Altus Insight July, 2017

The Altus Insight

Market news, commentary and relevant topics for today’s alternative asset investor
Date: July 31, 2017
FR: Forrest Jinks
RE: Stacking Up

It remains a busy time of the year for the Altus team. In addition to the projects in process, we are preparing for the close of the eleven properties in Norman, Oklahoma during the second week in August. I also had the blessing of another daughter joining our family on July 12th. Everyone is doing wonderful but, as can be expected, sleep is at a little bit of a premium.

Before jumping into the heart of this month’s content I want to mention a couple events from this month:
1. Janet Yellen, “Would I say there will never, ever be another financial crisis? You know, probably that would be going too far, but I do think we are much safer and I hope it will not be in our lifetimes and I don’t believe it will be.” Granted, Ms. Yellen is considerably older than I am so her look-forward timelines may not be as long as mine, but the last time a Federal Reserve Chairman (person) made that kind of statement was in 2006: “Housing markets are cooling a bit. Our expectation is that the decline in activity or slowing of activity will be moderate, that housing prices will probably continue to rise.” Or maybe it was 2007: “…we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system.” Or maybe I was actually thinking of Mr. Bernanke’s quote from 2008: “The Federal Reserve is not currently forecasting a recession.” The point of this exercise is not to point how misguided the Federal Reserve has been (nor how often), although with a forecasting record that has been shown to be worse than pure chance, it would be easy to do so. It is simply to point out that Ms. Yellen has far more confidence than any person in her position should ever have, in anything pertaining to the economic future. As an investor, I spend my time worrying about everything. Not to the point of paralysis, but definitely to the point of wanting to understand the full range of possible outcomes. The fact that someone in charge of the largest central bank in the world isn’t doing the same is concerning, especially with the forecasting record of that same central bank.

2. It was brought to light that Google has been actively paying academics from top universities to write academic papers in such a way to support Google business initiatives. And not just a little money -  up to $100,000 for a single paper. It probably isn’t a surprise that companies like Google would be seeking to influence information dissemination, but it is a good reminder to maintain perspective when reading “facts”. As a citizen, I can take a moral position as to whether or not this type as activity should or shouldn’t be happening. As an investor, it is more important to understand that it is happening and hopefully be able to grasp where public opinion is being guided. I can either invest in what I think SHOULD happen, or I can invest in what I think WILL happen. The second is likely going to produce much more attractive returns.

3. The head of the Bank of Japan, Haruhiko Kuroda, pledged to buy an unlimited amount of Japanese bonds to keep ten-year government bonds no more than 0.1% (yes, you read that correctly - 0.1%, ten-year money, as in one-tenth of one percent). This pledge was a follow up to previous, more limited, pledges to keep yields below 0.1%, that were being severely tested by the bond market. Unlimited purchases of a sovereign’s debt by the central bank of that same sovereign, amounts to debt monetization. It was only a few years ago the Bank of Japan was the 2nd most important central bank in the world. Despite entering the realm of debt monetization, Kuroda was quoted, “I have no particular concern about the increased balance sheet or negative interest rates on the short end of the curve.” Despite using untested central banking methods far outside standard, historical precedent, and despite pledging to fully monetize Japanese debt, the man in charge is not worried. That means I am.

Towards the end of June, I spent a few days in New York meeting with some people with whom we do business. I additionally met with a couple groups that raise and place investment dollars. Those meetings brought into focus some differences between the way we structure our investment opportunity and the way many others in the industry structure their opportunities. I don’t think there is a right or wrong way to do it, but the differences are significant. Not just in terms of the investment return structure, but also in the way and philosophy in which the sponsor runs their business. Below is a comparison between our normal syndication structure, including the Norman deal we are closing in a couple weeks, and two other syndications that were successfully funded. I would love to receive feedback from you as Insight readers and investors, as to what you see as the pros and cons of the different structures, and how you would structure deals for the greatest risk adjusted returns and sponsor/investor alignment.  

 

Fund One: Apartment repositioning

Fund Two: Ground up mixed use development

Structure Detail                                                                  Altus            Fund 1            Fund 2
Acquisition/Due Diligence Fee                                           3%                2%                  2%
Commissions on purchase*                                                No            Unknown           Yes
Equity raising fee                                                                0%                7%                  0%
Financing costs                                                                   1%              1.75%           Unknown
Construction management                                                  0%              10%               3.50%
Project management/Developer Fee                                   0%                0%              $360,000
Asset Management                                                             0%                3%               1.25%
Preferred return 6-                                                               8%                8%                 10%
Post preferred return splits                                                60/40           65/35                50/50
Loan responsibility                                                      Altus principals  Non-recourse   Non-recourse
Pro Formas                                                                    4 scenarios     1 scenario        None provided
Expected Investor IRR                                                       18.5%             21%             None provided

 

From my perspective, there are a couple things that jump out at me:
1. The preferred returns to the investors for Fund 1 and Fund 2 are not truly preferred returns. They are called preferred returns but are paid only AFTER the sponsor first receives their asset management fee and/or developer fee.
2. Altus and Fund 1’s expected investor returns are very similar. Fund 2 provided no project analysis
3. Fund 1 has more than double the upfront fees of Altus (not taking into account any purchase commissions). This means the investors are starting at a great deficiency in value.
4. The tradeoff for post-preferred return splits in Fund 1 are better than with the Altus structure meaning the investor has greater benefit in the upside.

My (biased) takeaways:
1. Investors in the Altus structure have much stronger initial returns due to the reduced upfront cost and no ongoing asset management fees. Said another way, the likelihood of receiving some level of return is much higher in the Altus structure than in the other two structures. 
2. Construction cost on Altus repositioning deals usually runs between 25% and 40% of the cost of the real estate. Altus hires Construction Management at 5% and does all Project Management inclusive in the deal structure. Fund 1 collected 10% for Construction Management as a fee for this service. This is a substantial difference in cost that are paid out ahead of the preferred return.
3. The tradeoff for the higher upfront costs/fees and added asset management and construction management fees, is that the investor can benefit in outperformance at a higher split level (65% versus 60%). For some investors, this is a good trade off, while for others it may not be. 
4. I have no idea how Fund 3 was able to raise money. Not only did they provide no analysis of the project to their potential investors, they also charged huge asset management fees and still kept a rich back end split. However, their preferred return was higher than Altus or Fund 1.
When it comes to creating a successful investment deal structure there are many ways to skin a cat. We are partial to our method, with its emphasis on limiting investors’ upfront cost and focus on investor/sponsor alignment. However, we are always looking to improve everything we do, and the manner in which we structure investment opportunities is no exception. We welcome, and look forward to, any feedback you are willing to share.

Happy Investing.

Forrest Jinks
Altus Equity Group, LP
off: 707/932-5887
fax: 707/544-2972
www.altusequity.com