Wealthy real estate investors build their empires on the backs of other people’s money (OPM). They use years of experience and relationships to arrange deals that provide a reliable return to their investors. Current cash flow and upside from value appreciation pays the investors while leaving some meat on the bone for the investment manager.
Investment management is a specialized field with many subcategories. Private and institutional investors rely on managers that are experts in their subcategory to deliver above average returns with average or below risk. Investment managers that consistently provide a positive risk-return trade off like this are known as high alpha mangers.
Every investment manager (AKA deal sponsor) seeks to be a high alpha manager. Their livelihood relies on attracting and retaining investment partners that trust them. Investors trust the investment manager to do what they do best without getting in the way. The deal sponsor is responsible for daily decisions, while all partners vote on major decisions.
Deal sponsors build expertise in CRE investment management over many years of executing on simple and complex business plans. This expertise comes from studying deals that went poorly and identifying what went well in those that were big successes. Finally, it comes from nurturing relationships that help source unique deals and execute on challenging business plans.
Great investment managers stand out from the crowd. Industry press loves them because they are involved in big, successful deals. Emerging managers are more difficult to identify.
Business cycles make it difficult to identify whether emerging CRE sponsors were successful because of a good buy or astute execution. A high alpha manager can source good deals in every business climate.
Expert deal sponsors have a healthy relationship with risk. They consciously identify and address potential hazards in every area of the investment. Risk mitigation policies are well-documented and communicated to every influential stakeholder in the deal.
Transparency and communication are the hallmarks of a great investment manager. Expertise does not hide from challenges.
Experts specialize. They understand that it’s far costlier to adapt their platform than to search harder or be more creative within their area of expertise. This provides a healthy foundation for confidence in all aspect of their deals.
Hotels are a particularly difficult asset class to manage. Property and asset management are two distinct skills with a natural, healthy tension. A great investment manager has distinct strategies for each discipline that highlights the value enhancement provided by each.
The sales and marketing process for attracting other people’s money helps strengthen and focus their specialization. Further, the successful funding of a deal adds another level of confirmation that the business plan is reasonable.
A tangible asset with intrinsic value secures every real estate investment. That is, the real and personal property are still worth something even if the whole business plan fails. This security provides comfort for risk averse investors. It allows them to accept a lower rate of return in exchange for the right to take over the property in case of default.
Cost of Capital
A financial pro forma projects the expected investment return with a given set of operating and capitalization assumptions. Investors measure returns in absolute – profit and MOIC – and relative terms – IRR and cash-on-cash. Investment managers build the capital structure based on these return metrics by matching the appropriate financing to the deal.
Cost of capital is the driving force behind capitalizing a deal. Lenders and investors target their risk-adjusted return based on where their last dollar is in the capital stack. Sponsors are interested in the size of the spread between the blended cost of capital and the deal’s projected return.
Consider the following example:
- Total Capitalization – $10 million
- Annual Net Operating Income – $1 million
Assume the sponsor takes a 70% LTC loan at a 5% interest rate and syndicates 90% of the required equity. The syndication limited partners get an 8% preferred return, and all profits above the 8% is split 50/50 between the sponsor and the limited partners.
- $7 million loan @ 5% = $350,000/year
- $2.7 million equity partner @ 8% = $216,000/year
- $300,000 sponsor equity @ 8% = $24,000/year
- 50/50 split to equity = $205,000/year each
The cost of capital is 7.71% ($350k + $216k + $205k) on this deal that is returning 10% per year. The deal sponsor takes the remaining 2.29% spread. This doesn’t even account for asset and property management fees to the deal sponsor.
This is an extreme example, and it does not consider return of capital upon refinance and sale. Still, it is not uncommon for investment managers to earn extraordinary returns relative to their contribution. Further, most passive investors don’t mind the investment manager’s lucrative returns so long as they hit their target risk-adjusted return.
Note: NOI growth and sale assumptions impact profitability and IRR. This simple case only illustrates the costs of capital in a static environment.
Debt vs. Equity
Other people’s money comes in many forms. Debt and equity are the broad categories, but even these have many variations. The primary differentiation between debt and equity comes in the form of rights to the property upon business failure. Lenders have the first right to all cash flow, and they have the right to take the property upon failure.
Lenders provide two levels of debt – senior and subordinated. The senior loan is the least risky position in the capital stack. The subordinated debt – also called mezzanine debt – is a more flexible arrangement, and it sits right behind the senior loan in payment priority.
Mezzanine lenders take more risk than the senior lender. However, they have an option to take control of the property upon default so long as they don’t allow a default on the senior loan.
This kind of arrangement opens the senior lender to additional risk. Many senior lenders don’t allow mezzanine debt to sit behind their loan. Therefore, most deals with mezzanine debt use the same lender or the mezzanine lender has a good relationship with the senior lender.
Equity is expensive compared to debt because it is a risky position with no payment guarantee. Additionally, investors have no recourse in the case of a business failure. Therefore, deal sponsors stretch the loan proceeds as high as possible to minimize the blended cost of capital.
While debt is more affordable, equity is much more flexible. Common and preferred are the two primary variants of equity. Preferred equity is more like a mezzanine loan with limited default protection. Common equity bears the full risk of the deal, but it also benefits from all the upside.
Each deal has a unique structure.
Experienced investment managers bring integrated platforms, sophisticated processes, and access to unique opportunities. You can only do as many deals as the platform and balance sheet allows, so it’s important to manage these resources effectively. Wealthy managers try to contribute as little as possible even though they rarely get away with no money down.
Investors like when deal sponsors contribute a portion of the total equity – “skin in the game” – but this is not a requirement. Many emerging managers do not have the bankroll to contribute cash to the deal. However, they bring expertise and relationships that allow them to earn sweat equity.
Joint ventures and syndications are the typical ways to incorporate other people’s money.
A joint venture involves two or more parties that form a partnership to execute a defined business plan. The joint venture agreement (JVA) clearly outlines roles and responsibilities along with equity contributions and profit distributions.
Most large transactions involve a joint venture between an experienced operator and an institutional investor. The operator controls minor day-to-day property and asset management decisions, and the JVA dictates how the parties handle major decisions.
The partners typically divide profits according to a distribution waterfall that incentivizes the deal sponsor to reach higher return metrics. For example, a waterfall would require a repayment of capital along with an 8% preferred return to both parties according to their equity contribution. Thereafter, a series of hurdles gives the deal sponsor an increasing share of the profits.
|IRR Hurdle Rate||JV Partner||Deal Sponsor|
|0.00% – 8.00%||90%||10%|
|8.01% – 15.00%||80%||20%|
|15.01% – 18.00%||75%||25%|
|18.00% – 25.00%||70%||30%|
This is a complicated deal structure that requires transparency and sophisticated modeling, which is usually out of scope for non-institutional investors.
A syndication involves a group of investors that put their money into a pool controlled by the deal sponsor. The offering documents – private placement agreement, subscription agreement, and operating agreement – define the roles, responsibilities, and economics of each participant.
Deal sponsors typically have full control over major decisions for the deal. Limited partners must approve major decisions regarding changes to the offering documents.
Simplicity is critical to the success of a syndication. Other people’s money typically come from outside of the real estate business – doctors, attorneys, and entrepreneurs. They look for quality of sponsor and expected returns. There’s a high likelihood that they’ll continue investing with a single sponsor if they are successful once.
A typical syndication pays a preferred return, return of capital, and a single level of profit split. The waterfall above may reduce to an 8% preferred return and 50/50 profit split after returning capital.