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Risky business

Weigh dangers before making exempt market real estate investment

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LOOKING at Frank Lonardelli's track record over the last 15 years, it's not difficult to realize the former Winnipegger has a natural talent for real estate speculation.

More than a decade ago, he sold a half-block of homes adjacent to an old Safeway at the corner of Corydon Avenue and Stafford Street that is now the location of a drugstore and an office building.

With profits from that deal, Lonardelli moved to Calgary, building over the next decade a successful real estate investment firm, Arlington Street Investments -- named after the Winnipeg Street where he was born and raised.

Arlington has fared well in Calgary's Wild West where property values crash almost as quickly as they soar.

At the height of the market, the firm sold most of its properties -- all rent-producing, smaller commercial sites -- to developers for a substantial profit. Arlington had paid an average price of $175 per square foot to purchase the properties between 2000 and 2004, and sold them for an average price of $425 per square foot.

"My strategy has always largely been to buy and hold, but in 2007, I was taught a very valuable lesson," says Lonardelli. "That is what real estate looks like from a value perspective when you're at the top of an energy cycle."

Arlington sold when everyone was buying, and now at the bottom end of Alberta's boom and bust energy economy, Lonardelli says Arlington is poised to enter the market again at a time when everyone else is looking for an exit.

Recently, Arlington was in Winnipeg testing the waters for interested investors for two real estate investment offerings, one of which is a buy, hold and sell deal similar to the one it successfully sold off in 2007.

Both of its offerings are part of the exempt market.

Exempt market investments often involve higher levels of risk than run-of-the-mill investments like mutual funds, stocks and bonds, but they can also provide higher returns.

And it's the potential for higher yields that attracts many investors. But unlike a stock or mutual funds, which are often scrutinized by several financial analysts, it's up to the investor to weigh the risks and rewards.

"Exempt market opportunities tend to be pretty risky because you have to rely on the company offering the deal to provide you with all of the information," says Len Terlinski, an investigator with the Manitoba Securities Commission, whose job includes looking into complaints about exempt market investments.

Although some investments in this sector do turn out to be downright fraudulent, including Bernard Madoff's hedge fund firm, most are legitimate and some provide their investors with spectacular returns.

"But the problem is it's hard for the average investor to tell the difference between the good and the bad," Terlinski says.

And Arlington illustrates how investors are often faced with the difficult task of evaluating whether an exempt market deal will turn out to be great, good, mediocre or just plain bad.

"You have to be able to do your homework and know whether or not you can rely on the information that is being put forward to you," says Sheldon Stier, president of Winnipeg-based Hatch Alternative Investments.

Hatch, an exempt market investment and advisory firm, is investing in Arlington Street Mortgage Investment Corp. -- one of Arlington's two offerings -- because Stier says Hatch is bullish on the Calgary firm's strategy to fill a lending market niche, providing short-term, high-interest mortgages in Alberta.

"Credit markets are still not loose enough to allow people to continue building, so mortgage investment corporations (MICs) are really filling a void, which has been left alone by traditional lenders," he says. "There's great opportunity to lend into MIC and receive a great yield as they take advantage of the new borrowers in the market looking to continue building and developing."

Arlington's target yield for the MIC is between 8.5 per cent and 10 per cent annual returns on invested capital. The returns are not guaranteed, but the investment can provide them because mortgages the MIC provides charge very high interest rates.

"Borrowers who come to a MIC don't qualify for conventional lending," says Arlington Street Mortgage Investment Corp.'s chief investment officer, Eric Stewart. "A pretty standard rate for a MIC across Canada is 12 per cent."

Stewart, a past chairman of the Real Estate Council of Alberta, says the MIC will provide mortgages mostly for six-month terms up to 75 per cent of the value of the property. Borrowers are usually individuals needing bridge financing to purchase a new home until they can sell their current home, or small contractors and developers that have bought land but need additional financing to build the home.

"(MICs) are for people who need money really quickly when a bank can't do it," Stewart says. "They may be able to get the loan from a bank, but they need it with better timing than a bank can provide."

But short-term mortgages can be tricky business, especially in the current economic climate where another recession in the short term is possible, says Ken Cooper, director of the Winnipeg Angel Organization.

As an angel investor, Cooper invests capital in business deals when traditional lenders are unwilling to do so. While he says he would have to know more about the Arlington deal to evaluate its viability, Cooper also emphasizes the importance that investors must understand any exempt market deal is typically a high-risk, illiquid investment.

