Capital Insights: September 2024

From Executive Vice President Trevor Schuesler, CFA

Investing in What Matters

In Robert Brunswick’s December 2023 Board Minutes from the Chairman, he touched briefly on some of his successes in philanthropy including the growth in Hoag Innovators, a philanthropic endeavor in partnership with Hoag Hospital targeted at catalyzing innovation in healthcare. This led my mind down a path of investing in what matters. Investing to have the means to be philanthropic, to be able to give your kids a better life than you had, to buy a house, to retire comfortably, and the list goes on. I think this purpose of investing often gives way to less reliable reasons like the fear of missing out (“FOMO”) on the hot new IPO, getting into the latest real estate deal with your golf buddies, or chasing the returns of some high-flying chip stock. And while I don’t have the expertise of Robert to discuss philanthropy or know your purpose for investing, what I can speak to is investing in what matters when it comes to selecting investment opportunities. Earlier in my career I was the Director of Research for the largest capital allocator in Orange County and served in a similar capacity for a large SoCal based family office.

To distill it down in its simplest form, investing in what matters to me means choosing opportunities that deliver the highest risk-adjusted, after-fee, after-tax returns consistent with your risk tolerance. If you are successful in this, you should be successful in achieving your personal purpose for investing. I have found that the three biggest deterrents to this success are 1) Ignoring Risk, 2) Misunderstanding Fees, and 3) Disregarding Taxes.

Ignoring Risk

Risk is difficult to measure in financial markets and there is no mutually agreed upon metric that represents it. This is due in part to it being difficult for investors to fully understand the different forms of risk they are taking on in an investment. This is especially true in private markets where track records may be limited, incomplete, or calculated in different manners. Additionally, there is limited “mark-to-market” in private markets making it impossible to assess risk using traditional metrics like standard deviation. Without an appropriate way to measure risk, investors often default to comparing investment opportunities relative to target returns, historical returns, or other even less reliable metrics. Although most veterans of investing fully understand Past Performance is Not Indicative of Future Results, they can’t help themselves in the absence of additional information. 

Following the Global Financial Crisis real estate benefited from multiple years of falling interest rates and limited supply.  It had been an environment that “lifted all boats,” but now the tide is going out and we are seeing the aftermath of many poor investment decisions. The real estate managers that had performed the best as cap rates compressed and rents swelled were typically those that used massive leverage, floating rate debt, and targeted more tertiary markets. As it relates to capital raised, these same groups enjoyed much success being able to highlight their strong track records and their high forward-looking returns.

However, this success was an artifact of a very specific market environment that has come to an end. As markets have shifted to higher interest rates, borrowing costs, and cap rates, these same managers have come under extreme duress. They are being forced to give back property, and many of their investors (that ignored the inherent risks that seem so obvious today) are seeing a complete wipeout of their investment.

To avoid taking on undue risk, you may want to consider the following when assessing a real estate fund manager (these are adapted from Buchanan President & CEO Tim Ballard’s March 2024 Capital Insights):

• Risk 1: Historical returns were generated by luck, not skill. Were those returns generated due to cap rate compression or NOI growth? Was a specific sector or geographic exposure particularly “hot” during the period reviewed?  How repeatable is the strategy given current market dynamics?
• Risk 2: Too much leverage. Is the leverage commiserate with the risk of the opportunity and/or the risk you are willing to take as the investor?
• Risk 3: Inexperienced manager. Has the manager executed their strategy through multiple cycles, and do they have the team and infrastructure to continue doing so in the future?
• Risk 4: Manager risk alignment. Does the manager get paid to take on excessive risk? How much of the manager’s own capital is in the investment?

Misunderstanding Fees

Investors have gotten much smarter when it comes to fees and (rightfully so) much more attention is paid to them. Fees are the one (negative) performance factor that is knowable in advance of making an investment. However, the fee on the cover isn’t always the fee incurred. The number of one-time and recurring fees in real estate can be overwhelming, and include fees like asset management, incentive, property management, acquisition, financing, development, disposition, etc.  To make things even more complicated there are implicit fees that can be quite large. Many real estate fund managers rely on a 3^rd party “sponsor” to source and manage real estate investments for them. This approach can be helpful for a manager’s sourcing and execution efforts, especially if they don’t retain the requisite acquisition or asset management staff in house. However, it comes with additional hidden costs and does not allow the manager the ultimate control over the opportunity. The fee “waterfall” paid to the 3^rd party sponsor can be as much as 50% of cash flows after a certain level of performance. This is called a “double-promote” when there is a performance fee paid to the underlying sponsor at the property level and again to the investment manager at the fund level and reduces the returns of the end investor.

