltdown to move quickly beginning in 2009 to the point where we can see an increase in the rate of liquidation of assets and the levels of foreclosures.

The supply of new homes is now at record lows, and without this supply the inventory of existing homes and foreclosures will be significantly reduced in the next 24 months. We are confident that once valuations are down 40 per cent significant demand will be created. A lot of families in the 20-26 age group would like to buy a home but have postponed this over the past three years, and who will be a major factor in the recovery of this market.

HW: What opportunities are you currently looking at?

DM: We have received a large loan proposal from a California home builder to lend 50 per cent in a first charge mortgage on 300 lots in a coastal area of San Diego. The borrower is purchasing the lots at 70 per cent lower than the defaulted previous owner, and our loan would be half that, around 85 per cent lower than the previous peak value.

We can today get better security and high rates of returns because normal banking relationships and financial institutions are not making loans.

HW: What developments do you expect to see in the California real estate sector in the year ahead, and in other political and economic areas that may impact it?

DM: In 2009 we expect to see significant pressure on local banks by the regulatory agencies resulting in a large number of opportunities in late 2009. The level of the meltdown is now realised by Washington, and we believe the marketplace recognises the need to reduce these significant real property inventories held by financial institutions quickly to avoid a long and protracted recovery.
 
HW: How will these developments affect your portfolio?

DM: We believe that a skilful deployment of the fund assets will realise exceptional returns for a non-levered investment. We are anticipating a mid-teens return, which clearly depends upon the point of exit of these investments.

The current administration has dealt with the financial meltdown in a timely and efficient manner. Whoever turns out to be the future president who will inherit this problem, a clear liquidation plan will be in place thanks to the skill of the current administration through the office of the Treasury and the current agency's oversight regulators.

HW: What differentiates you from other managers in your sector?

DM: Our fundamental difference from other London- or EU-based funds is the local skill set in our markets, as well as the business model of primarily acquiring physical direct ownership without any leverage. The fund will have much better exposure to assets liquidated by the community banks due to the extensive network that the sponsor and managers have built up over the past 25 years.

HW: Do you have any plans for further product launches in the near future?

DM: We intend to work with the California Distressed Land Fund as our primarily focus and we have no current plans for other product launches. We have kept the fund size small to retain a very selective asset acquisition model with clear exit ability. We intend to have the fund shareholders participate in other real estate projects that may not fit the objectives of this fund rather than form a new entity.


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