Is an expected 25% IRR better than an expected 14% IRR? Is a 5-year investment better than a 2-year investment? Is an investment in an industrial project better than an investment in a new office building? Is a real estate investment better if it has 90% leverage or 50% leverage? Is it better to invest in San Francisco or Orlando? New York or Kalamazoo? If you work at Altus, your answer would always be “it depends”.
As readers of the Altus Insight are aware, we (Altus) are in the process of putting together our first real estate fund in almost 10 years. Readers probably know why we didn’t do funds over the past decade, and why we are choosing to go that route now. Readers may also know our investment strategy, yadda, yadda, yadda. A discussion of the Fund may be part of a future Altus Insight, but this isn’t the time. This month I want to hone in on one component of our fund process, which was compiling our historical returns. To raise any meaningful amount of investment into a discretionary fund, investors expect the manager to document their historical performance.
We have never really analyzed our portfolio wide returns for a couple different reasons; namely we don’t like to sell (which is required for a true IRR calculation), and our focus has always been on the success of each individual investment. We were surprised, and quite pleased, when we received the totals. Our historical returns are good. Really good. But while there is a certain amount of pride that is assigned to those returns, I fear focusing on the absolute return can lead to poor investment decisions and misalignments of incentives in the future.
Don’t misunderstand me, if we are analyzing an investment with a particular set of risks and returns, then obviously higher expected returns are better than lower expected returns. But when considering portfolio construction, only focusing on the historical returns misses a hugely important factor: what was the risk assumed to produce those returns?
Another factor to consider in evaluating returns is the time frame over which those returns were achieved. Said another way, how much of the returns were the result of market forces (mostly luck) versus the skill of the sponsor/investor. While not an absolute truth, sponsors in general faired much better between 2015 and 2022 than they did between 2006 and 2013. There is no question that our returns benefited from the rising market tide over the past several years, but if the returns produced are compared to the returns produced of contemporaries, then the return calculation is still of value.
The risk assumed to produce those returns are of true consequence. By its very nature, a new construction investment involves more risk than buying a stabilized multi-tenant building (all other things being considered). There is supply chain risk, contractor risk, lease up risk, governmental risk, interest rate risk (construction loans almost always have adjustable rates), and many more. If purchased with fixed rate debt, a stabilized multi-tenant investment doesn’t have contractor risk, doesn’t have supply chain risk, and doesn’t have financing risk. Additionally, governmental risk and lease up risk are significantly diminished. Lastly, there is substantially more entrepreneurial effort that goes into a new construction project than into a stabilized investment. All the extra risk associated with new construction, or any other level of increased risk versus a different investment, need to be compensated as such.
Let’s consider an example:
Dallas metro class B multi-tenant industrial vs. Greeneville, SC metro brand new construction class A industrial/warehouse lease up.
- Ironically, we currently have off-market offers on both properties that we are considering/negotiating. Both of the investment should return investors somewhere between a 16 – 18% IRR.
- Greeneville is one of the strongest industrial markets in the country, though Dallas is also strong.
- The Dallas property is decades old while the Greeneville property is brand new.
- But the Dallas property was purchased fully occupied using 10-year fixed rate debt.
- The Greeneville property was purchased empty (though again, in a really hot market) with fixed rate debt, but in a more complicated structure.
Note that in both cases the investor IRR produced was roughly the same. But in one case I would judge the IRR to be really strong (we had originally projected a 13% IRR), where in the other case I would deem the investment, while not a failure, to be less successful. The Dallas property had a really low risk profile, and so the originally anticipated returns (13%) could still be considered strong, while the risk profile for the Greeneville property was much higher, so the returns can be considered relatively poor. What if we were able to produce an entire portfolio of Dallas type properties all with 13% IRR proformas? Does that mean Altus is a worse investor than if it had a portfolio of Greeneville properties that produced 18% IRRs but with a much higher risk profile? I feel strongly that the answer is NO! But that then leaves the question remaining, how can we as sponsors appropriately communicate our results? And how can passive investors pick sponsors that have a proven risk/reward weighted track record?
Stock markets have a measure of risk from which gains above/below market returns (called “alpha”) can be calculated. This is helpful for investment firms (like hedge funds) to be able to document their returns. However, even this measure of risk is deeply flawed because it only measures volatility, which at its best is only one of many different risk factors, and at its worse, is not a true measure of risk at all.
