Black-Belt Real-Estate Strategies from Investment Author Paul Kaseburg: Part 1
Why your sponsor’s performance-based compensation isn’t as aligned with you as they claim.
August 4, 2017 BY IAN IPPOLITO
(Usual disclaimer: I’m just an investor expressing my own personal opinion and not a financial advisor. Consult your own financial advisor before making any investment decisions).
It's a special treat to talk with Paul Kaseburg today. Paul's the author of an eBook on passive real estate investing that I wish I'd read when I started and think should be required reading for every beginner and pro.
Paul’s sat on both sides of the table on over $1.7 billion of real estate deals. And his book covers everything a newbie needs to understand: from asset selection, to evaluating sponsors, to capital structures. For pros, he challenges conventional wisdom and explodes sacred cows by exposing hidden conflicts of interests and mis-alignments that many in the industry won’t admit to. The book is called "Investing in Real Estate Private Equity: An Insider’s Guide to Real Estate Partnerships, Funds, Joint Ventures & Crowdfunding" (written under his pseudonym of Sean Cook).
In this, part one of the interview, Paul will talk about how your sponsor’s performance-based compensation probably isn’t as aligned with you as they claim. And he also discusses stress tests and the actual advantages of much hated capital calls. Then in part two, Paul will talk about how to analyze a sponsor.
1) TRECFR: 95% of real estate deal contains a waterfall/promote structure. Investors get a preferred return (say 8%) and if the investment does better than that, the sponsor gets a split of the profits (say 75% investor/25% sponsor). Virtually every sponsor brags about how this structure is great for investors since they only get paid when they’re successful. They say this aligns their interests with ours, which seems logical and most of us believe it. Why are we all wrong?
Kaseburg: There are essentially two types of compensation for sponsors, performance based (paid when a deal does well) and fee based (paid regardless of deal performance). At some point in our industry’s history, the phrase “alignment of interest” started being used to describe deals with a high proportion of performance-based incentives, usually paid through promotes. At a superficial level, this sounds true: the sponsor is paid more if deals do well. That seems… good?
In reality, highly performance based compensation structures incentivize sponsors to seek more risk with investors’ money. Think of promotes as being a call option on deal performance; there is an incentive to maximize returns but without the incentive to minimize losses. Without being normative, this structure clearly does not align interests between sponsors and investors.
On the other hand, much maligned fees such as acquisition or management fees aren’t as bad as they are often made out to be. It’s true that they can incentivize sponsors to do more deals (regardless of deal quality), but they offset some of the misalignments created by performance based fees.
There is no fee structure that perfectly aligns interests between sponsors and investors, so the industry standard is a mix of performance and fee based. Too much of either will skew incentives toward risk-taking or deal volume, respectively. Ultimately, investors’ priority should be selecting good sponsors who have the experience to execute their plans and an incentive to sustain a profitable platform over the long term.
[Editor’s note: when Paul talks about “platform”, he’s talking about something different than some crowdfunding investors mean by it.
Investors usually use the word “platform” to describe a real estate crowdfunding website that features potential investments for sale. When Paul says “platform”, he’s describing the staffing, management and expertise that the sponsor of the deal/fund has set up to perform all the major management tasks of the investment. That includes things like property acquisition, property management, property disposition, etc..
Some sponsors will outsource these things, so they’re not considered to have their own platform. Also, running such a platform successfully through cycles is not only a sign of additional expertise, but can also be an additional source of stability. It's an additional revenue stream that might increase the chances that the sponsor can "keep the lights on" over challenging portions of the real estate cycle.]
TRECFR: Many newer investors don't have easy access to good sponsors who’ve done business over multiple cycles. For them, or anyone evaluating a "young" sponsor, might the overall fee structure be a way to glean some additional information? For example, I was recently pitched on two “young” funds that both claimed that to be fairly conservative core + investments. One of them had the majority of its compensation based on backend performance fees, and the other had no such fees at all. In cases like that might a fee structure skewed against the purported strategy of the fund be a potential yellow flag?
I think having compensation too heavily weighted to either fees or promote creates misalignments of interest. Having a bit of both helps sponsors support their platforms but also provides incentive to make deals perform. The compensation structure is also an indicator about how the sponsor views their own business. There’s no perfect compensation structure but I would try to at least avoid the extremes, particularly with a newer sponsor.
2) TRECFR: In your book, you have a graph that was a real eye-opener for me. It shows a multiple-stage waterfall and the return of the sponsor looks almost exponential compared the linear return of the investor. This is not what alignment looks like. Some investors might be thinking “okay I’ll just avoid multiple-stage waterfalls”. Does the same dynamic still exist in a one stage waterfall?
Kaseburg: That example (the chart is below) compares the investment multiple for sponsors and investors in a somewhat typical investment structure that mixes incentive and fee compensation (1% acq. fee, 1% dispo. fee, 8% pref, 70/30 to a 12%, 60/40 to a 15%, and 50/50 thereafter, with a 10% sponsor co-invest including the acq. fee, 5-year hold).
In short, the acquisition fee creates the step up in returns for the sponsor for poor/modest return scenarios, and the disposition fee and the promote create the kink upward once the deal starts to do well.
