Over the last ten years, we’ve launched and executed three private real estate funds at Origin. Last year we closed Origin Fund III and, since then, many people have asked when we are going to launch Origin Fund IV. The short answer to that question is that the Origin IncomePlus Fund is Origin Fund IV.
The core strategy of the Origin IncomePlus Fund is to acquire core plus and value add apartment complexes in ten fast-growing markets in the U.S., the same strategy that we utilized for Fund III. So why not call the IncomePlus Fund Origin Fund IV? The name IncomePlus more accurately identifies what the Fund is designed to do for investors: generate income and appreciation. The IncomePlus Fund is our flagship investment and the best way for investors to build and preserve wealth with private real estate.
One of our core values at Origin is continuous improvement and this extends to every Fund we bring to the market. Each of our funds has been a better version of the one before it and the IncomePlus Fund is the culmination of ten years of learning. The goal of this Fund is to create the same amount of wealth as our previous funds, but do it with less risk and by managing capital more efficiently.
From Buy, Fix and Sell to Buy, Fix and Hold
We believe that real wealth is built by holding quality real estate assets forever. With the IncomePlus Fund, we’ve shifted from a buy, fix and sell strategy to a buy, fix and hold strategy because this minimizes the frictional costs of selling assets. Selling an asset means risk is taken off the table, but it also creates a taxable event and can cause capital to sit idle for months as it waits to be deployed into the next deal, a concept known as “cash drag.” Both of these events negatively impact the ability to build wealth. The IncomePlus Fund’s buy fix and hold strategy solves these issues and enables investors to realize the full tax benefits of owning private real estate.
Even though the IncomePlus Fund can hold assets forever, we most likely won’t, because forever is quite a long time for physical real estate to last. In the event we do decide to sell a Fund asset, we can defer those taxes by rolling the gains into another asset utilizing a 1031 exchange. And, even though the Fund has no expiration date, investors aren’t locked in forever. Investors can enter the Fund by buying shares and then exit by redeeming those shares if and when they choose. The difference in this model is that you choose when to trigger a taxable event, rather than us deciding it for you.
Tax Efficiency is Paramount to Building Wealth
Tax efficiency is something we considered in our last three funds but only within the constraints of a buy, fix and sell model. One of the greatest benefits of investing in real estate is its tax efficiency. However, our strategy was to sell assets once we completed the business plan. We made sure that our investors received long-term gains versus short-terms gains, we depreciated assets while we owned them, and we returned capital back to investors tax-free when we refinanced. However, all of those tax benefits were largely diminished when we sold an asset because we triggered a taxable event.
The impact of taxes on overall investment returns and building wealth can’t be underestimated. Every taxable investor must consider this on overall portfolio performance because money that goes to the government is money no longer working for you. Whenever a gain is realized on any asset, investors only keep 50% to 70% of the profits after paying state and federal taxes. And, paying 30% of your profits to the government is no different than losing 30% of your money overnight.
Below is a chart that illustrates this point. The dark blue column represents the wealth created on a $10 million investment that earns 10% but generates a tax liability each year at a rate of 30%. The light blue column represents the wealth created in an investment that also earns 10% each year but its tax obligation is deferred.
Growth of $10 Million
After ten years, the tax-efficient investment grows to $26 million, while the tax inefficient investment grows to roughly $20 million, a difference of 30% in wealth. After 20 years, the wealth difference is even more pronounced. The tax-efficient strategy grows to more than $67 million, while the strategy that gets taxed every year grows to around $39 million, a 74% difference in wealth just from minimizing taxes.
How does this apply to the IncomePlus Fund? The goal of the IncomePlus Fund is to deliver a 10% annualized return each year with little to no tax consequences. Income generated from the Fund will be partially or fully shielded from taxes via depreciation, which means there will be almost no taxable income on the 6% annual distribution, once the fund is fully stabilized. The other 3% to 5% in appreciation grows tax free. And, investors can take advantage of compounding returns by simply reinvesting their distributions.
IPF Article Investments Page
Now Accepting Investors for the Origin IncomePlus Fund
One of the other common challenges we’ve addressed with this new fund is the capital call process. In a private equity capital call model, managing your capital commitment while you are waiting for the fund to invest it can be a hassle for many. We surveyed our investors and found that 60% kept capital earmarked for Origin Fund III in short-term securities earning little to no money. While this might be a safe place for money, it’s not the most optimal way to build wealth because that money isn’t working to the fullest extent possible.
