One fund, one property, one deal. This is how the majority of real estate investments are made.
Investors know the property, how much it costs and are able to see the income statement and balance sheet. While this may be the market norm and appears straight forward, it introduces unintended secondary reactions and hidden pitfalls not generally found in other real estate investment structures.
By segregating investors into a single asset, the “upside” of this is that the investors know exactly what they are buying, but the knowns introduce more risk into the fund. The perceived safety is a myth is that investors perpetuate by applying home purchasing logic to commercial revenue generating assets. The thinking being “who would buy a house without seeing it first?”. Meanwhile institutional investors and professional investors routinely and quietly go about getting the largest returns with the lowest risk because the structure and the perception framing is far different.
These are the top Six Deal by Deal Pitfalls:
1. Misalignment to Market Realities
Great real estate doesn’t come to market and sit around. It lists and closes in 20 to 30 days in Canada. If agent led, it won’t even make it to the realtor website. This means all the due diligence, environmental assessment, bank financing will close within that timeframe. Unlike home buying, a non-refundable deposit is required to hold it during this time period ranging from $100 thousand to well over a million dollars.
All real estate needs an “equity” type component and a debt component. A typical equity offering period, by well-established public companies can take 90 days. Drafting of the legal agreement (prospectus or offering memorandum) in order to take investment capital, can take easily 30 days to complete. This timeline doesn’t include the pre-marketing period where sponsors (company that seeks the equity) are marketing to select the best underwriter for their offering. The alternative is to raise capital investor by investor, going around to wealth managers and presenting or marketing directly to high net worth investors. Because this is not the sponsors primary role, that marketing process can be time-consuming, and capital intensive.
2. Creates a Conflict of Interest
The mismatch between the time it takes to raise capital and when properties close creates a problem. The only way to solve this is by a conflict of interest. Every deal by deal investment has a conflict of interest baked in. Conflict whereby the owner of the property is related in some way to the buyer. This is called non-arms length transaction. And creates the well-known “principal-agent problem”. Summarized as: “The principal-agent problem develops when a principal creates an environment in which an agent’s incentives don’t align with its own”
http://www.investopedia.com/terms/p/principal-agent-problem.asp This happens with deal by deal investments because the principal(s) (owners of the property) need/want/can make a return on their investment prior to outside investors. An succinct study of this is found in this research paper: Rutherford, Springer and Yavas (2005) find evidence of agency problems in residential real estate by showing that real estate agents sell their own houses at a price premium of approximately 4.5% compared to their clients’ houses.
The only other way to be non-conflicted is to overpay the arm’s length (not related) owner for the existing property as compensation to the seller for the extended time frame. An inducement to do this would be high, unlike the study. An overpayment ranging from 7% to 15% or more would be needed to induce the owner to trust the buyer to raise the financing need. Feeding into this lowers IRR, overall returns and places investors in higher risk brackets without the compensation for taking that risk. It also erodes trust and puts these mangers in a “Us versus them (investors) alignment”.
3. Over Concentrates the Risk
Investors in deal by deal structures expect a high consistent dividend or distribution. Revenue properties base their value on revenue generated. With a single property, 100% of the revenue comes from that property.
If the market changes, investors are stuck with a fixed single asset in a single property type, class and geographic location. If the market changes, the sponsors are stuck with the single property and may reduce or defer the dividend. In some funds they may pay dividends out “in specie” or “in kind” with the share being of a different class ie; never paying out- watch the offering documents for this.
Couple of notes about senior secured or “secured” debt. Many times investors will be assured that the debt is senior.
Unlike Europe, Canada is very vanilla about debt- it’s a small market. So senior debt can actually be riskier that unsecured debt.
In a few ways;
If the debt is senior, it will be “geared” very low- meaning super low returns because of no mortgage debt and leverage.
Senior debt plus a mortgage in Canada is viewed as 1 big pile of debt. As a consequence, it introduces more risk by not being able to get great mortgage terms- think subprime type rates.
The big pile of debt is monitored by the bank as a ratio, the amount of revenue to the debt payments- or debt coverage ratio (DCR), IF the debtor triggers this DCR by having too much debt to income, the bank can call the loan or implement all sorts of debt covenants. None of which will fare well for the non-bank senior debt holders. Even though the debtor may have more than enough cash to meet the payments of the 2nd senior debt and the bank debt it places the deal in more risk because of the bank looking to repo the building and keep the paid down principal.
Funds may also advertise secured but on closer inspection investors find only a portion or none of their investment is secured. The sponsors as they may create a paying co. that is a subsidiary of the actual company that holds the assets and cash. That is 100% security of nothing. Another way to talk secured is mortgage companies (MICS) that underwrite single family developments, again a long time if ever investors would see a return of capital if the company actually had to take possession of a half finished house out in some suburb.
Unsecured debt acts like equity and can benefit by having the sponsor get very aggressive with the banks to get the best rates because of the great DCR and better leverage. In cyclical market conditions having that extra cash can act as a cushion. It can also help managers conduct routine maintenance or improvements to the properties to seek higher rents. All the while being able to meet their investor obligations. Same as any public company common stock.
4. Offers No Scale of economy
Small funds holding a single property never scale. Sponsors (investment firms) selling single property fund can only hold a single asset per fund. They cannot rewrite the offering documents after the initial investment is closed. Fixed costs in fund administration, oversight and audit are just duplicated and are not able to become cheaper unless the single property dollar value grows. This has an effect on performance relative to better structured funds.
5. Misses Market Opportunities
As before great real estate is never on the market long. Cash buyers are king and fast closers are a close second. Deal by deal makers miss out on portfolios (multiple assets in one sale) and miss out on auction properties which are becoming more popular. Especially with the rise of companies like google backed Auction.com. On proprietary led deals, ones where a sponsor finds an owner that wants to sell, a big trust issue can be addressed by a simple atm or bank statement showing proof of funds for the equity portion of the financing.
Old deals are like frozen pizza, no one prefers it to a fresh one.
6. Extends the Funds Lifespan
Common in deal by deal investments is sunset or extension clauses the extend the fund life. Typical in this sector is 5-year fund life with 2 one year extensions. This serves as an escape mechanism for management to deal with low preforming properties via mortgage pay down or to buy time to sell a dud property. Either way its shoddy investment management. Continued distributions or dividends are a seldom paid out when a fund enters into an extension. When done this way, funds can tout returns higher than what a fixed 5-year fund can, or more commonly, fix chronic under performance problems. Deal by deal can never experience the market attractiveness of a professionally managed and maintained portfolio of properties bought at arms length to the seller.
The vast majority of Deal by Deal funds are riskier and are rife with conflict. If you need real estate exposure in your portfolio, look closely at the structure. Create a list of deal killers, and parameters for a potential. If you do not have a list, get one by talking a lot of fund managers. Once a list is complete, vet out funds to get to the “no” quickly. Get comfortable reading prospectuses, offering memorandums, and offering documents.
Structure is more important than the people in it. With a bad structure, its impossible to create a return. Smart management teams put together dumb deals all the time or create deals that don’t favor the investor, so focus on them last. Don’t rely on track records, funds may have returned XX% over a millennia but the problem with track records is SEC rule 156 “Past Performance is Not Indicative of Future Results”.
We strongly believe that correct structure, planned portfolio diversification, and being able to respond quickly to market opportunities is superior to deal by deal funds.
This material is contains information from publications prepared by the Trebuchet Capital Partners and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of June 2015 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by Trebuchet to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by Trebuchet, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader.