Now more than ever, high net worth investors have endless opportunities to preserve and grow capital via private commercial real estate investments.
Along with traditional real estate managers operating limited partnerships/funds, the innovations of “fintech” have brought us real estate “crowdfunding”: while past vehicles required larger capital commitments and limited scope, crowdfunding offers accredited investors the opportunity to commit smaller amounts of capital to a wider array of real estate deals.
While this innovation has opened to door to more opportunities, it is more important than ever to consider this maxim:
Who You Invest With Is Probably More Important Than What You Invest In!
The “human element” remains the most important factor when deciding on an investment manager. This is where crowdfunding can fall short: without a face-to-face discussion with a potential real estate manager, how can you determine if they will meet your expectations, and will have your best interest in mind?
As in all business relationships, trust is key. If you cannot trust the person managing your investment, how can you be confident of the outcome? Never be afraid to ask questions or for references.
Above all else, before committing capital, know your investment manager, and do your own due diligence!
These five questions should provide a strong outline of the kinds of information you should be getting from your potential investment manager:
1. What’s Your Track Record? How Has Your Firm Managed During Varying Market Conditions?
Past performance is not predictive of future results, but it offers insight to how a potential manager will fare during varying market conditions.
The most important aspect of a manager’s track record is the ability to adapt strategies to market conditions. MLG Capital and its principals have operated for over 30 years through multiple real estate cycles, picking up valuable insights along the way. These insights allow us to adapt our strategy to market conditions.
“Buy Low, Sell High” may not be the correct mantra when adapting strategy to market conditions. Trying to scoop up deals at a market’s low point is easier said than done, with tepid tenant demand and scarce financing options making a “record low” price not quite a bargain.
On the flipside, a hot market may mean record high prices, but it is not an invitation to sell everything and buy nothing. A strong market offers greater opportunity to improve the cash flow/valuation of a property due to the increased demand for real estate. Operating history and a deep ability to source transactions, regardless of economic cycle, are key attributes of a strong real estate manager.
2. What’s Your Overall Investment Strategy? How Does This Strategy Give Your Firm an “Edge” Over Other Real Estate Managers?
When assessing the strengths of potential real estate managers, consider their overall investment strategy, and how this strategy gives them an “edge” over other managers in the space.
At MLG Capital, we’ve developed a deep sourcing strategy that may be of benefit to high net worth investors considering private real estate for wealth preservation:
- Hybrid direct acquisition and parallel private equity strategy provides diversification and specialization while generating 55-60 potential investment opportunities per month for review.
- Our strong sourcing network allows us to cast a wider net and consider the “best of the best” deals, across the country
- Capitalizing on prior operator mistakes to improve the cash flows/valuation of properties.
- What’s Your Asset Management Fee?
The fee structure of a manager is often an area overlooked by investors conducting due diligence on a potential investment. While it is important to assess a manager’s investment strategy and past performance, it is imperative to understand the fee structure of a prospective manager.
There are two important aspects of the management fee to consider-the asset management fee and the manager’s profit participation (also known as the “promote”).
While many alternative investment firms charge asset management fees of 2% or higher of invested equity capital, MLG Capital’s annual asset management fee is typically 1.25% of total equity capital contributions to the fund that have been invested in real estate assets.
When comparing the promote, or the profit participation split that the management team realizes, ensure that your interests as an investor are aligned with the sponsor. For example, does the manager only realize their promote piece once you’ve received a return of 100% of your original capital? Are you paid 100% of your indicated preferred return prior to any splits? Are there clauses that allow the sponsor to “clawback” a portion of their promote along the way?
4. What is the Preferred Return? What are the Terms of Profit Participation for the Investor and the Manager?
Alternative investments in real estate typically compensate the manager in the form of profit participation, or “promote”. However, limited partners (investors) typically must accrue a preferred return before the manager is entitled to the promote.
MLG Capital’s fund structure is as follows:
- First, 100% of cash flow* is sent to investors. Investors accrue an 8% preferred return on their investment.
- Second, 100% return of original principal invested
- Remaining distributions are split 70% investors/30% MLG Capital
- Distributions paid quarterly
- This targets a net IRR return of 13-15% for Fund investors*
When assessing an investment opportunity, it is important for the manager to be clear and upfront about their fee structure.
*Please reference MLG Private Fund III confidential private placement memorandum (version 1.0) and current supplement for full details. Preferred return is subject to availability of cash flow.