With the IncomePlus Fund, we now call 100% of your capital at once which means all your money goes to work on day one. The way the capital call process works is that anyone who signs a subscription agreement is essentially in a queue or line and their capital gets called when we find a deal. If the queue is $50 million deep and we find an asset that requires $20 million in capital, then we call $20 million in capital from the front of the queue and the rest of the capital moves towards the front of the line. We still don’t take money until we have an asset to purchase, but this alleviates the two to four years of managing a capital commitment, and investors can avoid the logistical challenge of funding 15-20 capital calls over the life of an investment.
A Better Fee Structure
Our fees are lower in this Fund, which means that for every dollar the property makes, more goes into your pocket. The reason is simple: Real estate will only generate so much profit and our goal is to make sure that profit is split up in way that works for both Origin and the investor.
In a traditional private equity structure, an investor typically pays the manager a committed fee, an asset management fee and a performance fee. The committed fee is used to pay the team while they are looking for opportunities and assembling the portfolio. The asset management fee is used to pay the team while they are managing the assets and building value. The performance fee aligns the interest of the manger with the investor and rewards the manager for outperforming.
With the Income Plus Fund, we’ve eliminated the committed fee altogether. Instead, we take an acquisition fee of 50 basis points on each deal we close. This essentially transfers the risk to us from the investor because we only get paid this fee when we acquire an asset. While this may seem like an incentive to acquire assets, this is a one-time fee on an asset we may own forever and is a small piece of our overall revenue. We are still heavily aligned with investors through a principal co-investment of more than $10 million and a performance-based fee structure.
Our annual asset management fee in the IncomePlus Fund is 1.25% and is charged based on the equity value of the investor’s account. For example, if your account value is $100,000, you will pay $1,250 in an annual asset management fee. Managing real estate is an incredibly labor intensive process and this should not be mistakenly viewed in the same way an asset management fee is paid to a financial advisor. We may use the same word, but it takes five to ten times the number of people to manage private real estate as it does public securities. This fee was 1.5% in our previous funds, but we now charge based on the true value of the assets instead of the initial invested capital. For example, if in the example above, the account grew to $200,000, the fee would be $2,500 per year. In an open-ended and evergreen fund, this is standard practice and incentivizes us to focus on increasing shareholder value.
Lastly, we charge a performance fee of 10%, subject to a preferred return of 6% which means our fee is only earned when you make more than a 6% annualized return. For example, if your account grows from $100,000 to $110,000 in one year, we would be entitled to a $1,000 performance fee bonus. This fee incentivizes us to outperform and further aligns interests. The performance fee in this Fund has been reduced by 50% as compared to what we charged in our previous funds.
The information provided does not take into account the specific tax or financial situation of any specific person. You should consider the suitability of any type of investment for your circumstances and, if necessary, seek professional advice. This material was produced by, and the opinions expressed are those of, Origin Investments as of the date of this publication, and are subject to change based on regulatory changes and market and other conditions. The information and/ or analysis contained in this material has been compiled or arrived at from sources believed to be reliable, but Origin Investments does not make any representation as to the accuracy, correctness, usefulness, or completeness. The information in this material may contain projections or other forward-looking statements, or other expectations, and is only as current as of the date indicated. The information in this document, including statements concerning taxation and tax rates, are based on current federal tax regulations, which may be superseded by subsequent regulations or for other reasons.
Many of Origin’s partners are sophisticated investors and experienced at buying investment property. And as high net worth individuals, they have the means to invest in commercial real estate and understand its potential benefits and rewards. So why are they putting their money into private equity real estate funds?
After 15 years of successfully investing in commercial real estate properties that ranged from multi-family buildings to speculative industrial properties, “I learned enough to know that I can’t do it myself. It’s impossible to understand all the risks without being involved at a professional level and it pits me against experts like Origin, who have a knowledgeable team with a different skill set,” says Jeff Cardot, a California investor. Cardot came to this conclusion after a large investment he made in a retail building went south.
While many high net worth individuals continue to hold investment property, they have found it more advantageous to participate in private equity real estate funds and share their experiences here.
