Michael Episcope, Principal, Origin Capital Partners
There was probably no asset class hit harder than real estate during the economic crisis of 2008 and 2009, and many investors swore never to return again. After double digit returns for 3 years in a row and counting, those investors are seriously regretting this decision.
Cyclical and event driven downturns can’t necessarily be avoided, but we can limit their impact to our real estate investment portfolio by taking the time to find the right manager.
Great managers invest prudently and can create downside protection when times are bad and generate outsized returns when times are good. The question then becomes, how do you assess one from another? Top tier managers have five basic qualities that set them apart, and they all revolve around the concept of how aligned they are with their investment partners;
1. Significant Co-investment Capital: Does the manager invest a significant amount of capital alongside yours? Meaningful “skin in the game”, whether it’s the manager’s own capital or funds that they have raised from “friends and family”, ensures that the manager is personally and emotionally invested in every investment decision that is made.
2. Evaluate the Infrastructure: Do they have the requisite infrastructure to service your needs and do their job effectively? Pay particular notice for companies that have employees devoted to individual department areas such as asset management, acquisitions, investor relations, and accounting. However, don’t take this to mean that bigger is better. Bigger firms are just bigger firms. In fact, smaller sized firms, defined as companies with less than $1bb in assets, have outperformed their larger counterparts by a substantial margin, according to Preqin data from 1994 to 2008, so time spent here can potentially pay large dividends.
Do they run other businesses that may create a conflict of interest? Many firms are vertically integrated with property, construction, asset, and investment management all under one roof. Can a company really be best-in-class in all of these areas across multiple geographies? An additional consideration is that these revenue streams provide much needed revenue to the firms, especially the smaller ones, so the decision to sell may easily become more of an internal dialogue about an income stream rather than an external dialogue about the investment objectives of the client.
Do they outsource accounting? Having an internal controller is a must at most every firm, but it is essential that the bulk of the accounting and cash management is handled by an outside, independent agency for control purposes.
3. Compensation and Fees: Are their fees guaranteed or are they performance-based? Fees paid to the investment manager should be disproportionately weighted towards performance. Guaranteed fees, which shouldn’t generally exceed two percent of invested equity per year, should do no more than keep the lights on and pay minimal salaries but not be a profit center for your manager.
How much of your money is being invested on day one? Good real estate investment managers are efficient in the way they raise capital and manage fees and will invest more than 95 cents of every dollar that comes in the door. Certain real estate vehicles, such as privately held REITs, can have front end loads in excess of 15 percent; meaning that for every dollar you give them, only 85 cents is actually being invested. You have lost 15 percent on day one!
What is the gross to net return? This is a test to evaluate how much the investment produces in pure profits versus how much you receive, net of all fees and expenses. When things go well, investors should expect to receive 65 percent or more of all profits generated by the property after all fees and expenses have been paid to the investment manager. When things don’t exactly go according to plan, the fees should be minimal across the board.
4. History and Track Record: How much experience do they have in the industry? Experience in a variety of areas of the investment and management process is important and division leaders should have 10+ years of experience in their fields of expertise.
How have their investments performed? Ask them specifically to provide detail about their last five realized returns and don’t simply rely on the brochure. Also, ask them about the investments that went poorly and how they handled the situation. How an investment manager behaves when things go wrong, and, from time to time they undoubtedly will, is the truest depiction of the integrity of the firm.
5. Strength of Balance Sheet: What do they have to lose? Firms with strong balance sheets and large cash positions are in a far better position to serve their clients and maximize investment value, especially through the downturns. In a vacuum, a healthy balance sheet paints a picture of a fiscally sound firm, one that has made good decisions in the past and will likely be in existence for years to come.
The guidelines set forth are extremely important in selecting a real estate investment manager because of the illiquid nature of the asset class. To be clear, these five qualities are not interchangeable – a qualified manager should possess every one of these characteristics - not just a few. What difference does their co-investment make if they are immediately pulling it all out in guaranteed fees? How can they have such a great track record but have no depth to their balance sheet?
Baseline criteria such as honesty and integrity are a must with anyone who is acting in this capacity. Obtain personal references and look for these qualities throughout your diligence process. Even something as simple as a Google search of the management team and the company can uncover a surprising amount of information.
If you need help in locating firms to interview, or have questions beyond these areas, then consider hiring a real estate advisor to help assist you in the process. The investment manager you ultimately invest with will appreciate you taking the time to ask the questions and will feel good about the fact that you’ve made your investment decision as an informed investor.