Before jumping into the meat of the matter for this month’s Insight, I have to acknowledge the presidential campaign going on around us. Thus far I have not had the courage to address it within an Insight because regardless which of many points of analysis can be made on either of the two candidates, someone somewhere will be offended, and wading into political arguments is not the purpose of the Insight. But we still must contemplate the impacts of potential policy of each party. Some additional thoughts are shared at the bottom, after the core of this Insight.
Those in the real estate investment industry, or maybe those just reading the back page of local news sources, are aware that interest rates have pulled the tide out on many real estate investment companies (to steal a saying from Warren Buffet). Not only is it evident who is not wearing any swimming trunks financially, but far more troubling is the discovery of how many real estate companies were swimming without legal or ethical swimming trunks. We know of several groups, some of them quite large and well known, that are under active FBI or DOJ inquiries – with SEC involvement sure to come. While not being privy to the specifics of each individual case, there is some level of evidence of misappropriation, theft, and fraud (investor, insurance, and lender). Equity investors in these investments are taking the financial brunt. The result almost certainly means that the regulatory burden of offering nonpublic investments will increase over the next few years as regulators try to avoid repeating the past crisis. It could be understood that this is a benefit to companies like Altus that are large enough to have capable and expensive legal teams, as the increased regulatory burden will make it harder for new market participants to create competition. But from an investor standpoint, while ineptitude and dishonesty are bad (obviously), the increased competition more broadly benefits investors through choice and better return structures. As someone who has both offered and invested in others’ private investments, the key is being able to avoid the dishonest and inept players, while finding and focusing on strong market participants to the financial benefit of the investors.
There is no silver bullet here – I have made investments with bad sponsors – but whether you are a new private investor investing in your first syndication or a family office investing in a complicated JV structure, there are certain things that can be done to reduce the risk. There is a reason why family offices and institutional investors have fewer instances of perverse outcomes: because they are better at these things, but even they are still impacted on occasion. As investors, whether new to the world of private investing or grizzled investment fund allocators, there are no absolutes, but there are definitely certain things to which close attention should be paid:
- Communication and transparency: Duh! If someone or some company does not communicate openly and consistently, and is not transparent in that communication, there are lots of reasons to not invest with them. Transparency includes communicating bad news in a timely manner. This is investing. There is no investor/sponsor out there with any meaningful level of experience that hasn’t had things go differently than planned.
- As a subset to this, investors should always be able to call and get someone on the phone or a return call within a relatively short amount of time. At Altus, our standard is a return call within 24 hours, and we try to do it within the same business day. Others may have a different standard, but the important thing is there is someone available to get in touch with on a consistent basis.
- As a subset to this, investors should always be able to call and get someone on the phone or a return call within a relatively short amount of time. At Altus, our standard is a return call within 24 hours, and we try to do it within the same business day. Others may have a different standard, but the important thing is there is someone available to get in touch with on a consistent basis.
- Willingness to answer questions: Earlier this year someone tried to get me to invest in an entity that had a special right to invest in a company that was bringing game-changing technology to the real estate world. Or so they said. They wouldn’t tell me what the technology was, they wouldn’t tell me the name of the company, wouldn’t tell me the names of any of the board members whose redacted bios I was given. The list went on. Who in the world would invest in this, even if legitimate? I don’t know. It certainly wasn’t me, but I know that at least several people did. Along these same lines is the famous story of Elizabeth Holmes and Theranos. They had a slick investor presentation showing how great their technology was and how quickly their business was growing. Investors – big, famous investors – flocked to invest. Some asked questions, which were never answered, and they were blacklisted. Many others invested without asking questions, and they lost millions.
- Availability of warm-blooded referrals: If an investment company will not provide a potential investor with referrals to past and existing clients, don’t walk, run. An added bonus if the investment company is willing to provide introductions to past or current clients who have lost money on an investment.
- Willingness to say “I don’t know”: Especially as investments become more and more complex, both in singularity and as a portfolio, no one can have all the answers at the top of their mind. If they never say I don’t know, it means they are making up some part of story. Huge red flag. If someone will make a small fib about something that may not even be important, it is not a large jump to more serious actions.
- Clear and consistent reporting: To report the news, you need to know the news. Someone not willing (or able) to share how things are going is a huge red flag. Just because reports are provided doesn’t mean they are correct, but it at least provides an opportunity for investors to see discrepancies; and provides a paper trail if in fact they are fraudulent.
