How We Manage the IncomePlus Fund to Perform in Any Market Cycle
Origin’s flagship IncomePlus Fund was created to deliver high risk-adjusted returns on our multifamily real estate investments in every market cycle. Since the Fund was created three years ago, we have protected and grown our investors’ wealth, despite the 2020 recession and continuing impact of a global pandemic, by staying vigilant to changes in the market cycle and remaining agile in our tactics.
The Income Plus Fund’s primary purpose is to deliver a stable and tax-efficient 9% to 11% net annual return, with income and appreciation. Our current strategy to build, buy and lend to multifamily real estate investment in growth cities around the United States employs a flexible mix of common equity, development capital and preferred equity—key to providing capital protection, yield and price stability. Buying and holding assets maximizes appreciation and minimizes taxes, both of which build real wealth. And it’s open-ended, so we are always accepting capital.
This year, inflation is averaging more than 8%, the yield on a 10-year Treasury note has doubled to 3.08% from 1.5%, and the stock and bond markets are enduring double-digit percentage declines. In this climate, we are positioning the Fund’s real estate portfolio defensively against exposure to economic downturns and the looming threat of a recession.
How the IncomePlus Fund Has Adapted to Market Shifts
When the Fund was created in 2019, it employed a buy, fix and hold strategy employing core-plus and value-add multifamily housing. During a normal real estate market cycle, with healthy fundamentals and prices expected to appreciate, the Fund’s target portfolio is 75% equity and 25% preferred equity. As the year went on, though, property prices began to exceed values, so we began to tilt the Fund’s target makeup more toward preferred equity investments.
At the point that we entered the COVID-19 pandemic in early 2020, the portfolio was made up of 54% common equity, 36% preferred equity and 10% cash. That balance stabilized the unit price during the pandemic and enabled us to continue to pay a 6% distribution yield to our investment partners. In mid-2020, we retargeted the portfolio closer to 75% preferred equity, 20% equity and 5% cash, protecting our capital while allowing us to pay dividends and increase the unit price.
As the real estate market heated up and the price of existing multifamily assets increased, we began investing in a more cost-effective build-to-core strategy—buy, build and hold. In 2021, we reaped the benefit of that strategy with monthly returns (net of fees) that totaled 21.2%.
How We Allocate the Fund’s Portfolio in Today’s Market
Here is how the Fund is currently allocated:
Interest rates are nearly double what they were in January, affecting our financing costs, specifically in the 19% of the Fund earmarked for development assets, which are financed with floating rate debt. In the core plus equity portion (20%) of the Fund, only one of the three assets has floating rate debt.
We mitigate interest rate risk with respect to these portions of the portfolio first by building cash flow at the asset level, and second by hedging our exposure to floating rates. Earlier this year we entered into swaptions contracts with multiple banks (swaptions, or swap options, essentially make money when interest rates go up and decline when rates dip or stay the same). We exited those positions in June after four months, and our initial $15 million outlay across all our Funds turned into a $24 million profit. The IncomePlus Fund was allocated around $2.5 million of that profit. That has become a small war chest to offset the cost of higher debt in the next few years.
While interest rates create a challenge, they also protect the portfolio. That may seem counterintuitive, but a big strategy within this multifamily real estate investment Fund is lending, and more than 60% is either in or committed to preferred equity. It provides yield, and more importantly, a lot of stability.
Upside, Downside and Base Case Scenarios for 2022
So far this year, the Fund has generated a 4.3% total return, and it’s on track to deliver at least our target return of 9% to 11% or more. However, we stress-test our expectations by playing out multiple scenarios, so we have worked out a downside, base case (or mostly likely set of assumptions) and an upside scenario in order to play out different possible outcomes.
As shown in the chart above, our downside scenario envisions a world where our development projects make zero money, and our well-insulated preferred equity position performs as expected. Based on the information we have currently, this scenario is unlikely, but even so, the net return to investors is 4.00%. In our upside scenario, we generate a 32% annualized return on our developments, and common equity generates a 30% return, for a net return of 16.56%. Getting this type of return is realistic, and in our opinion the upside scenario has a much higher probability than the downside. Our base case scenario achieves a 10% or more return, what we generally target in this Fund.
There isn’t a wide variance in these scenarios because 60% of the Fund is committed to preferred equity, which provides stability and gives us priority in distributions of cash flow. The development equity, on the other hand, is the “jet fuel” that helps our multifamily real estate investment outperform even in a highly inflationary environment. While it’s true that construction and labor costs have increased over the past 18 months, so have multifamily rents, which have increased into record-breaking territory this year. Those margins provide enough cushion in the Fund that they can withstand future corrections.
Looking Ahead: Following Demand
In the southeast and southwest cities where we invest, demographics and demand for multifamily housing remains in our favor. If there is a more serious downturn, the IncomePlus Fund remains defensively positioned. In that case, if we enter a scenario in which distressed assets provide opportunities, we can shift tactics to acquire assets strategically from lenders. We already have the experience for this scenario: Our first two Funds were in distressed assets, and we oversaw bankruptcies, restructurings and foreclosures.
As our 2021 returns showed, IncomePlus can provide exceptional upside returns. And while we can’t predict the future, we know how to plan for it, taking a risk-management approach that removes as many uncertainties as possible.