What Type of Real Estate Deals Fit Into Our IncomePlus Fund?
Origin’s new IncomePlus Fund is designed to offer stable income and appreciation through a combination of equity and debt—and provide investors exceptional tax efficiency at the same time. Portfolio construction is the first key to accomplishing this tall order, and to this end the IncomePlus Fund will have a target allocation of roughly 75% equity and 25% debt.
The second key to achieving this goal is choosing the best assets possible for each type of investment, be it equity or debt—namely assets that are best positioned to outperform their peers. These are in high-growth real estate markets that we’ve identified through the creation of a proprietary objective risk model that factors in a comprehensive range of fundamentals, from a property’s city, sub-market, attributes and competition, to the financial risk of the deal.
Still, choosing equity assets to hold long-term and debt deals on assets that have strong underlying fundamentals is different than acquiring deals for shorter periods of time such as three to five years. Here’s how they differ.
Characteristics of an IncomePlus Equity Deal
We intend to hold properties in the IncomePlus Fund for as long as they produce a superior income stream. All equity assets will be held in a real estate investment trust to offer the pass-through tax advantages of a REIT for our investors. The Fund will look for value-add, core and core-plus assets. We will not include new construction, since opportunistic development has an inherently higher risk.
When evaluating equity investments for the IncomePlus Fund, our rigorous underwriting process means we look at every market fundamental. But for the IncomePlus Fund’s equity deals we look for these top four characteristics, which we believe are catalysts that lead to high occupancy rates that yield ample cash flow – essential keys to any quality, long-term investment:
1. Building and Site Quality. The quality and overall functionality of an asset matters regardless of when it was built. A multifamily asset must have easy physical accessibility, functional floor plans, and amenities that set the property apart. To hold an asset for a long time, it should also have “good bones.” Design and finish preferences change over time, but structural elements can’t easily be updated. High ceiling heights, multifunctional floor plans, spacious bedrooms, balconies, well-designed amenities, and communal spaces will attract tenants no matter the age of the building.
2. Asset Location. That old real estate mantra “location is everything” always holds true. Owning assets located in a thriving, vigorous neighborhood is a major differentiator that determines a property’s ability to outperform its peers, especially over a long period. Finding a great neighborhood starts with identifying quality employment options and transportation to conveniently access those jobs. Beyond employment, a quality school system, housing affordability, and a robust retail and food scene show a neighborhood’s staying power.
3. Supply and Demand. Identifying where people want to live and work means understanding the factors that ultimately attract people to a specific submarket. Focusing on submarkets that have high barriers to entry—such as tough zoning ordinances that can stymie new construction or limited buildable land—can greatly increase the chances of achieving higher rental rates because competition from new construction will be constrained. Conversely, a submarket that has a significant amount of construction in the pipeline can significantly hamper the ability to achieve rent growth in the interim. However, new supply can boost overall market rents because the new apartments will demand a higher rental premium given the higher cost to build. But an existing property can only command higher rent if its fundamentals are strong enough to compete with new construction.
4. Investment Basis. While the strategy for the IncomePlus Fund is to invest in core, core-plus and value-add properties, they will often require renovations. That makes it imperative to understand the total cost of each project relative to the cost of new construction when underwriting the property. The vintage of the asset and the capital being injected for upgrades must not equal or exceed the cost of building new product. Having a lower cost basis, which is the original value of an asset for tax purposes, makes it possible to raise rents yet still keep them lower than any newly built competitor that might lure tenants away.
Characteristics of an IncomePlus Debt Deal
In the IncomePlus Fund, we are seeking investments in two types of real estate debt: current pay preferred equity, or “current pay pref,” and accrual pay preferred equity, or “accrual pref.” Current pay pref has an agreed-upon interest rate that is typically paid out monthly from cash flow. Accrual pref is typically used for development projects and involves a set interest rate that is not paid until the property is built and begins to generate cash flow from operations. At that point, accrual pref is paid off through refinancing or sale of the underlying asset.
IncomePlus Fund debt investments will be comprised of assets that have strong underlying fundamentals with solid long-term viability according to our objective risk model, but do not meet our target return threshold for an equity investment in the fund. However, debt investments are more predictable and have less risk than equity investments because they don’t vary with a property’s cash flow, and they have a set position in the capital stack that makes them safer.
To this end, we will take a preferred equity position in the capital stack, and limit debt to what amounts to 85% of a property’s total cost. For instance, a property owner may have 65% of their funding at a 4% interest rate, which is the average for most lender-backed mortgages today. In a case where an owner needs 80% to 85% leverage to close on a deal, we would provide a loan up to that level and would earn an 8% to 10% return on that additional 15% to 20% of the capital stack.
Moreover, we also sit at a lower level on the capital stack than if we had invested as equity, which means we have more protection if something goes wrong with the deal. Also, all cash flows generated by the debt investment are distributed to the IncomePlus Fund before the same investment’s equity investors receive their share of the cash flows or gains.
Bottom line, stringent fundamentals are required for all transactions for our IncomePlus Fund. The near future is anticipated to be challenging for capital markets and asset performance and gets harder every year as real estate becomes a more competitive asset class. However, we believe that picking the best properties with strong fundamentals in our target markets can produce high risk-adjusted returns. By creating a fund that provides current income and appreciation, Origin is building on proven experience in recognizing a property’s potential and executing plans that realize its value.