The traditional real estate private equity model is broken.
Here is how it works now:
- Sponsor finds deal
- Sponsor raises equity from investors, then uses as much debt as possible (to enhance the returns to investors)
- Sponsor adds value to deal (renovating, building ground-up, whatever)
- 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:
- 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.
- 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.
- 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.
- 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).
- 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:
- Notch a “win” on their track record – After all, everyone likes to see 25% IRRs in pitch-books, and damn the tax consequences
- Charge fees coming and going – Acquisition and disposition fees are a standard part of the set-up
- 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.
Have been spending a lot of time over the past few weeks speaking with capital partners, both existing and prospective.
Yesterday, a guy who has backed us for a lot of years said something that really stuck with me.
He said something like: “The way you describe your business has really changed over the past few years.”
And it’s not just words – our business has changed in some important ways.
But, critically, those changes weren’t random.
Our north star on every deal is trying to maximize unlevered yield while minimizing all-in price per square foot.
As the environment in which we operate (asset pricing, construction pricing, zoning, rents, etc.) has changed, we have made changes to our business model in order to continue to head in the direction of our north star.
When an organism undergoes changes in order to thrive in a changed environment, we describe those changes as “adaptive”.
Was browsing the LinkedIn newsfeed yesterday and came across a video a guy had posted of his latest acquisition, which included the name of the neighborhood in which it is located.
The video had a ton of likes and comments (mostly from brokers) and I admit to feeling a bit jealous. (Side note: If you think me getting jealous about a real estate acquisition gives you a window into my personality… you’re right).
So, if letting everyone know about your latest deal gets you a lot of attention, the question is: Why don’t I do it anymore?
The answer is, when we find an area or a building type that works for our peculiar business model, we don’t just want to buy one of those buildings. We want to buy all of them.
And alerting our competitors to what we find interesting is stupid, because it drives up competition for deals.
So, I will (sadly) forgo the ego boost that comes from telling you about what, exactly, we’re buying, in order to give us the time and space to put out as much capital into these interesting opportunities as we can.
Had a nice-but-unhelpful call with a real estate investment banker yesterday and thought the conversation would make for a good blog post.
First: What’s a real estate investment banker? That’s a fancy name for a person or company that connects operators (like us!) with debt and equity. Generally, “investment banker” is used to distinguish the players who can (at least theoretically) bring equity to the table from your standard loan broker, who just does debt.
Because we’re always on the look-out for capital partners, I have had a lot of conversations with investment bankers. But they never go anywhere, and here’s why:
- We have a spectacular loan broker. The price we pay her is fair. The service is excellent. Any time someone else has quoted a deal for us, their terms have been inferior. And I’m not going to take a risk on someone new, who might fail to execute, unless the terms are WAY better than what we’re seeing. So we don’t need real estate investment bankers to provide us debt.
- The equity investment bankers provide is, generally, on standard JV equity terms, something like: 9% preferred return, 80/20 split after return of capital and pref, low fees, and we have to put up 10-20% of the capital. Those economics make no sense for our business model, which involves long-term holds… we’re not going to sit there falling further and further behind the pref, hoping that the rents finally rise so that someday, decades from now, we can own part of the building. No thanks.
It turns out that intermediaries don’t really provide what we want: Investors who think like we do (improving neighborhoods, serious value add, conservative debt, long-term holds, etc.) and put enormous value on relationships (as opposed to “hot money” / transactional / one-off type deals).
And the reason they don’t is because they can’t make a fee from those introductions.
So, we are likely going to keep growing the way we always have: Through word of mouth, introductions from the service providers with whom we work, and readers of this blog.
I remember reading one time that being the leader of an organization means repeating that organization’s story over and over and over again, to anyone willing to listen.
Lately, I’ve found myself telling all kinds of people what we’re about. So, I figured I’d repeat it here, for those of you willing to listen.
- Buys older, dilapidated buildings in improving neighborhoods of Los Angeles at fair prices
- Closes quickly, paying cash and refraining from chipping price or screwing brokers down on their commissions
- Thoroughly renovates, replacing / upgrading all major building systems, using permits
- Re-tenants, leasing to anyone who can afford to pay (without regard to race, ethnicity, immigration status, etc.)
- Refinances, using long-term, fixed rate bank debt to pull out 75-100% of capital invested
- Distributes the refinance proceeds to investors (usually, roughly 18 months after acquisition of the property)
- Manages the buildings thereafter, maintaining them in good condition and distributing free cashflow from operations quarterly to the investors
- Holds forever
This business model is highly unusual in the real estate private equity space, because it does not print very high IRRs, nor result in the sponsor (Adaptive) getting rich quickly.
However, we’ve never been the kind of people who do things because everyone else is doing them. And this model feels right to us. So we’re going to keep doing it, probably for the rest of our lives.