How Do Real Estate Fund Managers Generate High Returns for Investors?
Fund managers are a resource to help investors grow and preserve their wealth through real estate. The fund manager and investor partnership requires a great deal of trust from the investor, who pays a fee to the fund manager and entrusts them to invest their hard-earned money on their behalf. A good real estate fund manager will educate these investors on how they plan to put their money to work and what strategies they utilize to maximize returns.
At Origin, our value-add investment strategy involves finding real estate investment opportunities that have solvable problems and constructing a solid business plan to fix them. As a real estate fund manager for over a decade, we have executed nearly $1 billion of transactions with zero losses and were cited as a consistent top performing private real estate manager by Preqin, a research company that tracks the performance of alternative investments.
In our experience, we believe that real estate fund managers should adhere to these five investment strategies to limit risk and maximize value for investors.
1. BUY RIGHT.
In real estate, disciplined investing starts with buying right. Real estate fund managers can find the most profit by looking for the right property in the right location at the right time, and, most importantly, at the right price.
This takes discipline and time. In fact, our acquisitions team receives nearly 1,000 investment opportunities per year to only acquire four to five properties and it took us nearly five years to find and acquire our first investment in Denver. We utilize an objective risk model so we can better evaluate every deal that we come across and understand what price we can afford to pay in order to maximize returns. This model has allowed us to properly allocate our time and resources towards acquiring the right deals.
Location is an essential factor when it comes to buying right. As real estate fund managers, we must be cognizant of what markets are performing well and which ones are falling behind. We rarely leave a market, but this recently changed when we decided to stop investing in Chicago and instead start investing in Orlando. We carefully ran the numbers using our objective model to ensure this would be the most profitable decision for our investors.
2. USE DEBT RESPONSIBLY.
Just because a real estate fund manager can leverage a property up to 90 percent doesn’t mean they should. It’s important to remember that more leverage means more risk and while debt can enhance returns when projects go according to plan, it can also work in reverse. As fund managers, it’s our job to educate our investors on the amount of leverage we choose to use towards a project and how they will be compensated for that level of risk.
At Origin, we match our debt-to-equity ratio to our business plan by basing the amount of leverage we use on how risky we consider the deal to be. If a fund manager chooses to highly leverage a property, investors should inquiry as to why. Some fund managers choose to financial engineer returns by increasing the amount of leverage to add additional cash flow. This strategy can deliver high returns but it’s extremely risky as a minor mistake could entirely destroy a deal. At Origin, our returns come through increased operational performance of the real estate and we also don’t use preferred equity, mezzanine debt or other instruments to get higher returns because they expose us to added risks.
3. DON’T CROSS-COLLATERALIZE ASSETS.
Cross-collateralization has taken down many real estate funds. It is the act of using as asset currently used as collateral for one loan as collateral for a second loan. This can be useful for borrowers who can’t otherwise get approved for a loan but can be very risky, as the borrower could lose control of all assets if they default on one asset’s loan payment.
Real estate investors should be wary of real estate fund managers who guarantee loans at the fund level because it exposes the fund to unnecessary risks and has destroyed one of the best attributes of the fund, diversification. A best practice to generate the most returns for investors with the least risk is to structure every deal within a fund as a separate venture. For example, when we buy 15 assets, they are essentially 15 separate companies. If something goes wrong with one investment, it won’t drag the fund’s other assets down with it.
4. BE FULLY ALIGNED WITH INVESTORS.
Another best practice for real estate fund managers is for the principals to invest their own money in their deals to show that they believe in the opportunities. My business partner, David Scherer, and I have personally invested $54 million alongside our investors including $10 million in our open IncomePlus Fund.
At Origin, we also believe real estate fund manager compensation needs to be aligned with performance and not simply guaranteed. We tie the compensation of all our acquisition officers and asset managers to the overall performance of our deals to incentive them to spend the necessary time to vet each individual deal within a fund.
Alignment involves more than just having skin in the game. It also means the fund manager should be transparent and not deceptive. Investors should question the legitimacy of a fund manager who advertises a low-cost fee structure to draw in investors and uses complex, confusing language in their marketing materials. Both can be signs of a misleading fund manager who doesn’t have an investor’s best interest in mind.
5. ANCILLARY REVENUE STREAMS CAN CREATE CONFLICTS OF INTEREST.
There are some fund managers who prefer to control most, if not all, aspects of a real estate investment. Vertically integrated real estate companies are organized to handle all the following aspects of the real estate investment process: capital raising, acquisitions, property management and construction. Generally speaking, vertically integrated real estate firms are comprised of several business units that all operate as distinct entities. In contrast, there are managers who prefer to focus on certain aspects of the real estate investing process.
At Origin, we choose the latter approach because being vertically integrated can create conflicts of interest between management and investors. An investment manager who also manages the properties has an inherent conflict of interest because a property can easily generate tens of thousands of additional dollars in property management fees.
Thus, the dialogue of whether to hold or sell an investment can easily turn to the well-being of the employees and the property management revenue stream. That can compromise a decision to sell the property at the optimal time and price. For that reason, we believe it’s a best practice to hire the best third-party management team for the job. One of our compelling value propositions as a fund manager is that we focus solely on asset management and work with best-in-class property managers to carry out our business plan.
Fund managers who adhere to these five strategies not only limit risks while still driving high returns, but also likely have their investors’ best interest in mind. We’ve seen value-add real estate investments underperform because the fund manager has failed to follow one or more of these strategies. Investors will be rewarded if they’re vigilant to discuss these behind-the-scenes details with their managers and ask questions about how risk is managed.