Why commercial real estate?
Commercial real estate attracts high net worth investors thanks to its high potential return on investment. “When everything is said and done, I believe real estate will outperform the stock market,” says Sidney Jain, a Chicago radiologist.
High net worth investors favor real estate for its track record of resisting stock market cycles. “For me, real estate was a way to diversify my investments to reach my retirement goals. I felt I had enough money invested in equities and not enough in real estate,” Jain points out.
Besides rental income and capital gains when a property is sold, another way to realize a higher return on investment is through the tax benefits, which are structured to reward investors who have equity in a property. Depreciation lowers the basis on which capital gains are calculated at sale, while the gains themselves are taxed at a lower rate than ordinary income.
“It’s an alluring asset class,” Cardot says. “It is so efficient tax-wise. If you own a property, you get to write off the depreciation against the income, so the tax structure makes owning real estate beneficial versus other asset classes like stocks and bonds,” he says.
Why DIY real estate investment? It’s the ROI
Jain looked at publicly traded REITs, but “I realized that the profits weren’t as high as investing on your own, which offered greater opportunities to earn better returns,” he says. In 2013, he formed an LLC with four fellow physicians to pursue do-it-yourself property investments.
Initially, buying investment properties proved profitable for Jain and his colleagues, who hired a realtor that specialized in investment properties; handled both acquisitions and subsequent sales; and also served as their property manager and general contractor.
“There was a greater opportunity to make a better return on investment if we went out and actively participated in the real estate market. We realized that we wouldn’t be that successful on every flip, so we steered towards value add properties” — making renovations to maximize ROI.
Cardot held a similar assumption but focused on commercial properties. He bought and managed properties in several cities and business sectors, even building speculative projects, and focused on producing cash flow rather than the appreciation that lures property flippers. While the market was stable and appreciating, “my real estate investments seemed to perform well,” Cardot says.
(Article continues below)
Real estate investing education delivered to your inbox twice a month:
Thank you for subscribing to Origin Insights for the latest resources on private commercial real estate.
Headwinds from three directions
Ultimately, both high net-worth investors came to rethink their real estate approach once their returns diminished.
“We did phenomenally well on our first few flips,” Jain says. “But then we went into multi-family units, first with six units and then with 30, and management inefficiencies cost us money and diminished our ROI. Our goal was to annualize returns at about 20 percent, but based on cash flow, now we are at 10 to 12 percent and this comes with a lot of work and stress.”
Finding good properties has also proven more difficult. “On paper, it sounds great, but the challenge is not having the connections, knowledge and expertise to acquire the best properties,” Jain says. “Real estate professionals usually get first crack at the best properties,” Cardot points out.
Real estate professionals also know what to look for in specific markets, a realization that came to Cardot in 2008 when the market went south and the lessee in one of his commercial properties went bankrupt. When it came time to find a new tenant, he got a surprise — rent rates fell from $12 per square foot to just $4. “After holding the property for 10 years, I sold it for 65 cents on the dollar and lost all my invested capital. A professional real estate firm like Origin wouldn’t have missed something as basic as that rate decrease. I asked myself ‘how much more was I missing by trying to invest in real estate myself?’”
The investors noted three basic issues with maintaining a DIY real estate portfolio:
1. Buying investment property is harder than it sounds. Jain and his partners parlayed limited contacts in real estate and banking. “We’re all physicians, and we partnered with a single consultant who brought us deals, but we had to vet them ourselves.” Cardot felt outgunned. “The country club deal isn’t vetted the same way a pro would look at a deal,” Cardot says. “Buying real estate is complex. Gaining exposure to stocks and bonds is more straightforward, but it’s not the same with real estate. If you find property to buy, you aren’t buying the same property as the professionals. They’re the ones selling it to you and it may be something they rejected. Or you may be competing against them and don’t have the same knowledge they do about structuring deals.”
2. Managing real estate is challenging and rigorous. “Our ROI could have been much higher if our property management was better,” Jain says. “Though we had a partner, he didn’t have the same kind of experience as a seasoned professional manager.” There’s also the time involved — which can be substantial. “On a weekly basis, I am approving maintenance, managing the books, writing all the checks, solving problems. It takes at least a couple of hours when nothing is happening and everything goes right — and even then it’s constantly on your mind and a burden,” Jain adds.