5. How Do You Consider Inflationary Risk in Your Investment Strategy?
Changes in interest rates can play one of the biggest macro roles in the performance of a real estate investment. Facing the specter of rising interest rates, investors today are concerned on how a potentially inflationary environment can impact returns.
An increase in rates may lead to a rise in cap rates, which can negatively impact valuation. It is important for an investment manager to understand this risk and have a proactive strategy to preserve and grow your capital.
MLG Capital understands the inflationary cycle’s role in real estate investing. By taking active steps (property improvements, leasing) and steps to grow operating income, we can do a lot to offset a worsening in valuations (cap rates) caused by higher interest rates (underwriting conservatively on an exit).
Here’s an example of how cash flow can be impacted in a strong market experiencing an increase in interest rates. In the below, we are taking into consideration the margin, or spread, in loan rates that banks impose by looking back over the last few cycles, specifically the 2008 cycle and pre-election cycle of 2016.
- If a multifamily property had an NOI of $1 million at acquisition, and cap rates grow from 5.46% to 6.3% during the hold period, to retain the value of the equity, the NOI must grow by ±15.4%.
- Such growth would require gross rental revenue growth of 7.7% during the holding period (or 1.55%/year for 5 years).
- There is also the impact of inflation to consider: however, as multifamily leases are typically short-term, rents can be raised to counter increases in operating costs.
The key assumption is that cap rates are heavily driven by debt constants, which is what we believe. The debt constant is a function of the interest rate on a loan plus the term being amortized. For multifamily, there is plentiful debt available with a 30-year amortization. In fact, interest only debt is also available, which forgives any principal amortization for usually 2-3 years. The other key factor is the margin added to the index (usually 10-year treasury rate) to determine a loan rate. For example, today a usual margin is 2% plus a 2.80% 10-year treasury rate to obtain a 4.80% interest on a loan.
The above spreadsheet highlights this concept of margins added to an index. For example, when the 10-year treasury was 1.6%, the margin was about 2.2%, and the loan rates were about 3.8% with a 5.59% debt constant. Back when the 10-year treasury was around 4% (1.2% above today, or about 2.4% above bottom), the margins were only 0.9 to 1.25%. With a 1.2% margin and a 10- year treasury of 4%, loan rates were about 5.2% or a 6.59% debt constant. So, a move from 1.60% to 4% (2.40% move) on the 10-year treasury, only changed the debt constant by 1% (6.59% vs 5.59%). Therefore, you cannot assume that 2.4% move in interest rate changes cap rates by 2.4%. In fact, history shows that is not the case. Our example shows a 2.4% move in 10-year treasury that only changes a debt constant by ±1%.
Our experience is that cap rates do not move proportional with interest rate changes. It is certainly correlated, but not proportionally.
There is also another key consideration of interest rate growth. You must ask what is causing rates to grow. If it is caused by strong economic growth, rents usually grow as demand starts to exceed supply. The spreadsheet attached shows the NOI or EBITDA growth needed to offset cap rate growth.
If the NOI was $1,000,000 at acquisition and cap rates move from 5.46% to 6.30% during the hold period, the NOI needs to grow by 15.4% to offset higher cap rates to keep the value of the equity flat. A 15.4% NOI growth requires gross revenue growth of about 7.7% over the hold period or a little over 1.55%/year, for 5 years, of gross revenue growth. This assumes operating expenses are about 50% of the gross income, which is typically the case for multifamily properties. See lines of the spreadsheet showing a value of $18,329,305. There is also the impact from simple inflation, which likely covers the impact of rising rates as most leases are short-term giving real estate owners the ability to raise rents.
As we’ve discussed, all the deals that MLG invests in has a proactive strategy to grow revenues thru either property improvements and/or occupancy improvement. Most deals have a minimum rent growth during a 5-year hold. Also, most costs are fixed in private real estate so a high % of any growth falls to the bottom line NOI or EBITA. These growth amounts greatly exceed the 1.55%/year growth needed to offset impact of a 4% 10 US treasury rate.
A strong understanding of the inflationary cycle requires optimal use of leverage. Examples including using short-term financing (allowing for refinancing once rates come down), as well as using interest-only financing (which removes the principal pay-down element). Removing the principal pay-down element improves the cash-on-cash return.
These 5 questions are just a starting point when conducting due diligence on a potential manager. But, they offer a strong starting point to the types of questions you must ask before you invest. Remember, at the end of the day, “Who You Invest With” is probably more important than “What You Invest In!”