How a fund manager gets paid

Do you ever wonder how, exactly, Adaptive makes money? Figured I’d break it down for you.

Today, let’s talk about our investment funds. These are discretionary investment vehicles. That means a group of people with capital to deploy commit a certain amount of money (say, $100-250k) to the entity. Then, we, as managers of the entity, take the money committed by all of the investors (typically in the $2-5MM range) and use it to buy, renovate, lease-up and (eventually) sell apartment buildings.

So, how exactly do we, Adaptive, make money from these investment funds? Here’s how:

  • Asset management – Like most money managers, we generally take 1% of the capital committed to the fund as an annual fee. The purpose of this fee is to help offset the cost of running our operation (bookkeeping / accounting / investor relations / acquisitions staff / etc.);
  • Brokerage – If we find the deal, generally Adaptive Realty, Inc. acts as the broker on behalf of the buying entity and therefore collects a 2-3% buy-side commission. Of course, if it’s an off-market deal that comes to us via another broker, that broker takes the commission;
  • Acquisition fee – Whether we broker the deal or not, we typically take a 1.5% acquisition fee to compensate us for the work that goes into finding the deal, negotiating the terms, and undertaking the due diligence necessary to ensure it’s a good fit for the fund;
  • Construction oversight – There is an unbelievable amount of design, purchasing, and construction project management that goes into one of our projects. We therefore charge the fund a construction oversight fee, of 10-15% of the construction budget to off-set the cost to our organization of providing these services; and
  • Property management – For better or worse, we do almost all of our own property management, for which we are paid 5-6% of the annual rents on completed buildings. I almost forgot to add this fee in, because property management is a terrible, loss-making business and neither Jon nor I see a dime of this money.
  • Exit brokerage – When it comes time to sell a deal, we typically act as listing broker under standard industry terms (5-6%), earning ourselves a brokerage commission which we split with the broker representing the buyer.
  • Promote – This is our share of the profits. This comes only after investors have received all their money back and also (usually) a pre-negotiated “preferred” return on their money. The split varies depending on the deal and how high the pref is.

Does the above sound complicated? It is. But we’re providing an incredibly valuable service to investors, one which requires an awful lot of effort and experience, and we obviously need to get paid for it.

Tomorrow, we’ll talk about the brokerage and property management business.

Note: This blog post is not a solicitation for investment or an offer to sell any securities.

Why our infrastructure is falling apart

The NY Times had an interesting piece over the weekend about LA’s failing infrastructure. It focused, as all these pieces do, on the age of our pipes, sidewalks, etc., plus on CA’s general tax-aversion.

What it left out was any discussion of the role our zoning code plays.

Here’s the deal: If, as a city, you make it difficult to build dense multifamily, you do two things, both of which are awful:

  1. You force people to spread out. This means that you need to maintain more road miles per person, more sewer pipe miles, more water pipe miles, etc. So your costs are higher; and
  2. You limit the value of your land and therefore artificially reduce your tax base. There’s a reason developers want to build more units on every given plot of land… the land is worth more if you can fit more people on it (either via rent or condo sale proceeds). Property taxes (imperfectly, due to Prop 13) reflect the value of the land, so less density equals less tax revenue.

So that’s why we’re in the position we’re in: An expensive to maintain infrastructure with limited revenue to pay for it.

Unfortunately, we can’t go back and change the way LA developed. We’re stuck with, for example, maintaining absurd one lane roads up in the hills, the utilities that service the homes up there, and the fire department required to prevent them from burning down.

But we can change the zoning code, right now, to prevent further sprawl and begin to densify core neighborhoods of the city. Changing the zoning code to allow for much denser development wouldn’t cost anything and would dramatically increase property values in the affected neighborhoods, leading to happy owners and a city with sufficient resources to re-invest in a world-class infrastructure.

Lyft, Uber and America

Regular readers know I’m a major fan of ride-sharing companies. They’ve totally changed the way that I, and many other Angelos, get around our city. And, as I’ve written before, I think the changes are sufficiently profound to eventually reshape the built environment here, too.

But today I want to focus on what I regard as a side benefit of using these services: The opportunity to speak with the drivers.