A fee should be earned and should be utilized for purposes that generate the results investors expect. Managers that do “wholly-owned” direct investments avoid the fee burden associated with a double-promote and allow for control when executing a property’s business plan. To execute with this level of hands-on precision, it is important to have best-in-class and experienced staff. In many cases, this requires attracting and retaining employees with 15-30+ years of experience, a long track record of success, with the ability to manage assets in a difficult environment. However, this can be expensive to do, resulting in many managers 1) relying on a 3^rd party sponsors to transact and manage properties, 2) hiring younger, less experienced (cheaper) acquisition and asset management professionals, and/or 3) burdening their investment team with too broad of coverage in an effort to bring down the average cost to manage each investment. These approaches may be successful in lowering explicit fees to investors, but they may come at a much higher end cost.

Some questions you may want to ask as it relates to fees include:

• Do I understand all the explicit and implicit fees? In addition to understanding all fees earned by the manager, ask what fees may be earned by related and unrelated parties, and how cash flows are paid at the property and fund level.
• Is the fee being earned? Make sure the fee being charged is for a service being provided and at a level that would constitute fair compensation. Avoid paying too much or paying for something that requires little effort.
• Are you paying too little? This may be counterintuitive, but bear with me. If the fee seems too good to be true, it probably is. The manager is either earning their fee elsewhere or you are paying for it implicitly with poor execution.

Disregarding Taxes

“It’s not how much money you make, but how much money you keep.” -Robert Kiyosaki

Like fee-drag, tax-drag is something an investor should be able to ascertain prior to investing. Some assets like private credit can be terribly tax inefficient generating ordinary income taxable at the state and federal level in the year it is earned.

Other asset classes, like real estate, have the tax-code working in their favor allowing income to be earned today but allowing for taxation to occur at more favorable rates much further into the future (or maybe not at all!). Other investments likely sit somewhere in-between. Finding opportunities that not only generate strong returns, but generate strong after-tax returns is paramount to compounding wealth over time.

We live in an uncertain market environment with high interest rates. That has driven massive flows into lower risk, higher yielding assets (CDs, Treasuries, private credit, etc.). I have some exposure there myself and believe the environment for this exposure is favorable. However, I see an overwhelming preponderance of investors sitting on the sidelines waiting for market dynamics to shift to pivot from cash-like assets to risk assets. In the process, they are paying a massive amount in ordinary income taxes while they wait. Instead, investors should be taking advantage of the investment horizons they have (an 80-year-old has a 9.4 year time horizon!) and seeking opportunities they reliably expect to outperform over that period net of taxes. Real estate, after a recent reset in valuations, is providing opportunities today to buy in-place cash flow at 5%+. Additionally, that cash flow should grow reliably over longer periods time, offer principal appreciation, and avoid taxation for many years (or in perpetuity) if there is the ability to depreciate, utilize a 1031 exchange, and/or take advantage of a step-up in basis. For me personally, I’m betting on real estate’s after-tax return over Treasuries or Private Credit over the next 9.4 years and beyond.

Tax questions you can ask when evaluating an opportunity include:

• How will this investment be taxed (e.g. ordinary income, capital gains, other)?
• Can I defer or eliminate taxes in this investment?
• Where should I hold this investment (e.g. taxable account, IRA, etc.)?
• What is my return expectation after taxes?

Achieving your purpose for investing becomes much easier when you maximize your investment strategy for wealth compounding. Although it is tempting, going after the investments with the highest target or historical returns are unlikely to put you in the best position to achieve your desired level of wealth creation. Instead, choose opportunities that deliver the highest risk-adjusted, after-fee, and after-tax returns consistent with your risk tolerance. To me, that is investing in what matters.