Virtus Real Estate Capital - Monitoring Report - Rewritten January 2017

Due Diligence Monitoring Report Virtus Real Estate Capital Updated – January 2017

Due Diligence Monitoring Report – Virtus Real Estate Capital – April 2016 2

Table of Contents Virtus Real Estate Note ................................................................................................................................................................ 3

Virtus Real Estate Capital II, LP ................................................................................................................................................... 3

Strategy Summary ........................................................................................................................................................................................ 3

Property Sub-Sectors ................................................................................................................................................................................... 4

Senior living .............................................................................................................................................................................................. 4

Medical Office Buildings ........................................................................................................................................................................... 5

Self-Storage ............................................................................................................................................................................................. 7

Student Housing ....................................................................................................................................................................................... 8

Workforce Housing ................................................................................................................................................................................... 9

Charter Schools ..................................................................................................................................................................................... 10

Properties ................................................................................................................................................................................................... 12

Senior Living – Oklahoma City& Tulsa ................................................................................................................................................... 12

Senior Housing – Assisted Living and Memory Care ............................................................................................................................. 12

Self Storage – Charleston, SC ............................................................................................................................................................... 13

Workforce Housing – San Antonio, TX .................................................................................................................................................. 13

This is not an offering for any investment. It represents only the opinions of Orenda Partners LLC (“Orenda”) as of a particular time. Such

views are subject to change at any point and Orenda shall not be obligated to provide notice of any change. Any views expressed on are

provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest. Any

securities information regarding holdings, allocations and other characteristics are presented to illustrate examples of the types of

investments or allocations that Orenda may have bought or favored as of a particular date. It may not be representative of any current or

future investments or allocations and nothing should be construed as a recommendation to purchase or sell a particular security or follow

any investment strategy or allocation without reference to each investor’s specific goals and situation.


Virtus Real Estate Note

The fund recently distributed approximately 12.2% of invested capital with appropriate redemption premiums for

investments made less than 3 years ago. As the table below shows, there was $49,612 paid in redemption

premiums to those investors whose subscriptions to the fund were made after 4/1/2013.

The distribution is driven by 11 asset dispositions that have occurred since May 2015 as summarized below. None

of the sold properties were held for more than 36 months with an average holding period of 29 months. The net

proceeds of the sales amount to 28% of the original capital raised and resulted in an IRR of 34.1% (1.9x ROI)

Virtus Real Estate Capital II, LP

Strategy Summary Virtus Real Estate Capital II, LP follows a similar strategy as that implemented in VREC I with several variations that

can be referenced in the Virtus II Due Diligence Memo and the funds’ prospectuses’. Some of the differences

include an expansion of the targeted property sub-sectors to include Workforce Housing and Charter Schools, in

addition to a variety of changes to the structure of the fund(s). Some of the differences include:

VREC Realized Rollup

Asset Name Asset Class

Disposition

Date Months Held

Net Proceeds /

Original VREC

Capital Raised IRR ROI

1. Woodstock Self-Storage 05/12/2015 23 1.4% 35.5% 1.8x

2. Professional Medical Center Medical Office 08/07/2015 26 3.3% 25.8% 1.6x

3. Treeo - Orem Senior Living 09/30/2015 23 3.1% 19.2% 1.4x

4. Park Place at Heritage Village Senior Living 11/30/2015 35 5.1% 31.7% 2.1x

5. Sterling Woods Senior Living 11/30/2015 31 2.0% 32.2% 1.8x

6. Olive Branch Self-Storage 12/17/2015 36 1.3% 57.7% 3.9x

7. Palmetto Self-Storage 12/17/2015 36 2.5% 75.0% 4.4x

8. Pensacola Self-Storage 12/17/2015 36 1.0% 45.8% 3.0x

9. Pro Storage Self-Storage 12/17/2015 17 1.1% 36.1% 1.5x

10. Aspen Heights - Norman Student Housing 01/04/2016 17 4.3% 53.5% 1.8x

11. Loker Medical Arts Pavilion(1) Medical Office 03/31/2016 35 3.1% 18.0% 1.6x

VREC Consolidated 29 28.3% 34.1% 1.9x


Variable monthly distribution – Fund 1 paid an annualized 8.25% distribution on a monthly basis to both

onshore (VREC) and offshore (VREN) limited partners. VREC II will pay variable distributions that depend

on the net cash flows generated from the underlying investment properties.

Upside potential – VREN was essentially designed as a loan to VREC with no potential upside from

property price appreciation. VREC II is structured so that all limited partners will participate in the valuation

changes of the underlying properties – including both gains and losses – with offshore investors pooled into

the master fund via an offshore share class (H).

Catchup contributions – in order to compensate early investors for the added risk that comes with the

uncertainty of investing first, investors coming in to the fund at later subscription dates will compensate

earlier investors with a 9% catch-up interest rate in addition to pro-rated expenses such as management

fees, commissions, etc.

VREC II consists of one master fund with multiple share classes instead of a series of feeder funds.

VREC II is targeting a $400 million raise with an option to increase to $500 million

The following is a brief description of the investment strategy and rationale for the fund as well as for each of the

property sub-sectors, including a summary of current and forecasted activity within the fund.

