“The more you know about the past, the better prepared you are for the future.” -Theodore Roosevelt
With President Roosevelt’s sentiment in mind, today we’re continuing through the list of alt strategies we’ve used on behalf of clients – moving on to those restricted to accredited investors – to reflect on our experience thus far. As an aside, “Roosevelt” is a word I always want to pronounce phonetically (like “ruse-a-velt” instead of “rose-a-velt”), and my wife, Katie, likes to make fun of me for it. Appropriately so. Here we go.
For Accredited Investors
Triple-net-lease, Single-tenant Real Estate
“Triple net lease” refers to being able to put the onus of property taxes, insurance, and maintenance on the tenant. A single net lease is where the tenant has to pay property taxes, a double net lease also includes property insurance, and “triple-net” adds maintenance to this equation. It can mean greater certainty for the landlord (less overhead cost), but also generally translates to lower rents vs. a standard non-net lease, as the landlord’s costs are inherently lower. For the tenant, it can mean greater flexibility in how the property is utilized (customization).
Investopedia helps summarize the approach, and there’s no need for me to reinvent the wheel, as their description aligns very well with the strategy in question:
“Triple net leased properties have become popular investment vehicles for investors seeking steady income with relatively low risk. Triple net lease investments are typically a portfolio of properties with three or more high-grade commercial properties fully leased by a single tenant with existing in-place cash flow. The commercial properties could include office buildings, shopping malls, industrial parks, or free-standing buildings operated by banks, pharmacies, or restaurant chains. The typical lease term is for 10 to 15 years, with built-in contractual rent escalation.”
The REIT we invested in began as a series of direct investments for a wealthy family and then continued to evolve from there, as other friends and family wanted to get involved in what they were doing. I like the idea of such organic development, as it means the structure was created to serve the investment premise and not the other way around. It had a diversified mix of property types (Retail, Industrial, Healthcare, Office) and tenant mix, weighted-average lease terms in the range of what has been described above, and negotiated rent increases.
At first glance, a large retail weighting would have been of concern, but the team was very focused on recession resilience, and the underlying tenants were many well-known quick-service restaurants (QSRs), casual dining, and established brands that got us comfortable with the approach. In addition, leases were negotiated at the corporate level – not an individual property level – so the failure of an individual restaurant location would still leave the corporate entity on the hook for rent payments and insulate the fund from these situations. We believed all of this created a solid basis for continued stability, income, and growth.
This investment has definitely not played out as expected. First, the management team internalized sales operations that were historically outsourced to a closely related entity. The move made complete long-term economic sense, but, in hindsight, there was also another agenda brewing – to take the fund public via an IPO. Legally, an IPO cannot be communicated ahead of time, so it’s not something we knew until it was announced, and it had a few negative implications:
- Assets became locked up during the time leading up to the IPO and then restricted from sale for the first 90 days after going public.
- Instead of having the private structure we intended to hold for the long term, this investment became a publicly-traded REIT. It meant increased liquidity, but also retail exposure, intraday pricing, and increased volatility.
- The IPO price settled upon by the management and investment bankers involved in the transaction was well below the private pricing prior to the IPO. It’s essential to keep in mind that the management team all had to take this hit on their equity, and it was believed to be a short-term sacrifice for improved long-term rewards. Thus, the move was arguably aligned with investors’ interests, but it wasn’t a volatility profile we anticipated.
The strategy remained in good shape throughout COVID, despite casual dining restaurant traffic declining substantially and the fund’s largest tenant filing for bankruptcy. As with many of our real estate partners, the team was very hands-on in making lease adjustments where needed that may have even improved long-term economics. Where possible, we added to the position in the new public shares (post-IPO) to position for potential longer-term recovery and appreciation. The transition to a publicly-traded structure means accepting a different risk/reward profile than originally intended, and we have begun trimming some of the position (the original portion qualifies for long-term capital gains treatment) in favor of other private holdings.
- Structure: private REIT with quarterly liquidity (subject to gating).
- Fund life / Access / Liquidity: Originally evergreen fund, with monthly purchases and liquidity. Now public shares are traded intraday.
- Cashflow: derives consistent cash flow from the underlying properties/leases.
- Pros: Diversified triple-net-lease portfolio. There is a lot to like about the underlying portfolio.
- Cons: No longer a private structure. Unanticipated drawdown during the IPO process.
- Where Are We Now? An IPO was not expected when the investment was made, and we will most likely divest from the shares in favor of private structures. This endeavor has raised our awareness surrounding potential IPOs, and how that process can be unpleasant for investors, even if ultimately successful.
“Recession Resilient” Private Real Estate:
The founder/CEO of this strategy comes from a Texas-based multigenerational real estate family. They were wiped out in the 1980s as real estate prices collapsed in energy states, including Texas, because of falling oil prices (cited as one of the causes of the savings & loan crisis). Aligned with this current blog topic, the pain stuck with him, and there were lessons to be learned. He remained committed to real estate but was determined to avoid such outcomes again.
In the early/mid-2000s, he believed that real estate valuations were again becoming excessive, so the founder committed himself to researching the potential for recession resilient property types that could potentially insulate his investors from a downturn he believed may have been on the horizon. He wrote an in-depth whitepaper on the topic in 2006 and steered investments in this new direction, and it has become the core philosophy of the firm ever since.