3. Investing with partners is challenging. Investing with friends allows you to spread out risk by buying more properties, but it can also lead to tensions when it comes to making strategic decisions about what to buy, dividing up the work involved and how much to improve a project. Relationships also impact exit strategies and profits because it can be harder to sell properties when the time is most opportune. “Some partners may want to sell and other partners don’t because there are different tax consequences for each, so it becomes an issue,” Jain says.
Funds vs. Deals
Jain and Cardot are seasoned investors who are committed to buying investment property; Jain estimates one-third of his assets and Cardot estimates half of his assets are in real estate. And both investors are also participating in our recently closed Origin Fund III.
Cardot asks himself, “is Origin beating their peers in real estate investment at this timeframe? The answer is yes. Can Origin do it better than me? Again, yes.” Origin has completed over $1 billion worth of real estate deals since 2007 with zero losses. They invest side-by-side with investors, adhere to a disciplined investment philosophy and provide an unparalleled level of service.
“The problem is, there are not that many Origins out there,” Cardot says — “pros who are going to be transparent, have reverence towards the capital as opposed to using investor’s money to try and make money for themselves.” Also, “I know the Origin guys have put their own money in all the deals and all the funds,” he adds. “A lot of people try to do it on their own because it’s hard to find a company like Origin.”
How can we prevent our inherent biases from affecting investment decisions? Origin Principal Dave Scherer explains how Origin’s objective risk model counteracts this proclivity.
Before Origin implemented its objective risk model, we fell victim to two commonly held beliefs about private real estate investing. First, we believed off market deals held inherent advantages against marketed deals. We also believed joint ventures typically led to favorable returns. Both of these assumptions turned out to be false, and both were identified by our objective risk model.
Where else might our biases have prevented us from seeing clearly?
Watch the recording of our IncomePlus Fund webinar, hosted by Origin Principal Michael Episcope and Vice President Ben Harris.
Origin’s IncomePlus Fund is a diversified private real estate investment targeting a total return of 9-11% per year, inclusive of a 6% annual yield, paid quarterly. The Fund primarily owns and operates multifamily properties in 10 fast-growing U.S. markets and is supplemented by strategic real estate debt investments.
We covered the following topics during the webinar:
Welcome – 00:05
About Origin – 01:31
Fund Structure – 07:43
Fund Strategy – 18:21
Terms – 26:29
Get Started – 27:52
You can also learn more about the Fund by creating an Origin account, where you’ll have access to all our due diligence materials.
IPF / Portal Reg Modal
Now Accepting Investors for the Origin IncomePlus Fund
Real estate projects are typically capitalized using both debt and equity and investors can participate on either side or both. Equity investments involve ownership, a share of rental income the property generates, tax benefits and the potential for appreciation, while debt investments, like loans, yield regular fixed payments based on interest rates. But the idea of owning real estate and building equity has such a hold on the imagination that it’s easy to neglect the role debt plays in portfolios.
In truth, debt plays overlooked roles throughout a personal investment portfolio. Bonds are essentially debt—the issuer’s promise to repay the bondholder with interest. So are money-market instruments such as repurchase agreements and treasury bills. The difference between debt and equity comes down to control and priority of these cash flows; with debt instruments the investor locks in an income stream that is paid out to them by the property owner but does not share in rising values. However, debt gets paid before equity which places these investors in a lower risk position and contractual monthly payments make for a nice stable income stream.
Private Loans Bridge the Debt Gap Today
Investment companies have stepped up in the last ten years to compete where banks can’t, and many commercial transactions are closed outside of banks today. A Heritage Foundation study suggests that commercial and industrial loans of less than $1 million have plunged since Dodd-Frank compliance requirements took effect in 2010. Banks hold about half the volume of construction loans as a decade ago and even active commercial bankers may stop short of extending the credit necessary to undertake a commercial real estate project. There is a persistent slowdown in lending activity growth for commercial real estate, the Mortgage Bankers Association notes.
(Article continues below)
Real estate investing education delivered to your inbox twice a month:
Thank you for subscribing to Origin Insights for the latest resources on private commercial real estate.