I re-ran that chart to show a single-stage promote (70/30 after an 8%), which is shown below.
The multiple is lower in this case, but you still have the same disparity between sponsor and investor. Also, a higher split to the sponsor in a single-level promote will result in a similar outcome as the multi-level promote, as will a lower cash co-invest.
Of course, misalignments of incentives are everywhere in life. The only perfectly aligned structure would be if investors could participate without paying any fees or promotes – not a situation that creates a sustainable business model for sponsors!
There is nothing inherently wrong with these structures, it’s just important for investors to appreciate how they work and know that they can’t rely on sponsor alignment of interest without doing independent homework on the sponsor and investment.
Investing in private real estate deals is truly a partnership between sponsor and investor; one that requires similar goals, trust, and a long term commitment.
1b) TRECFR: If a sponsor pushes the risk curve too aggressively on every deal, investors will find out pretty quickly and leave them. Is the bigger danger from sponsors who push the curve in more subtle ways? If so, what things should prudent investors keep an eye out for?
Kaseburg: It’s worthwhile to review deal assumptions. These include: (rent growth, exit caps, value-add plans, operating assumptions vs. historicals).
Beyond the major disclosed assumptions it can get tough to evaluate underwriting objectively. The complexity of modeling real estate and the sensitivity of pro forma returns to small changes in assumptions makes it basically impossible to evaluate underwriting without running your own models (which is impractical).
Ultimately, the most important job is to pick the right sponsor. Good sponsors have solid investor demand and don’t need to make aggressive/unreasonable assumptions in an effort to underwrite returns and attract investors.
Note: more about picking a good sponsor is in part two of this article.
2) Most investors hate funds with capital calls. Instead of deploying all of your cash right away, they take small pieces over time when they find a new property or opportunity. It’s painful to watch much of your capital sitting idle and making no money, and having no idea when things will get better. But in your book you say that capital calls can actually be a good thing for an investor. How?
Kaseburg: Since deals usually are sourced and closed over a period of time, investor money in funds is sitting idle either way. If it’s called over time it sits idle in investors’ accounts. If it’s called immediately it’s sitting idle in the sponsor’s account until it’s needed to close an acquisition. Often the difference is that the preferred return starts accruing for investors when the money is called.
While that seems good for investors, the combination of accruing pref and idling cash creates a strong incentive for sponsors to buy deals as soon as possible. This could mean they are less picky about deals than they otherwise would be.
Also, the accruing pref doesn’t mean your money is productively invested, it just determines how money coming out of the fund is split between sponsor and investor. If your investment earns 0% economically, you’ll get a 0% return (less fees) regardless of your pref rate.
3) You wrote your book because so many friends came to you for advice on investments, and mentioned many times the deals they brought you were not that great. What are the top couple of mistakes you saw friends make, that investors should avoid?
Kaseburg: If I had to pick one mistake, it would be the decision to invest with the wrong sponsor. The choice of sponsor impacts nearly all aspects of the deal, because good sponsors are more likely to select good properties, have the ability to execute on their business plans, have reasonable compensation structures, and are more likely to treat investors fairly when unexpected problems crop up. Chasing modestly higher underwritten returns or an exciting deal story without a strong sponsor isn’t worth the risk in most cases.
Another common regret I hear is investing in deals with too much debt. Even if the real estate is solid and the business plan makes sense, too much debt can turn a temporary downturn into a permanent catastrophe.
I like deals that have the wherewithal to make it through unexpected surprises. The market can’t bail you out in a cyclical recovery if you already gave back the property to the lender!
3b) “TRECFR: You've mentioned on a podcast elsewhere that you analyze the risk of debt default by running a “stress test”. You take the ratio of the final cash distributions (NOI – capital expenditures, reserves etc.) versus the revenue. That ratio tells you how much revenue can fall, before the debt payments can no longer be made, and equity gets wiped out. After getting this number, what else should an investor be looking at?”
The basic theory here is: if you are buying good real estate and can hold on through a cycle, you will usually end up doing at least OK over the medium/long term.
Bad things often happen when a property can’t pay debt service during the hold period or can’t be refinanced at the end of a short debt term.
The stress test is helpful because it’s an intuitive measure that links directly to the deal underwriting. It helps investors evaluate the risk of default during the hold period. Once you know the stress test, think about what could happen in the marketplace or with the property that could cause revenue to decline that much.
Is there a large single tenant that could leave (or multiple tenants with coterminous leases)? Is the property in a location that is susceptible to market downturns? Is new development likely to impact lease rates? Is the property becoming functionally obsolete based on recent tenant demands? Brainstorm issues that could come up, and look through the “Risks” section in the PPM; important potential issues are usually disclosed there.
To hear more, please continue on to part two, where Paul will talk about how to analyze a sponsor.
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Ian Ippolito is an investor and serial entrepreneur. He has been interviewed by the Wall Street Journal, Business Week, Forbes, TIME, Fast Company, TechCrunch, CBS News, FOX News and more.
Ian was impressed by the potential of real estate crowdfunding, but frustrated by the lack of quality site reviews and investment analysis. He created The Real Estate Crowdfunding Review to fill that gap.