With declining fees, jittery interest rates and the real prospect of cap rate reversion, I've argued with my friends that the five- to seven-year hold model of multifamily investment has become too risky for the returns to the sponsor community.
The risks to long-term value—particularly interest rate risk, refinancing risk and replacement risk—are substantial, and not fully factored into the business model. Owners are chasing the requirements of short-term, IRR-driven capital, but there are alternatives.
In a low interest-rate environment, there are long-term investors who want yield, safety and a hedge against inflation and are willing to leave their equity to the grandchildren. Amazingly, you can match their equity with long-term Federal Housing Administration (FHA) debt for 35 to 40 years. While this strategy requires building operating capacity for an intergenerational hold, it eliminates interest rate, cap rate, asset replacement and refinancing risk from the sponsor’s equation.
Stop chasing 1031s. Structure a new model in which the GP earns increasing fees based on revenue increases. Want more? Perhaps include an equity split model that increases sponsor equity with asset value, so that in the long term the sponsor can own 40 to 50 percent of an asset without diluting yield to investors or otherwise taking advantage of them.
The current model of a five- to seven-year hold is predicated on an IRR-driven vision in which a sponsor exceeds investors' IRR hurdles and gets to make acquisition fees, asset management fees, disposition fees, property management fees and the fees to affiliated construction and landscaping contractors during the term of a repositioning. These income streams help keep the lights on for general partners awaiting their 20 or 30 percent split over a mid-teens hurdle rate at sale.
This timing-driven play worked out well for some in a declining interest rate environment from 1993 to 2011 (with the exception of 2009 and 2010) mostly because interest rates and cap rates came down in a steady, unprecedented progression. As a whole, the industry now faces stagnant carried interest returns going forward.
As a result, the new younger and less experienced general partners are finding investors unwilling to pay the kinds of private equity fees that used to be common. Fund investors dread paying acquisition or disposition fees and have successfully squeezed asset management fees nearly out of the picture, as well. Increasing competition for professional equity investors means those investors have more control and are tightening their squeeze on the fee-based income opportunities traditionally part and parcel of a decent deal. Something has to give.
From a macro perspective, it seems like today's play is to find capital that better fits our environment. High net-worth families are still grateful for yield. They invest with people they trust. They measure their goals in dollars, not IRRs. They are less sensitive to the age of assets and don't have asset allocation bands that require them to sell at arbitrary points as a property ages.
Long-term investors care less about quarterly performance. Instead, they want to minimize the amount of time required to safely manage their investments. A 35-year debt deal from the FHA is similar to what they've done with their other real estate investments and leaves the value of compound annual appreciation untouched.
High net worth investors are also more likely to buy into fees that correlate general partner reward to asset valuation growth. They’re also less likely to make arbitrary, rule-based decisions on allocation. Asset churn is bad. In the main, they prefer minimizing transaction fees.
While the herd is going one way, contrarians who want to be in this business for another 40 years are going another. As you struggle for your next acquisition and pay top dollar, ask yourself why you’d sell it in seven years after all of the work it took to find it in the first place.
Steve Lefkovits is the executive producer of Joshua Tree Conference Group and a partner with RealtyCom Partners. He is a former senior vice president for BRE Properties and former vice president of finance and technology for the National Multifamily Housing Council.
