Bucking the traditional real estate private equity model

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The traditional real estate private equity model is broken.

Here is how it works now:

  1. Sponsor finds deal
  2. Sponsor raises equity from investors, then uses as much debt as possible (to enhance the returns to investors)
  3. Sponsor adds value to deal (renovating, building ground-up, whatever)
  4. Sponsor sells deal as quickly as possible, pays off the loans, returns capital to investors, takes her cut (the promote)

The model above is designed to maximize pre-tax IRR (internal rate of return), which you do by using as little equity as possible and returning as much capital as possible (by selling), as quickly as possible.

Sounds good, right? What could be bad about maximizing IRR?

Well, there are some issues:

  1. Lots of leverage – To maximize IRR, you want to minimize the amount of equity capital used in your capital stack. So, you absolutely max out on debt, including really high interest mezzanine debt (the stuff that is junior to the senior debt, but senior to the equity – basically, risky loans that cost a lot). Regular readers know that leverage magnifies outcomes, good ones but also bad ones. Structures that load up on debt are EXTREMELY vulnerable to collapse in the event anything goes wrong (construction cost over-runs, construction delays, leasing delays, etc.). This is a recipe for foreclosure, which means total, permanent loss of equity capital invested. Ouch.
  2. Requires an exit – The churn-and-burn business model usually means adding a little value, quickly (the old lipstick-on-a-pig routine), and then flipping the property to the next buyer. But what happens if there is no next buyer, or rather, if prices have come down in the interim such that the next guy isn’t willing to pay what you’d hoped? In that case, you’re stuck either selling at a loss (permanent capital impairment) or else owning the deal as the lipstick wears off, and dealing with the rent stagnation/declines and opex increases that inevitably entails. Meanwhile, your investors, who were promised a quick turn, have their dough stuck in a deal they don’t really like.
  3. Maximizes transaction costs – Any time you buy or sell real estate, there are transaction costs, including broker fees, escrow fees, title fees, legal fees, transfer taxes, etc. In LA, those costs can easily add up to 6-8% of the gross sale price… and that’s before the sponsor takes her fees! On a good flip deal, where the unlevered, gross ROI might be 30%, a full 10 percentage points (a third of the total profit!) might be eaten up by transaction costs.
  4. Maximizes taxation – The private equity model was presumably designed with the needs of non-tax-paying, institutional limited partners (pension funds, endowments, foundations, etc.) in mind. Since they don’t pay tax, they don’t worry about the huge chunks state income tax and federal capital gains tax take out of each flip deal. But, for an “ordinary” high net worth investor or family office, paying out 25-40% of the profit on a deal to the government is ruinous to the after-tax return (which, after all, is what those investors should care about).
  5. Requires re-deployment of capital – When an individual buyer invests in income producing real estate, he’s making a simple deal (whether he knows it or not): Exchanging a certain amount of cash today (the downpayment) for an income stream going into the future. Contrast that to an investor in a churn-and-burn deal: He does all this work to vet the deal (if he’s smart!), then, like 18-36 months later, gets back his money, plus a heavily-taxed profit. And then he has to put the dough back out again… with the risk that this next deal doesn’t go as well. Or, if he likes the sponsor, maybe they go do a 1031 exchange to defer the taxation… which means having to buy a replacement property with a ticking clock, which makes it very tough to make a good deal.

So, if churn and burn deals aren’t great for standard, tax-paying investors, why do sponsors keep pushing them? Simple: Because they’re GREAT for sponsors, who get to:

  1. Notch a “win” on their track record – After all, everyone likes to see 25% IRRs in pitch-books, and damn the tax consequences
  2. Charge fees coming and going – Acquisition and disposition fees are a standard part of the set-up
  3. Crystalize their promotes (usually 20-30% of the profits) quickly – Since they didn’t have to put up the dough for that share of the profits (that’s the whole point of the promote), they don’t care about the taxation… it’s all income, anyway.

Bottom line: At Adaptive, we regard capital as precious and hate the idea of vaporizing it with taxes and transaction fees. So, we’re long term holders. And, if that means we need to buck the traditional real estate private equity business model, that’s what we’re going to (continue) to do.

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