As a brief reminder, I have briefly summarized the four criteria that all acquisitions must meet to be considered for

the fund:

1. Recession Resilient Property Types – demand must be driven by persistent demographic trends and

inuring social needs that are long-term in nature and less sensitive to short-term recessionary periods.

2. Fragmented Ownership – Virtus sources their acquisitions primarily through off market deals that can be

introduced by an operating partner or discovered by their localized grass-roots efforts in targeted areas.

Sellers are typically less sophisticated operators with inefficient operations or developers with expertise in

other property types, attempting, unsuccessfully, to apply their skills to another property type.

3. Superior Historical Returns – all property types must show a history of enhanced total return potential and

higher yields than conventional property types.

4. Structural Risk Mitigants – There are a variety of risk mitigants that Virtus will use at the property level,

including the current income of the property as a mitigant for longer holding periods – to structuring the

transaction to reduce the risk of loss.

Property Sub-Sectors

Senior living

The rationale for Senior Living is based on both short-term supply/demand imbalances as well as secular trends,

such as the aging baby boomer population, that should continue to drive demand for these types of properties.

The U.S. population above 75 is expected to grow at a 2.9% annual rate over the next 5 years, which would require

an additional 39,000 units to be added annually over the next 5 years while the current construction rate is only

28,000. Over the next 27 years, this supply and demand imbalance will require 69,000 units per year. As the chart

below shows, the supply shortage isn’t expected to level off until the early 2040’s.


Virtus’ specific focus within the senior housing segment is on the private-pay independent living, assisted living, and

memory care facilities. These property types lie in middle of the continuum of care spectrum for senior housing and

provides flexibility to adjust services as demand evolves, enabling providers to offer residents the option to ‘age in

place’.

The average age of entry into senior housing is 82 so demand for senior housing from baby boomers is only just

beginning and should peak by 2043, according to the National Investment Center for Senior Housing and Care

(NIC)

Medical Office Buildings

The MOB segment is attractive because of the healthcare reforms (Obamacare) recently implemented as well as

the long-term trend of an aging US population. According to Terrell Gates, the US will have some form of socialized

medicine regardless of who is elected the next president of the United States.

There is an overall trend in the healthcare industry toward more efficient healthcare services which are increasingly

being coordinated within the same facility, driving an increase in outpatient procedures and creating the medical

equivalent of a one-stop-shop – facilities that include physician offices, urgent care centers, diagnostic laboratories,

imaging centers, surgical centers, and long-term acute care facilities, to name a few.


These types of properties tend to have very long leases with annual escalators and have historically had very low

default rates. For this reason, institutional investors tend to favor them for their yield and inflation-protected cash

flows. Virtus looks for properties specifically near major hospital system campuses and may enter into both value-

add or development opportunities.

Capital has been flowing into the sector for some time but absorption continues to outpace construction – and

despite cap rates decreasing amid rental rate growth – Virtus still sees NOI growing at 2-3% annually.

Virtus believes cap rates will remain relatively flat at these levels or move slightly higher in the short-term as less

REIT participation is expected. Their strategy is to focus on local and regional full service operators in high growth

corridors. See map below.


Self-Storage

Current pricing for self-storage properties is unattractive and Terrell Gates expects acquisitions of these property

types to slow in the short-term such that VREC II will probably have fewer self-storage properties than VREC. They

anticipate reentering the market as pricing improves with their intended strategy to create critical mass in a specific

regional area in order to sell multiple properties as a portfolio.

Self-storage properties not only are recession-resilient but are also a play on an increasingly mobile workforce and

baby-boomer downsizing as they enter retirement. During recessionary periods, people that lose their jobs tend to

downsize and store their belongings in self-storage facilities. Meanwhile, millennial unemployment is still relatively

high and many within the age group have moved back in with their parents, storing their belongings in the

meantime. For those millennials with jobs, the tendency has been to rent first to evaluate specific areas before

deciding on buying – or even switching jobs more frequently, often in different cities – which tends to increase

demand for self-storage.

Finally, as baby-boomers retire and look to live a more leisurely lifestyle with less focus on home maintenance, they

sell their larger suburban homes and move into smaller, more centrally located condominiums or apartments,

storing their excess belongings in self-storage facilities.


Virtus target areas for self-storage are in Tier 1 or Tier 2 MSA’s and they typically buy from small mom and pop

operators.

Student Housing

Student housing is still an attractive sub-sector for Virtus and they continue to focus on Tier 1 universities (high

growth flagship universities with over 15,000 students). Their value-add approach focuses on the rehabilitation,

modernization, and amenitization of Class B properties located within 2 miles of campus - that compete with Class

A properties typically located closer to campus and charging much higher rates. With highly amenitized properties

set close to transportation mediums, Virtus is able to increase rental rates substantially while still being materially

discounted compared to Class A properties.

For investors not familiar with the sector, student housing can be one of the most resilient property types during

recessions. Specifically, during recessionary times and rising unemployment, individuals who have lost their jobs

find that returning to school to further their education or reinvent their careers is often times a better option than to

remain unemployed or underemployed.

