From President and CEO Tim Ballard
The Informed Investor — What 35 Years Have Taught Me
Over the last 35 years, I have been involved in over $8 billion worth of investments encompassing over 300 separate transactions. I have served in the capacities of borrower, property operator, lender, developer, investor and GP/fund manager. As a result of these experiences, I have had a front row view into many real estate organizations and what happens in good times and in bad. I have also been fortunate to have 2 partners in business for 30 years, operating through multiple cycles, including the Great Financial Crisis (GFC).
I wanted to share some observations with the goal of helping investors better understand the risks they are taking and what they should try to avoid.
When economic conditions are favorable, assets tend to appreciate, and most investment portfolios yield positive returns. During prosperous times, even poorly managed investment firms may seem successful due to the rising tide lifting all boats. However, what may remain hidden are managers that have taken outsized risks to deliver their performance, or said another way, investors may have unknowingly accepted much more risk than they bargained for.
The real estate industry has no shortage of eternal optimists and dreamers. Having said that, many don’t make it through a down cycle because they take enormous risks and don’t have the wherewithal —whether it be emotional strength, experience, expertise, or capital—to overcome the inevitable down market.
During the last few years, there have been many firms that were highly successful at attracting large amounts of investor capital but were run by inexperienced management teams and now are faced with what happens when their overly optimistic underwriting doesn’t materialize. Many of these firms have faced foreclosures of significant portions of their portfolios and the total loss of investor capital. This is happening right now in what many have assumed is a safe asset class, namely apartments. Unfortunately, investors in these firms did not fully underwrite the merits of their GP and made investment decisions not fully understanding the risks they were taking.
Based on my 35 years of experience, here are some of the areas that I would focus on in considering a new investment.
First, don’t be distracted by the deal that someone is pitching you, but first focus on whether you should be investing with the firm that is sponsoring the investment. Investments are long-term endeavors and are likely to encounter unforeseen events – recessions, interest rate changes, inflation, capital market illiquidity, personnel turnover, regulatory change, etc. These issues require that you have the right team captaining the ship in order to survive the inevitable rough waters ahead.
While not an all-encompassing list, here are some areas to focus on when evaluating a GP:
If a GP has been successful multiple times, i.e. more than 10x and across multiple cycles, you can at least reduce the risk that it wasn’t just an up-market cycle that resulted in their performance. Don’t invest unless the manager can meet this test. In the example I gave about failing apartment syndicators, their leadership teams have ranged from CEOs that were applying to college during the GFC or were marketing golf course software immediately prior to acquiring billions of dollars of apartments. These individuals would fail the test of having successfully invested across multiple cycles and because of their inexperience took on massive risk that resulted in some investors losing 100% of their capital.
GPs will often co-invest very little of their own capital (because they don’t have it) and much of the time they will syndicate their co-investment to third parties. Syndicated co-investment just dilutes the upside to the GP and does nothing to improve an investment opportunity, it perhaps makes it worse. Avoid situations where the GPs co-investment doesn’t come from the management team. I would suggest that GPs put in 10% of the total equity as co-investment. If they are either unable or unwilling to do this, it is a big red flag.
Some of the biggest risks to the success of a given investment often have nothing to do with the investment itself. Make sure the investment team is focused on the long-term interests of the investor, even when it may not be in the economic interest of the manager. When investing with a GP, you must ask yourself the question, “Will this GP and the investment team be around in 10 years?” Sometimes a vehicle may be run by employees that are just on to the next job or you have a GP that fails during an economic downturn and is unable to effectively manage a fund.
Entering into the GFC, Buchanan Street Partners had invested with many real estate firms that ranged from major international organizations to strong regional firms to small entrepreneurial companies. What became clear is that across the spectrum, many firms became solely focused on their survival, ignoring their fiduciary duty to investor capital. This was often due to flawed investment models that relied on acquisition fees and unpredictable carried interest in order to pay their expenses. When transaction activity stopped, these firms could no longer support their ongoing overhead.
Some investors are highly focused on negotiating asset management fees but are liberal with acquisition fees. If the investor thought about this a little longer, they should conclude that the closing of an investment should not be a big profit center as it doesn’t align incentives. Furthermore, if an asset manager is paid minimal fees during the life of the investment, the GP may not be able to attract and retain the necessary talent to ensure good investment outcomes. Real estate, unlike the securities business, is an operational intensive business that requires strong employees and infrastructure to ensure the best possible outcome. Inevitably, there is going to be the next recession, and you want to make sure that your manager can continue to provide a high level of service, even if the prospects of collecting a carried interest are no longer there. We believe that managing the downside risk is more important than the potential upside. It’s hard to recover from losing all of your capital.
I often share the analogy that a hammer only looks for nails. This applies to real estate in that if a firm’s only capability is a single asset class, they must sell you that investment strategy for their survival. While I would agree that having a highly skilled expert in one field is a big positive, this could also be an impediment. There have been long stretches of time where certain strategies just don’t work well. Office is a great example of this. Investments in office buildings have been a really bad idea for at least the last 7 years. However, plenty of investment firms raised significant capital to do exactly that. There are days that the markets are flooded with capital and the best strategy may be to just do nothing at all, or if you do something, it’s to sell the assets that you have.
Always ask yourself the question of what generated the historical performance track record. In the case of the apartment firms mentioned above, some of them had very high rates of return initially but much of their performance was due to cap rate compression coupled with massive leverage. In hindsight, their performance was much more about luck vs. the execution of a disciplined strategy. The legal disclosure that states, “past performance is not indicative of future results” couldn’t be truer in the case of the inexperienced manager. To really understand historical performance, it is best to understand if the manager improved property cash flows, derisked assets, performed in line with budgets and avoided over investment during peak market times.
When investing with a GP, you make at least two big bets. The first bet is what most investors focus on – the property investment strategy and potential returns associated with it. The second bet is on the long-term viability of an operating business/ investment manager. Many investors ignore this second bet and unknowingly accept too much risk.
We are often presented with loan requests where a couple of individuals have left careers at larger organizations to start their own real estate investment firms. We generally avoid these situations as being an employee of an organization is very different than being an entrepreneur or leader of a company. Unfortunately, we too have made this mistake before. We once invested with two individuals that were both with large public REITs where they ran billions of dollars of apartment assets very successfully. When they decided to strike out on their own, they found and acquired interesting investment opportunities but failed at attracting and retaining strong employees to execute their strategy. This resulted in cost overruns, delayed execution of business plans, and terrible operating performance. On paper they looked strong, but in reality, they were unable to translate being a good employee investor into being even an average entrepreneur.
There are many things that go into creating a successful company that are often ignored. I am a big believer that good culture leads to good behavior when no one is looking. Hard-earned reputations create more opportunities for outperformance. Strong balance sheets allow firms to weather the inevitable storm and make decisions for the long term. Seasoned investors are less likely to be fooled by temporary phenomena, i.e. WeWork, zero interest rates. GPs earn their fees and carry based upon learning from their prior mistakes and avoiding them in the future.
In the end, investments have risk. The informed investor is the one that does their best to fully understand the risks they are taking before making an investment. I can accept having an investment turn out poorly if I made an informed decision about the risks and was wrong. What I strive to never accept is making uninformed investment decisions and losing because I wasn’t aware of the risks.