- Shared responsibility, especially outside parties: One group of investors we recently met with shared that a company they had invested with over the course of many years had a single person (the owner) doing all the books (though no reports were sent out), calculating all the distributions, and preparing all the tax returns. This was across dozens of different properties/entities worth hundreds of millions of dollars. Maybe Altus just hasn’t figured out how to be that efficient yet, but it takes a village for us to oversee and report on a similar size portfolio. If we had to do the tax returns on top of it, there is no way we could hit our tax return delivery dates or maintain ongoing financials. Plus, tax accounting is complicated. No one person can be proficient in real estate tax law, be able to take the time to do accounting, and be able to oversee a real estate portfolio. Also, while it isn’t the job of most third parties – like a tax account – to find fraud, the more people that are looking at information, the higher the likelihood someone will see it. Inside a company, one person can easily commit fraud. Two people may get together and do something untoward, but as more and more people become involved, the harder it is to keep suspicious activity a secret.
- Distribution consistency: There is some nuance in this one, and it applies more to long term yield plays. But if an equity investor (as opposed to preferred equity) gets exactly the same distribution for long, contiguous periods of time, there is probably something wrong. Investing in real estate (or most other high return vehicles) doesn’t work like that. Tenants move out, insurance cost goes up, there are entity filing fees, etc. If the distribution amounts don’t change, it quite possibly could mean the full distributions aren’t being made, or the sponsor is covering distributions from another source for reasons unknown.
- Access to documentation: Investors should keep record of their investment documents. These are important documents that outline your rights as an investor. But sometimes those documents are misplaced or hard to find. Your investment company should be able to quickly and easily provide you with copies. If they push back on providing any sort of investor documentation, that is a red flag.
- Investor Portal: Bonus points to companies that provide easy and ongoing access to investor documentation, financial reporting, tax filings, etc., all in one convenient place. There is plenty of white label technology available so that even pretty small companies should be able to provide this service. Altus was once much, much smaller, and didn’t have the resources to have a portal, so I understand why small and newer companies might not, but as a company grows this is a must.
- Investor Portal: Bonus points to companies that provide easy and ongoing access to investor documentation, financial reporting, tax filings, etc., all in one convenient place. There is plenty of white label technology available so that even pretty small companies should be able to provide this service. Altus was once much, much smaller, and didn’t have the resources to have a portal, so I understand why small and newer companies might not, but as a company grows this is a must.
- Bonus: Fund Administrator/Third Party Audit: By the very nature of the roles, Fund Administrators are keeping an eye on proceedings. The job of auditors is to find discrepancies. Both of these roles protect investors. However, they are also quite expensive, which means there is a tradeoff. This expense impacts investor returns, and the smaller the investment vehicle the larger the impact on returns, which means in many single purpose entities and smaller funds, having these third-party reviews just isn’t feasible. Larger funds almost always have one or the other (or both). Each investor has to decide what level of 3rd party oversight is worth to them in reduced returns.
There are many great private investment companies (sponsors) throughout the US. A few bad apples don’t spoil the whole bunch, but it does give us an opportunity to examine our existing investment partners and view potential new partners with a more discerning eye.
Some quick thoughts on potential policy (or lack thereof) as referenced above…
The policy platform put forth by the Republicans is a mish mash of things, but at least it is a platform. Their presidential candidate has overtly called for the president to take over control of the Federal Reserve (among other crazy statements). Assuming implementation on any scale, it will be highly inflationary. The Democrats have not put forth a platform at all, and until yesterday on CNN, have refused to do any interviews or press conferences so we can only guess about policy intent. But we do know that they are bragging about the policies of the past four years, they have proposed price controls on grocery stores (one of the lowest margin businesses around), and the VP candidate has openly supported socialism (calling it the same as “neighborliness”). We also know the presidential candidate was THE most progressive senator in the Senate during her time in that position. Even more so than Elizabeth Warren or Bernie Sanders. This peak behind the curtain indicates highly inflationary policy. Both candidates, different policies, all highly inflationary. This doesn’t mean we will have inflation, of course, because there are many other factors at play, but I am a lot less sanguine about the possibility of an inflation flare-up (potentially serious in nature) over the next few years than I would have been had either Dean Phillips or Nikki Haley (or any other reasonable adult) had won (or been appointed) through their party’s nomination process. As we have found out over the past couple of years, inflation can be quite painful and creates substantial winners and losers. We really need to hope for a divided government. Divided governments are almost always better for investors, and this will be especially true with whomever we end up with in the world’s most powerful position.
In other news this past month, the Bureau of Labor Statistics revised employment numbers down by 818,000 workers. This is the second largest adjustment in history and came as a surprise to almost no one outside the government or the administration. All other data has been highlighting the data discrepancy for many months. But even more shocking than the revision is the Commerce Secretary’s (post revision release) interview with ABC, first blaming the revisions on a past president who has been out of office for almost four years, and then when the ABC interviewer pointed out again the revision was done by the Bureau of Labor Statistics of her own government, she responded by saying she didn’t know anything about them (the BLS). People, and especially those in government, claim to not understand why the general populace is losing faith in government. If the massive revision was not enough, the Commerce Secretary’s lack of knowledge about employment numbers surely is. Blaming it on the past administration just further erodes credibility.
Happy Investing.
