David Sherman makes the tough claim that there is good money to be made in real estate even after it has outperformed nearly every other investment class for the past 10 years.

“The industry is on average fully priced,” he acknowledges, “but it was really underpriced 10 years ago.”

He has a point. Mr. Sherman runs a private equity fund of funds called Metropolitan Real Estate Equity Management, which oversees about $900 million in capital from more than 100 institutional clients. Speaking recently before the New York Society of Security Analysts, Mr. Sherman recounted the ups and down of the sector over the past two decades. He reminded the audience of the ravages wreaked upon property valuations of all kinds by the Resolution Trust, which was set up to liquidate the assets of hundreds of failed savings and loans in the early 1990s. The trust auctioned off more than $100 billion in real estate assets in two years. “It was the sloppiest process ever seen, and drove prices down by about half,” Mr. Sherman says. “But, it worked.”

The upshot? “Anything bought in 1994 or 1995 earned big returns,” he says.

While the playing field is not so verdant today, Mr. Sherman says there are still inefficiencies in the industry that allow him to return 13% to 15% net of fees to investors. He maintains that the industry has become more user-friendly (the sub-prime space being an obvious exception) since the coming of age of the Real Estate Investment Trusts. That evolution saw an alignment of interests between management and investors as well as the greater transparency that comes with publicly owned companies. A consequent greater flow of information also improved returns. “It takes five years to build an office building,” Mr. Sherman notes. “The cycles were exaggerated by a lack of information; no one knew what anyone else was doing.”

Given that some sectors look more promising than others and that results vary widely between different markets, Mr. Sherman advises diversification, and understandably favors the fund-offunds approach. He reckons “there are about 400 real estate funds in the U.S. today, the vast majority of which didn’t exist 15 years ago.”

Most funds in America may be described as “opportunistic” or eager to invest in anything that can yield above 20%, or “value-added.” The latter group anticipates improving returns through renovation or better management.

Mr. Sherman’s firm focuses on value-added funds that are buying properties for the most part below replacement cost. Currently, Mr. Sherman likes the rental apartment market. He expects the rise in residential mortgage rates, and especially in the subprime sector, to drive people back into the rental pool, boosting rents in the next few years. Valuations in the sector generally are high today, at about $100,000 to $110,000 a unit, and compare to replacement cost of $115,000 to $120,000. The yield on such assets today is only about 5%, but Mr. Sherman expects that percentage to rise to the low teens going forward.

Mr. Sherman especially favors the urban rental markets, where apartment turnover is slower and rents tend to lag the market. City units are generally selling at bigger discounts to replacement cost. The opportunity is to buy properties at a current 4.5% yield, engage in intensive renovation, and roll rents up to a 7.5% to 8% yield. He assumes that this sector won’t appreciate much in value over the next couple of years, but neither will there be any fall-off in prices.

In other words, Mr. Sherman is replacing capital markets risk with execution risk, a path he has followed for the past few years. The same approach has been successful in the office building space. Buyers are making their profits through aggressive management of properties, rolling over rents ahead of schedule, which in turn drives value. This process is not for the faint of heart, according to Mr. Sherman. “Volatility levels are as high as I’ve ever seen them; risk levels are higher, too,” he says.

Mr. Sherman notes that though America dominates the global real estate industry in terms of talent, liquidity, and sheer size, Europe may offer more interesting opportunities for investors. Most investment in the region has traditionally been in established properties; a trend toward more opportunistic investing is likely to emerge. Core values in Europe (and even Eastern Europe) are roughly equivalent to those in America That is, the easy money has been made. However, consolidation is under way, and the trend toward wresting value from corporate holdings of real estate (such as doing a sale/leaseback of a headquarters building) is not as well along as in America.

Asia, too, has excellent prospects, especially in the developing countries, but it is far harder to find investment vehicles in that part of the world. The Chinese and Indian markets will perhaps be the most exciting regions over the next several years, but also the easiest place to lose money overnight, Mr. Sherman says. The legal systems and the difficulty of finding a partner are both problematic.

The Japanese market is strong, and investors will find many opportunities to invest in the country because there was virtually no renovation or addition to the building stock during its many years of recession.

Bottom line? Thanks in part to the increased flow of institutional money into the sector, real estate values will likely continue to rise. “There is yield compression all over the world,” Mr. Sherman says.

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