I speak with every driver, because I’m naturally curious. And, so far, particularly on Uber, the drivers tend to be immigrants. They are all studying, learning English, working multiple jobs, and looking out for opportunities to start businesses.

Every time I have one of those conversations, I’m reminded what an amazing country we have. Because we’ve set up a free economy where people can get ahead by working hard, we attract the hustlers from everywhere, the ones who are willing to forsake the places they were born to follow a dream.

Not all of them will succeed; indeed, many will probably end up going back where they came from. But, from among that group of hungry, energetic risk-takers, you know that businesses are getting created, jobs are getting created, and capital is being formed.

I find it almost impossible to be discouraged about the future of our country, no matter our problems. As long as the hustlers choose us, we’re going to be just fine.

Highland Park gentrification response

Hat-tip to Curbed for linking to this really fascinating piece on Highland Park gentrification.

Before I get into my problem with the article, I want to congratulate the author on what I think is a fair, reasonable account of the changes taking place in Highland Park.

Now, to the problem. Here’s the money quote:

These [renter] residents have reason to be anxious about what gentrification may bring to Highland Park…[w]hile rising property values allow homeowners to cash out, there’s no economic upside to gentrification for renters, many of whom are likely already stretched financially…”

Can you tell what’s wrong with the above paragraph? Read it again.

Give up? Here’s the problem: It’s like the author has never heard of rent control.

It’s true that Highland Park has a large number of non-rent control apartment buildings plus plenty of single family rentals (which are non-rent control by definition). So there are definitely residents who are getting pushed out by the more affluent tenants moving into the area.

But there are also tons of pre-1978 apartment buildings which are covered by rent control, which limits rent increases for existing tenants to 3% per year. And, because much of HP is covered by a huge Historic Preservation Overlay Zone, most of those buildings can never be torn down, so matter how high market rents get.

What does it mean to be a rent-control tenant in a gentrifying area?

The market rent is the price put by the market on consuming a particular unit in a particular building. The price is determined in part by characteristics intrinsic to the unit (number of bedrooms, baths, condition, etc.). But it is also determined by extrinsic factors, principally how desirable the neighborhood is.

Rents in Highland Park are running up way faster than 3% / year, in large part because the neighborhood is gentrifying (better food, booze, retail, etc.). And legacy tenants get to patronize those new restaurants and coffee shops alongside the newbies.

So, one way (not the only way) to interpret the above facts is this: As a rent control tenant in Highland Park, you’re getting a better and better deal with each passing year (as your rent falls further and further below the market price for your unit).

The two economies

If you’re reading this, you probably don’t know about LA’s Other Economy. How do I know? Because you can read English, and the Other Economy is not, for the most part, English-speaking.

What is the Other Economy? It:

  • Comprises mainly immigrants and their American-born children
  • Is conducted in Spanish, Chinese, Tagalog, Khmer, and other languages
  • Is transacted in cash
  • Is offline
  • Has prices that are anywhere from 20-50% lower than those in the mainstream economy

Picture a food truck. If what comes to mind is a new vehicle with cool graphics staffed by hipsters with ironic facial hair, you’re a mainstream economy kind of person. The Other Economy foodtrucks are the original ones: usually a bit more beat-up, with hand-lettered signs, staffed by Latin people (often families), and charging much, much less (even though the food is often much, much better).

Car window broken? You can go to your dealership and pax X. Or you can go up towards Chinatown to the strip of places that specialize in just fixing windows, negotiate in Spanish, transact in cash, and get it done for probably 33% of X.

Need an apartment? All over LA, there are neighborhoods where no apartments get rented on Craigslist. Instead, when there’s a vacancy, the resident manager, who often speaks no English, puts out a sign in his/her native language advertising the vacancy. Unsurprisingly, the rents achieved this tend to be way, way less than what you would probably consider to be market.

One way to think about gentrification is as a process that moves physical assets (apartment buildings) from the Other Economy, where they generate lower returns, to the mainstream economy, where they generate higher returns. The negative side-effect of this process is that the Other Economy shrinks, making life more difficult to the people who live and work in it.