Publications

- May 1, 2021: Vol. 8, Number 5

Unaligned interests: Modern real estate investing means putting investors first

by Aaron Halfacre

Think 21st century real estate investing and technology typically comes to mind. Websites, apps and other digital tools have definitely made investing easier and quicker than ever. While the adoption of technology within the real estate industry has become more widespread and increased access for all types of investors, one component that has lagged, even when compared to its publicly traded counterparts, is ensuring that real estate investing is designed for the investor and not for the sponsor. That’s what modern real estate investing is truly about: putting the investor first.

It’s easy to say the investor comes first, but what does that really mean? At the heart, it’s about alignment of interests between the sponsor and its investors. That means decisions are made in the best interest of the investor, not the sponsor. It’s about taking steps to remove fees and reduce costs. It’s about avoiding conflicts of interest and installing best-in-class corporate governance. It’s about making sure the sponsor wins only after the investor has won.

TOO MANY HIGH FEES AND RELATED COSTS

Between external advisory fees, management fees and performance fees (among others), investors’ returns are oftentimes seriously diminished when investing in commercial real estate. Of course, acquiring, owning, managing and operating real estate has costs, just as any business has inherent costs, and those costs must be paid. But it should be incumbent on the program sponsor to seek ways to lower or eliminate those costs.

Looking at other investment options, we know this can be accomplished. In the 1970s, Vanguard embraced the no-load mutual fund when others would not; Charles Schwab was a pioneer in lowering stock brokerage fees, creating better and more affordable access for the average individual investor. At the time, many industry pundits claimed the financial industry couldn’t survive, let alone thrive, without the myriad of fees charged by sponsors. In time, not only did the low-cost approach survive but it helped introduce financial services to more individual investors.

Today, a modern investor would view a fee-laden mutual fund or high-priced stock trading commissions as out of touch relics from a greedy sponsor. Yet, in the real estate investment industry that caters to individual investors we find high-fee relics at nearly every turn. We know the real estate investment industry does not need these fees to produce good products as evidenced by the fact that institutional investors have long ago demanded (and received) proper alignment of interest from product sponsors. From the numerous sponsors who offer products following NCREIF indices to the robust public real estate markets that evolved with the modern REIT era, the institutional real estate investor has benefited from an investor-first, low-cost approach.

Real estate crowdfunding platforms, which have grown in popularity as they further the democratization of real estate investing for individual investors, have the potential to lead the next real estate capital markets evolution, but only if the crowdfunding sponsors are willing to embrace the same investor-first, low-cost mantra that has proven successful time and time again.

INHERENT CONFLICTS OF INTEREST

If you read the prospectus for any number of nonlisted real estate products or other crowdfunding offerings, you’ll find external managers and related parties that charge investors a litany of fees — many positioned as necessary for a real estate transaction. The incentives to generate fees from this structure don’t necessarily align with shareholder interests and they negatively affect overall returns. Further, the very nature of these fees creates conflicts of interest between sponsors and investors. Removing these conflicts, and other financial incentives, align the interests of both parties and can create better outcomes for investors.

For example, let’s compare the typical real estate offering to a mutual fund. Imagine you were offered a mutual fund that charged a 3 percent fee to buy the investments held within the fund, another 1 percent fee to finance the purchase of the investments and another 3 percent fee to sell the investments ... plus 10 percent or more of the upside potential. Interested? Doubtful. You would either be offended the greediness or concerned for the sponsor’s sanity. Yet, those layers of fees are typical of real estate offerings sold to individual investors on a daily basis and the sponsor thinks nothing of it.

FLAWED CORPORATE GOVERNANCE

An investment offering that embraces strong corporate governance can deliver better results for investors. Unfortunately, many nonlisted or private commercial real estate investment vehicles lack strong corporate governance structures.

Corporate governance policies that publicly listed REITs adhere to should be followed by all REITs. It starts with registering the company as a Maryland or Delaware LLC, which provides comprehensive legal frameworks written specifically for REITs and decades of relevant case law. A best-in-class board of directors and senior executive team is a top priority to manage the enterprise, ensuring the charter, policies and guidelines are upheld for the REIT’s investors and providing a formal approach for checks and balances. Other key components include public filings, reports and communications for full transparency; a qualified independent external auditor; and formally adopted compliance policies and procedures, including a code of business conduct and ethics.

ELIMINATING FINANCIAL ENGINEERING

Traditionally, many private real estate investments have been sold, not bought. It’s important to change that dynamic and create investment offerings that are bought, not sold, based on the merits of the product and the opportunity to provide exposure to an asset class that can help provide diversification and other potential benefits.

If you think about the mainstream financial services industry, there are regulations in place that outline how an investment opportunity can be advertised. That’s why you won’t find companies like Schwab or Vanguard advertising 15 percent or 20 percent returns. Far too often in the private real estate space, you’ll go online and find a nice picture or a rendering of a real estate deal with a projected IRR or return. But an IRR or projected return is based on many (subjective) variables and inputs that are often used to sell that opportunity. Those variables include: What will the property be worth later? How much income might the property generate? What is the financing rate? How much leverage is being used and is it appropriate? What condition will the markets be in at the targeted exit period? The reality with any investment is that the future is unknown and to cherry pick the best potential future return to entice an investor is not only prohibited by FINRA but also a reprehensible conflict of interest.

As a registered investment adviser, real estate executive or financial professional, you know it’s impossible to predict what’s going to happen four or five years from now, and projecting returns does not serve the investor. Investors need to buy into a strategy, a management team and an overall product structure, not be led down a primrose path.

Accessing alternative asset classes and real estate specifically has definitely become more mainstream for individual investors. This should continue to drive more transparency, new platforms, innovative product offerings, technology integration and more within the space. If real estate sponsors are not willing to embrace an investor-first philosophy, the evolution of modern real estate investing will continue to lag more mainstream options — to the detriment of the investor and the industry.

 

Aaron Halfacre is CEO of Modiv Inc.

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