The chart below highlights the growth in post-secondary enrollment growth which confirms that enrollment tends to

increase faster during recessions but is still generally on an upward trend since the early 1990’s. The recessions in

the early 1990’s, early 2000’s and 2008 all had noticeable increases in secondary enrollment growth.

Some of the demand drivers for student housing are sustainable enrollment trends as shown above, combined with

limited university budgets that are causing universities to minimize on-campus housing and/or outsource some of

their student housing needs to 3rd parties.

The number of new beds delivered had been on a dramatic upward trajectory from 2011 to 2014, hitting a high of

60,000+ before pulling back to an annual rate of new beds of less than 50,000. Meanwhile, the total number of

post-secondary enrollees has continued to increase and is expected to reach 23 million by 2020. SOURCE?


Source: Virtus Real Estate Capital

Workforce Housing

The workforce housing sub-sector is an additional sector not targeted in VREC. The rationale for workforce housing

is driven by the widening income gap and increasing demand for affordable housing for lower-income earners.

According to ???, 62% of all American workers make less than $40,000 annually. As the level of renters has

increased, there has been solid growth in multi-family construction from 2010-2014. Unfortunately, because of the

high cost of development and the required rents for lower-income multi-family development to be profitable, there is

a lack of adequate supply for this demographic and very little interest from developers to enter the space.

Most

new multi-family construction is high-end Class A product with a median asking rent of $1290, which is 50% of the

median renter’s monthly household income. This level of housing cost/income is termed severely cost-burdened

and exemplifies the challenges within the industry and the opportunity within the space.

Virtus targets MSA’s with populations over 1,000,000 with both a substantial population of lower-income earners

and employers that typically hire at lower than median income.


The Joint Center for Housing Studies of Harvard University confirms in its report titled America’s Rental Housing,

that housing for lower income renters is in drastically short supply. With wages stagnating and rental rates rising,

the percentage of renters severely cost burdened (greater than 50% of income goes toward housing) has remained

at an all-time high, as the absolute number of renters has increased from 7.5 million in 2001 to 11.4 million in 2014.

Virtus’ value add approach for the sub-sector is to focus on Class C+/B- properties and upgrade to Class B. The

first property within the fund, mentioned below, is a development property with tax abatements that eliminate

property taxes for 75 years provided a certain percentage of units are leased to renters with income below 80% of

the area median income. (AMI)

Charter Schools

The Charter School investment opportunity will be focused on high need school districts and is driven by

educational reforms resulting from an increasing demand for better educational outcomes not being satisfied by

many public school systems. Charter schools currently serve 2.5 million households at over 6400 schools and has

grown over 640% since 2000. Despite this growth, current national enrollment stands at just 4.6%, substantially

below the enrollment rates of states with the longest track records of charter-friendly legislation.


Virtus will focus on areas with low teacher union influence and charter school-friendly regulators with authorizers.

TG mentioned a property currently being evaluated that includes partnering with an existing charter school using

space typically used for other purposes. (i.e. Church). Virtus and its potential operating partner have identified a

location that can accommodate 800 students and a waiting list is already being established.

The exit strategy for these types of properties, and for this first property is to sell to the current potential operator

after three years, when the operator will be eligible for public financing through the issue of a bond. The other two

options for exit strategies for this and other Charter School properties is to sell to a publicly traded REIT, such as

EPR, or a high-net-worth individual looking for cash flow.

The charter school lease structure will also be more restrictive than other property types discussed in this report.

For example, in other property types, a tenant cannot be removed as long as the lease payment is current even if it

is well-known that the tenant’s situation is in imminent default. Within the charter school property lease terms, the

operations of the school must meet certain ongoing performance standards or Virtus will have the opportunity to

remove the operator before the situation deteriorates and students are lost.


Properties

Senior Living – Oklahoma City& Tulsa

Senior Housing – Assisted Living and Memory Care


Self Storage – Charleston, SC

Workforce Housing – San Antonio, TX

Virtus 2016 outlook on relative value is as follows, which is a good indication of where it will be looking for

opportunities. The largest scale opportunity continues to be the senior living space which offers the highest return

potential but also comes at a higher level of risk. Student housing and workforce housing are the next largest

opportunity set with student housing at slightly higher risk due to heavier capital inflows into the sector. As

previously mentioned, Self-Storage seems to be slightly overvalued in the current environment and despite the

lower risk and higher return profile of this sub-sector, entry pricing is unattractive so it will not be a strong focus

during the early part of the investment phase of the fund.


Conclusion It is too early to tell how well the fund is performing. However, based on the opportunistic purchases of development properties early in the

investment phase, we expect cash flows to be lower than originally anticipated during the first few years. Had the fund found opportunities

to invest in cash-flowing properties, the situation would have been different.

For investors looking forward to receiving cash flows, we urge patience as the fund ramps up on those properties that are already

generating cash and the development properties are completed and leased. In the meantime, we look forward to higher potential upside

returns from the development properties purchased at attractive valuations.

Virtus Real Estate Capital - Monitoring Report - Rewritten January 2017

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