Those segments include medical office, senior care facilities, student housing, self-storage, and multifamily housing, BUT only in the context of attractive locations with favorable underwriting parameters (e.g., demographics, acquisition costs, and financing) and with the understanding that these segments may go in and out of favor as cycles play out. Sometimes ground-up development will make sense, sometimes light value-add is the preferred approach, but it can vary significantly. Thus, their structures since that time have been flexible and tactical in terms of the properties they will own, but all under the premise of “recession resilience.”
A structural element of the team that we believe is favorable is the separation of the sourcing team from the financing team. This effectively means that properties have to be underwritten from an “investment-case” perspective and separately from a financing perspective. Alternatively, some real estate funds may compensate acquisition teams simply for acquiring properties, and it can result in misaligned incentives (i.e., buying properties for the sake of buying properties rather than focusing on investment quality). The team is also very hands-on with the underlying holdings, regularly visiting and monitoring the local operators and sites.
The fund has adhered to exactly what it promised, including conservative underwriting and a tactical approach that has been resilient even through the onset of COVID. That situation involved working directly in the properties to renegotiate leases and financing where possible, and usually with better long-term economics for investors. One of the biggest challenges brought on by COVID was related to senior care facilities that were in the middle of “leasing-up” (aka finding tenants) at that time, as the process had to be temporarily shut down. However, it was a short-lived setback and minor enough that the value of the fund was virtually unaffected.
- Structure: Private equity structure (partnership) with all capital taken up-front (i.e., no drawdown).
- Fund life / Access / Liquidity: Anticipated life 5-7 years; all capital taken upfront. Illiquid.
- Cashflow: little cash flow in early years and then this should ramp-up in later years as the portfolio matures and underlying properties are managed/sold.
- Pros: Recession resilient focus and conservative approach. Seasoned team.
- Cons: Illiquidity and multi-year ramp-up period (common amongst private equity structures).
- Where Are We Now?: The fund has entered into the fully invested/harvest period, so the ultimate outcome will hinge upon ongoing rent collections and successful property sales.
Real Estate Credit Strategy (w/Focus on Construction Lending):
This strategy provides direct lending to private real estate projects/development, emphasizing downside risk mitigation through its approach to underwriting. By valuing properties with challenging market conditions in mind and ensuring loan terms are favorable to the fund, the following attributes can be targeted:
- Additional cushion built into loan-to-value ratios
- Efficient loan restructuring or takeover of equity stakes by debtholders (i.e., the fund), if things don’t go as planned
- A better chance for full recovery of an underlying investment in challenging situations (which should be expected)
The founder created the strategy after a long career in banking and developing a professional network we believed necessary to source deal-flow for this new endeavor. It was also partially driven by the lessons learned and opportunities created by the 2008 Financial Crisis. One revelation was that risk within real estate lending (or ownership) could be influenced dramatically by staying power. What was most often only temporary depreciation of real estate values during the crisis resulted in permanent impairment of capital because of forced selling at depressed values. It’s a similar concept to holding one’s stock portfolio throughout a volatile period and recovery vs. selling at a loss during a panic: staying power is vital to long-term success. Because many banks were hurt by the crisis and also faced increased government regulation in the aftermath, it created an opportunity for private lenders to step into this space and benefit from favorable terms.
This strategy was the first fund we entered into that offered less-than-quarterly liquidity. In addition to the appeal of income targeted to be multiple times higher than most liquid fixed-income segments, the structure was one of the most aligned we have ever encountered. There is no management fee (there are other 3rd-party costs), so the management team is paid only via an incentive fee – i.e., they keep a percentage of profits, as long as a minimum preferred return is achieved for investors. Access to the fund is through an alternative platform that helps facilitate onboarding and due diligence; however, it was considered a “direct” offering, where investors do not directly pay any platform fee (the platform is compensated by the manager on the back end).
- Structure: Private REIT (LLC). Note: the restructuring to a REIT was an adaptation made to add tax efficiency brought about by tax law changes after the original structure was created.
- Fund life / Access / Liquidity: Capital is accepted as it is deployed for loans but typically taken all at once. Annual liquidity (subject to gating/sidepocketing) after a lockup period of two full calendar years.
- Cashflow: derives cash flow from the underlying interest and loan repayments.
- Pros: Aligned fee structure; emphasis on risk mitigation.
- Cons: Focus on real estate development/construction phase, which involves more unknowns than completed properties. Potentially susceptible to a) drastic changes in the economy that could affect builders’ decisions to complete projects or the fund’s ability to sell properties (e.g., in the event of seizure due to default) or b) rate environment or regulatory changes that could incentivize increased competition.
- Where Are We Now?
- One of the first projects defaulted and is under contract to be sold this year. That sale may be at a slight loss but will have a limited impact at the overall fund level (the value was already written-down and the portfolio is diversified). The lesson learned is not to lend to high-end single-family residential real estate because the base of buyers is too limited.
- Due to COVID and other circumstances, additional loans have more recently defaulted, but the fund stepped-in to restructure deals, negotiate joint ventures, or take equity ownership as expected. A number of these situations are currently in process, resulting in the fund halting new investments and redemptions while they work through the details and allow some loans to mature (be repaid). It is not necessarily a problem for long-term investors but can be an issue for those seeking near-term liquidity.
- The original due diligence provider recently downgraded the fund due to several changes in senior management. The founder remains in place, and the strategy is intact, based on monitoring we’ve conducted, and it will be interesting to see how the portfolio progresses from here.
With that, we’ve made our way through three more funds and well over 2000 more words, and we’re left with five more funds to go.
Until next time, this is the end of alt.Blend.
Thanks for reading,