Last week, Max from our team gave a great overview of the Evergrande crisis that is unfolding in China. If you missed it, take a look at our archive or watch this explanation video by Graham Stephen. In fact, Evergrande missed a debt payment at the end of this week.
Grab a drink, sit back, and let’s get to this week’s topic – investing like a family office. If you’re new, make sure you subscribe to this newsletter so you don’t have to wait until Uncle Jim forwards it to you next week.
Investing Like a Family Office
Family offices invest in real estate for two things:
1) Preservation of capital, and
2) A return on capital in excess of inflation
As such, they typically (1) buy quality assets (2) in good locations with (3) little debt and (4) an infinite investment horizon. They also (5) choose metros where rent growth is expected to exceed inflation over the long term. It’s not sexy, but it works.
In contrast, the typical fund model involves creating quick value in risky assets with high leverage. In other words, the complete opposite of the 5 values described above.
I thought it was impossible to invest like a family office as a sponsor … how do you make money if you never sell an asset?
Then I stumbled upon Moses Kagan and his fund Adaptive Realty. In true Bullpen fashion, I haven’t told Moses that we’re writing about his fund today (and I don’t think he is a subscriber). If you know Moses, forward this to him and say thank you.
Moses invests how family offices like to invest … in great locations with little debt in markets where rent growth is in excess of inflation … and for the long-term.
It works like this …
1. Moses will buy a multifamily property with a big renovation need, funding the purchase and rehab with cash.
2. When the rehab is complete and the property is stabilized, he’ll take a loan out on the property that is used to return cash to investors (in some cases in excess of the initial investment).
3. After all of the investor’s capital is returned, his fund will hold and manage the property in perpetuity, splitting cash flow 70% to investors, 30% to the GP.
This strategy creates interesting advantages …
1. The obvious one … you can make really compelling offers on properties when you have the cash in hand and can close quickly.
2. The acquisition analysis is very basic. When you hold forever, you don’t need to project an exit cap rate and rent growth (two of the hardest things to nail down). Thus, your analysis is very simple.
3. With fewer closing costs and no interest reserve on a bridge loan, you keep a lower basis in the property.
4. With no debt, not much can go wrong. The probability of becoming a forced seller in a bad market is very low.
5. IRR isn’t relevant, and you don’t have the IRR “reinvestment” problem. Many investors don’t realize that IRR assumes they will reinvest cash distributions at the project’s IRR throughout the life of the investment.
Moses’s rule of thumb when analyzing potential investments is that he wants his pro-forma, unlevered yield (also known as return on capital) to be 200-250 basis points greater than current interest rates. Thus, his strategy only works when there is a significant value-add component in the investment.
If you’re interested in learning more about Moses’s business, I highly recommend listening to his interview on the Acquirers Podcast. Most of the above was gleaned from this podcast.
I hope you enjoyed this week’s letter!