"A lot of these are selling on yield, and stretching for yield is never really a good thing," he says.

While evaluating risk versus return is always at the heart of the decision whether to invest in the exempt market, Stier says the deal maker -- or breaker -- often boils down to a company's business model and its manager's ability to execute it successfully.

"When I met Frank, what I sensed is a lot of integrity in the business model, and that the deal had to be right, that it pays to be patient," Stier says.

But even when experienced investors have confidence in the deal and management, they will never risk more capital than they can afford to lose, says Jim Dewald, professor at the Haskayne School of Business at the University of Calgary.

"I would need to see a proven track record of results, looking mostly for conservative use of debt and a highly disciplined approach to selling," says Dewald, a former CEO of two real estate development companies in Calgary.

The average investor, however, often lacks the experience to judge a deal's worthiness, or its potential pitfalls. For that reason, he says, investors should always seek independent investment, tax and legal advice. Because once you're in, there's often no turning back -- at least in the short term.

"Liquidity is limited so if you have a change of mind, there is little you can do as an investor," he says.

Lonardelli says he has confidence in the Arlington business model's ability to mitigate the risks.

"We look at these as alternative investments, and we're happy comparing our investment and the ability for our company to mitigate any exposure for people's original equity against any other asset."

After all, he says, it's not just investors' money that's at risk.

"We participate alongside of our investors so we have skin in the game."


Who is qualified to invest in the exempt market?

TO be a qualified investor, individuals must either meet the criteria to be "accredited" or "eligible" investors, says Sheldon Stier with Hatch Alternative Investments.

An accredited investor must meet one of the following: The investor -- alone or with a spouse -- must have at least $1 million in financial assets; or has earned an annual income of at least $200,000 for two years (or with a spouse, a combined income of $300,000); or has net assets of at least $5 million (this can include a corporation as well as an individual).

Eligible investors must either earn more than $75,000 annually, or together with a spouse more than $125,000 annually, over the two previous years; or owns net assets, including real estate, exceeding $400,000. If you meet the criteria, "you can invest any amount of money as long as you receive an offering memorandum and you sign a risk acknowledgement form," Stier says. Investors who do not meet the asset and income tests can also invest up to $10,000 as long as they receive an offering memorandum and sign off on the risk acknowledgment form.

Or, alternatively, any investor -- regardless of income or assets -- can invest $150,000 or more.

How a speculative deal on commercial real estate works

While one of Arlington Street Investments' offerings involves a mortgage investment corporation, the other is a speculative deal in which investors buy an equity stake in a limited partnership with Arlington. Here's how it works. The company uses its own and investors' capital to buy an assembly of B and C commercial (strip malls, older, low-rise office buildings) properties in a high-impact location. The buildings are "lower density, older and don't have the best use, but if you assembled three or four of those buildings, knocked them down and built a big tower, you'd have an A-class building," says Frank Lonardelli, president of Arlington Street Investments.

Lonardelli says Arlington purchases a commercial property only when it meets three criteria:

1) Can be bought below replacement cost: "If you looked at a Class B building, you would ask how much it would cost to buy the land that it sits on, and then to construct the building in today's dollars," he says. "Let's say the number comes up to $355 per square foot. I need to buy below that." Basically, the property must yield enough rent income to cover operating costs and still have enough cash flow to return to investors. The closer the purchase price is to the replacement cost the less likely it will be profitable to own the building.

2) Leases signed at market bottom rather than top: For instance, leases signed in 2007 in Calgary at the top of the market will provide great rental income, but when they come due in 2012, perhaps near the bottom, the rents may be reduced, which would decrease income available for expenses and profit. "You have to underwrite the rent rolls based on the timing of the market," he says. "This comes down to what I refer to as timing, trends and techniques, aligned with location, location, location, but location in and of itself does not work."

3) Asset has additional value: Lonardelli says the property must have the ability to increase returns over time. "Can we increase the rates of the leases? Can we do that by repositioning a three-floor building that's always been office? Can we reposition the main floor to be retail? Most importantly, is there the ability to create greater densification on the underlying land that it sits on?" That last point, he says, provides "the ability to hit a home run" selling the properties to a developer to build a high-density highrise.

Republished from the Winnipeg Free Press print edition March 20, 2010 B10

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