While challenging, the slowdown we are currently facing is far from unprecedented, and may present chances for optimism. In 2008, for example, many opportunistic investors were able to capitalize on a rapidly changing real estate market. Even a brief look at our economic history, dating from the Great Depression to the present, will reveal that moments of great uncertainty are often followed by moments of great opportunity.
As a developer or sponsor, part of your job is to explain this brave new world to investors. With the right mindset—and with supporting data—you can address their concerns and help them overcome the fear of the unknown.
The Right Sponsor Partner Makes all the Difference
For Alpha Investing, the work we put in upfront is a major part of how we reduce risk for our investments. To minimize as much project-specific risk as possible, we begin by identifying and working with only seasoned, institutional real estate sponsors.
That word institutional gets thrown around a lot, particularly in the crowdfunding world. And it’s easy to understand why – marketing an “institutional” sponsor to investors is much easier than the alternative. However, there is no clear cut definition of what makes a group “institutional” – there are a lot of factors that need to be evaluated. In other words, this analysis is both quantitative and qualitative. And because sponsor vetting is more of an art than a science, you want real estate professionals sourcing and evaluating potential investment partners.
The vetting process starts with asking the right questions. What does the sponsor portfolio look like (e.g., how big is it, what do the assets look like, do their existing assets reflect their current investment strategy, etc.)? What is their track record (especially relative to their initial projections)? Who are the key principals and what experience do they have? How many projects have they completed and how long have they been involved in the industry? What do their debt and equity relationships look like? All of this upfront sponsor vetting work is critically important because partnering with the right sponsors is one of the surest ways to establish a competitive advantage. Working with the wrong sponsor partner, on the other hand, can be a recipe for disaster, and as such, avoiding bad relationships is just as important as finding the right ones.
A quick review of the legal disclaimers in any offering memorandum will show a warning along the lines of “past results are not indicative of future success” and while this is absolutely true (i.e., there is no guarantee that a sponsor who performed well in 2015 will continue to do so in 2020), we can still find very valuable information about a sponsor and their ability to execute by evaluating their portfolio and performance track record. In our work to evaluate sponsors we go through case studies, look at old models, and at projected versus actual results, further following up about what happened when actual results were meaningfully different from initial projections. These discussions often lead us to a place where we can identify whether a group, in short, knows what they’re doing. With that said, it’s important to note that not every strong performing deal (or poorly performing one for that matter) is the result of good or bad execution – market forces often play a significant role. Understanding how and why initial projections were right or wrong is an excellent way to learn if a sponsor truly understands the factors that played into their project’s performance. This is particularly important in evaluating sponsor performance over the last ten years – a period that has seen significant cap rate compression (and asset appreciation) across the board.
Finding the right sponsor group is one of the most important ways that we mitigate project-specific risk. We typically spend three to six months vetting groups before we ultimately decide whether to make our first investment. Some people may view this process as an over-abundance of caution, but the reality is, sufficient vetting takes time. Before we make a final decision, we must receive and then review all of the diligence information we’ve requested, have conversations with our sponsor partners about what we’ve reviewed, look at more models and case studies from prior deals, speak with existing debt and equity relationships, and otherwise work through a long sponsor vetting and due diligence checklist. This process is time consuming, but it’s the only way to find the right sponsor partners.
A Big Picture Look at Finding the Right Asset Classes for Investment
There are many factors that go into evaluating whether a real estate deal makes sense for investment – the devil is very much in the details – especially when the information we’re evaluating comes in the form of forward-looking projections. In looking at an opportunity from all angles, we simultaneously dive into the minutia of the deal while keeping an eye on larger macro trends that influence specific markets or even the United States as a whole. At the macro-level, we look at signs of employment and wage growth in areas with dense populations and goods transportation infrastructure as positive economic markers. We also look at broader population trends – e.g., where are people moving to/from. It is these larger macro trends that often indicate where we would expect to see population and job growth, which often translates into rent growth, higher occupancy rates, and asset appreciation.
Understanding macro trends has led us to implement a ‘need-based’ investment strategy when looking at our preferred asset classes. Multifamily and senior housing both fit this category because each asset class has larger macro trends pointing to increased demand, not through volition, like hospitality for example, but through inherent need – people need somewhere to live, and they need somewhere to grow old. Demographic, financial, and social trends are all moving in a very specific direction.
Understanding where we are in the market cycle today is always challenging. This is evidenced by the number of real estate and economics experts with differing opinions. With that said, the one thing we feel comfortable saying that that we’re not at the beginning. And because we believe that to be true, we need to evaluate opportunities as if we’re at or near the end of the market cycle. It’s here that we can find safety in certain types of multifamily assets because we know people will always need a place to live. This effectively creates a floor in the residential real estate market, even if this floor changes shape and form over time. We also know that home-ownership rates are at, or near, all-time lows – particularly among younger generations.
In the senior housing asset class, we know the population is aging and people are living longer. In the long-run, this trend would seem likely to result in an under-supplied senior housing market. However, this commonly held belief results in most senior housing sponsors today focusing on ground-up development. This void of acquisition focused sponsors, combined with the fact that senior housing ownership in the United States is very fragmented, presents an environment in which we find investment opportunity in acquisitions. We find the best opportunity in partnering with an institutional buyer to acquire assets from mom and pop sellers who often do not have the expertise or resources to optimally manage their senior living facilities. This strategy allows our sponsor partner to create value immediately upon acquisition by leveraging the resources of a more established owner/operator and benefiting from the economies of scale that stem from owning a larger portfolio of senior housing assets.
As a general strategy across asset classes, rather than looking at ground up deals that inherently have more risk, Alpha prefers to increase return relative to risk by looking at deals that are already distributing cash – properties that are already operational, but could benefit from institutional caliber systems and processes to add value. This is yet another element of our investment strategy that, over time, allows us to earn reliable returns while mitigating our overall exposure to risk.
Conclusion
Real estate investing (and investing generally for that matter) is never risk-free – that’s why investors receive a return for the capital they put at risk. Savvy investors are able to look at opportunities on a risk-adjusted basis. After all, smart real estate investing is about execution – it starts with putting in the work to find and vet the right investment partners and continues with thorough underwriting and deal evaluation by real estate professionals – all with the end goal of increasing the relative value of each dollar you invest.