Real estate is one of the most powerful long-term wealth-building investments to have in your portfolio. Michael Episcope and I founded Origin Investments 12 years ago to create real estate investment funds that reflect our investing goals. We commit our own capital to these funds and invite our investment partners to join us. For our latest investment, the Origin IncomePlus Fund, we took on a new challenge—but one that our investors have asked us to tackle: structuring a fund that would assure steady passive income streams while doing what we do best as real estate asset managers—generating the highest long-term returns possible.
The Origin IncomePlus Fund intends to provide a steady dividend of 6% annually and an overall return of 9-11%, including appreciation. The real estate fund’s investment strategy was created to provide this dividend, minimize risk and capitalize on the inherent competitive advantages at Origin. Here’s how we accomplish this goal.
Multifamily Investing Builds a Stable Portfolio
The IncomePlus Fund’s game plan starts with direct purchases exclusively in multifamily properties. Three-fourths of investments will be composed of multifamily real estate that Origin owns and manages. Multifamily investing has been our core competency over the past 12 years, and has provided the highest level of risk-adjusted returns in real estate over the past 25 years, based on the NAREIT index.
The fact that multifamily real estate is a low-risk asset class is intuitive. People will cut costs everywhere else before they cut costs that compromise where they live. Again and again through recessions, multifamily cash flows remain stable as budgets are cut for vacations. Hotels are not only an expendable expense in a recession, but they are also a riskier investment because leases are one night, while the average multifamily lease is one year. Short contractual cash flows on a nonessential product leave hotel passive income streams more volatile.
Multifamily properties are also sheltered from technological disruption. Amazon and other internet retailers have changed the face of brick-and-mortar sales. Yet e-commerce at midyear accounted for only 10.7% of U.S. retail sales. What further correction awaits malls and main streets in years ahead? Whatever is in store for retail, people will still need a place to live.
Multifamily Real Estate Outperforms Other Property Types
The goal of the Origin IncomePlus Fund is to produce high returns at the lowest risk to the investor. The below charts compare real estate property types reflected in the NAREIT index, a comprehensive family of REIT-focused indexes that span the commercial real estate industry. Over the past 25 years, multifamily real estate has been the most productive class in every five-year period, both on a cumulative and risk-adjusted annual return. We believe that this will continue, and have structured the IncomePlus Fund to capitalize on this asset class.
Cumulative Returns – NAREIT Unlevered Index
In addition to total returns, our goal is to produce returns at the lowest unit of risk to the investor. We measure risk in an investment through stabilized standard deviations. Simply put, if an investment fluctuates wildly through an investment period, it means the investment is riskier than one that increases in value at a constant rate. In the chart below, a lower standard deviation means the asset had lower risk during the time period.
Stabilized Standard Deviations
Origin’s Multifamily Edge
Origin’s focus on multifamily investing is borne out by 12 years of returns. Both Origin Fund I and Origin Fund II performed in the top quartile of real estate funds, reported by Preqin, a company that provides data and analysis on alternative investments. We continue to outperform in Origin Fund III by cultivating local relationships, carefully screening deals and delivering a first-class experience for our renters. The IncomePlus Fund will leverage our experience, local market presence, and relationships that are built through consistent interaction and transactions over time.
Origin’s track record for sourcing and management in our 10 target cities is based on three success factors:
- Build a local reputation. Our current portfolio includes 2,421 units, with another 2,178 units in various stages of acquisition and development. With this level of activity, Origin is a first call for both on- and off-market deals: Sellers will work with us early in their process and consider our offers seriously, based on our reputation for agility and performance.
- Underwrite to buy right. Origin tracks all multifamily properties that fit our criteria and screens over 1,000 deals a year using our proprietary risk/return models. This research allows Origin to respond faster to new investments, because we’ve already considered buying the asset or comparable properties.
- Stay two steps ahead. Origin tracks rents, occupancy and concessions in each market down to the level of individual assets. This helps us learn about momentum in the market, and validates what our local teams are reporting. Local knowledge matched with a quantitative process produce optimal decisions.
Adding Debt to the IncomePlus Fund Boosts Returns
Directly owning and managing multifamily real estate is not in itself enough to set a steady revenue pace. That’s where debt financing comes in, an attractive investment for investors in search of yield because it offers a consistent fixed income vehicle that produces cash income from the inception of the investment. While 75% of the assets in the IncomePlus Fund will be multifamily properties, 25% will target preferred equity and mezzanine debt in multifamily, office and industrial assets.
Origin has experience in subordinate debt investing, and our local teams see opportunities to provide capital to operators that we have done business with previously, or who undergo a rigorous vetting process. Origin underwrites the operator, then underwrites the deal. By holding preferred equity or mezzanine debt, our income fund investors are repaid before common equity shareholders in the deal. Origin requires that a minimum of 15% of the deal be capitalized with common equity, thus providing a 15% cushion before Origin’s investment is at risk in an underperforming deal.
Preferred equity and mezzanine debt do not share all the tax advantages of direct ownership. Dividends are taxed as ordinary income. The Origin IncomePlus Fund has been structured to minimize taxes for our fund investors, both by having the fund own assets that can be depreciated and by employing a REIT structure.
Using a REIT Structure Benefits Investors
Real estate income trusts are required to distribute 90% of their earnings to investors as dividends. REIT funds are sheltered from taxation at the corporate level. The new 2017 tax law also allows for a 20% deduction for entities in which profits pass through to shareholders. This structure can effectively lower the tax rate on ordinary REIT dividends from 37% to 29.6%. This is an amazing benefit for investors looking for income-producing property, as it increases post-tax returns by 20%.
In addition to these benefits, Origin IncomePlus Fund shareholders potentially will be able to shield a substantial portion of their taxable income through depreciation. Consider an example where the shareholder invests $1 million and the REIT fund borrows $1.8 million to buy a multifamily asset. For tax purposes, the IRS allows that $2.8 million residential rental property to be depreciated over 27.5 years. This means the REIT potentially gets to deduct $101,000 a year from taxable income as a non-cash depreciation expense.
Let’s assume the REIT fund generates a 10% annualized return with a current cash payout of 6% or a current year distribution of $60,000. Thanks to the depreciation offset of $101,000, an investor who receives $60,000 in cash distributions will potentially have no taxable income for the year. In this case, the distribution will be treated as a return of capital, which reduces the investor’s cost basis. This in turn increases the gains to be taxed in the future, but generally at the favorable capital gains tax rate.
Over a 10-year period, the investor would receive $600,000 in nontaxable distributions, which would reduce the asset’s cost basis from $1 million to $400,000. If REIT shares are redeemed at $1.4 million, the entire profit of $1 million would be taxable as long-term capital gains. The investor has potential to not just defer the taxes through depreciation but to pay at the favorable capital gains tax rate.