Real estate has no such measure, at least not that I can find. Maybe there is a way to use market appreciation rates and assign some standard level of leverage to calculate a “market return” and then compare that return to a particular portfolio’s return. But while returns can at least then be compared to a proxy for market returns, it still doesn’t take into account the risk assumed to provide any specific level of returns. The biggest of which may be the way investments are financed. Many sponsors produced great returns over the past four years riding the appreciation wave and maximizing (squeezing upward) returns by using the cheapest and riskiest debt. Many of those sponsors are now blowing up over that same debt that helped them obtain strong returns. Unlike stocks, real estate is not liquid, so measuring performance across a short time frame is even more misguided than those that consistently measure their securities portfolio against peers or the market over weeks, months or even years. Only over longer time periods can true performance be determined.
Taking off my sponsor hat, and putting on my investor hat, how do I understand the risk I am taking? I believe the risk falls into three broad buckets: sponsor risk, investment risk, and risk around the structure of the investment itself. It is absolutely vital to understand that risk in and of itself is not bad, and for most of us shouldn’t be avoided. Very few of us will achieve our financial goals by only investing in the supposed risk-free investment of T-bills. Rather, the key is understanding the level of risk and making sure we are being appropriately rewarded for the risks inherent in any particular investment:
- Sponsor risk:
- Is the sponsor honest? It doesn’t matter how great an investment opportunity is if the sponsor is siphoning funds.
- Does the sponsor communicate well and transparently? Investing is stressful, and the lack of these attributes only increases, rather than diminishes the stress. A benefit of passive investing should be to have someone else dealing with the investment stress, not increasing stress because they are inaccessible or hard to work with.
- Is the sponsor at least marginally competent? A great investment opportunity found by a low competence sponsor can still be a great opportunity, especially if things go well. However, a high competence sponsor is going to outperform less skilled sponsors over time because they are able to better mitigate the known risks and adjust course when unknown risks pop up.
- Investment risk:
- Loss of equity: Warren Buffett’s #1 rule is to never lose money, which is great advice, but there are also two types of equity loss. One is some portion, but not all of the invested equity. The other is the catastrophic risk of losing an entire investment. It is important to understand the difference and ensure that expected returns are commiserate with the potential for loss.
- Loss of expected returns: Nearly all investors are limited in the number of investments they can make, which means we have to choose between opportunities. Any time we choose one opportunity over another there is the opportunity cost of not making the other investment. If things go well, then great, the opportunity cost was worth it. But if they don’t go well, then the other investment could have been better. Said another way, what is the likelihood of any investment hitting its expected returns versus under or overachievement of those expected returns. When buying a single-tenant high quality NNN leased building, it is pretty easy to forecast returns out into the future, and with a high level of certainty. An apartment repositioning, especially in a rent-controlled state, is much harder to forecast, so the likelihood of having an outcome different than expected is elevated.
- Volatility in cash flow: Using the single-tenant NNN example in the preceding paragraph, the cash flow is dependable, forecastable, and consistent. But also has the potential for catastrophic termination of cash flow if the tenant for some reason is able to break their lease. Conversely, a “C” apartment building in a questionable neighborhood may have great cash flow, but severe variation month to month and quarter to quarter due to evictions, delays in government assistance payments, etc.
- Investment structure risk:
- Leverage: There are investment opportunities, like first position deeds of trust or no debt real estate ownership, that should never experience a complete loss of capital. Any time there is leverage (or more senior debt) the possibility of complete loss of capital exists; and increases as leverage increases. At least for any one particular investment. When looking at portfolio construction, it may make sense to invest less equity in any one particular deal (i.e. increase leverage) but invest in several different opportunities. If one doesn’t go according to plan, the lender ends up taking a portion of the loss instead of the investor losing the entire amount. This is also a great argument in favor of investing in a fund structure.
- Investor/Sponsor structure: The more alignment that exists between the passive investor (often referred to as the LP, or Limited Partner) and the sponsor (often referred to as GP, or General Partner), the higher the likelihood of overall deal level success. But there are also ways to structure an investment within a particular opportunity to assign risks. Is investment made by the GP pari-passu to the LP investment, or junior to it? Are the returns to the GP pari-passu or junior to the LP? Is there a preferred return? What are the fees? Etc. There is no right way to structure the investment into a deal. There is just ensuring that the rewards of that deal are in alignment with the risks being assumed by the various parties within that deal structure.
Strong high-level returns are great. Strong high-level returns on a risk reward basis are even better. Understanding and quantifying the risk to ensure appropriate enumeration is key.
About the Author: Forrest Jinks is CEO of Altus Equity Group Inc and a licensed real estate broker. Forrest has decades of experience as principal in a variety of alternative investment segments including real estate (residential rehab, in-fill development, multi-family, office and retail), debt, and small business start-up (online marketing and site retail). He can be reached at firstname.lastname@example.org.