As a result, private equity increasingly provides both debt and equity financing to buy and develop property. Real estate debt funds hold a record $57 billion in available capital, the Preqin research service says. In a Bisnow ranking based on the Preqin data, big names like Goldman Sachs, PIMCO and Blackstone are top private debt investors. But tight money has driven debt financing innovation for small business or real estate deals as well: Individual investors make direct loans in peer-to-peer lending networks.
When weighing debt financing vs. equity financing, property owners often prefer to borrow rather than cede control or dilute equity by taking on partners. Also, this strategy lets them focus on the business plan. They opt for private debt investments because they require less red tape while bank loans usually come with strings attached, such as owner equity, credit rating or cash-on-hand requirements. With fewer steps to approval, a deal can get done quickly.
Multifamily and commercial real estate projects need bridge loans for acquisition or construction, as well as longer-term commercial mortgages of five to 25 years. Short-term debt can carry substantial risk, especially for projects started from the ground up without rental revenue. These “hard money” loans are based more on the assets themselves than the project’s financials. The added risk brings the private debt investor high yields, tracking 400 to 800 basis points above the prime rate. Yet its position in the capital structure—always before equity—makes debt more secure than an equity investment that may never meet expectations.
Equity & Debt Investments: Pros and Cons
A debt investment is lucrative: It’s a reliable source of passive income, which can be budgeted to meet current or future obligations. Rather than earning the greater yields that come with appreciation when a piece of real estate is sold, private debt investors get paid regularly, regardless of the revenue the property generates or any rise or fall in value. Returns are capped at negotiated rates that often range from 9% to 13%.
But debt investments can be risky. The more debt on an investment, the more leverage risk—and the more investors should demand in return. Leverage is a force multiplier: added capital can move a project along quickly and ensure returns if things are going well, but if a project’s loans are under stress – typically when its return on assets isn’t enough to cover interest payments – investors can lose quickly and a lot. However, the loan is secured by the property so if the borrower defaults, lenders have first claim on the asset in a foreclosure. That’s easier said than done though. In many cases, owners can tie up properties in bankruptcy for months and even years, forcing the lender to advance more capital to protect a deteriorating asset. Property taxes and insurance still need to be paid and tenants must be retained. When the equity cushion disappears due to a declining market, so do the regular payments and the ability to be passive. Lenders need to make sure they are dealing with reputable sponsors with deep pockets who not only have a history of delivering projects on time and on budget but also paying their debts.
Additionally, private debt investments are not always tax efficient—the interest received from the borrower is treated as regular income. At first glance, it may seem like high yield, but after taxes, the gain may be similar to a lower-yield tax-free investment like a municipal bond. We encourage investors to remember to calculate after-tax returns when comparing investment performance.
In equity investments, partners share in the tax advantages of commercial real estate. The cash flow paid out in dividends is shielded from taxes through depreciation write-offs. When sold, while the lender gets none of the profits, equity owners share in the appreciation as capital gains that are taxed at a lower rate than regular income. Equity holders reap these rewards for assuming more risk than lenders.
Longer hold periods for equity investments can be an issue for some investors. Hold times for real estate properties, which may be ground up or value add developments, often stretch out as long as 10 years. For debt investors, hold times are stipulated upfront and usually last 12-to-36 months.
Choosing Between Equity or Debt Investments
A portfolio should have a mix of both debt and equity investments. Debt investments typically carry less risk than equity, which buffers a portfolio from the volatility of the equity markets. They bring consistent returns that don’t go up—but also don’t go down. That is especially important to meet ongoing obligations such as college tuition and living expenses. Getting involved in debt investment can be as simple as buying shares in a mortgage REIT, which pays out revenues from its loan portfolio as dividends. Investors also can lend even modest sums through peer-to-peer lending websites such as Prosper and LendingClub, or find a private equity firm that specializes in direct lending.
The Origin IncomePlus Fund was carefully designed to deliver consistent tax efficient returns and we deliberately structured the fund of both debt and equity investments. 75 percent of the fund’s capital will directly own apartment buildings, realizing the full benefits of being an equity owner, while the other 25 percent will be deployed as loans to developers and property owners. The depreciation expense created by the equity position in the fund more than offsets the taxable income of the debt investments of the portfolio, resulting in a dividend yield that is equal on both a pre-tax and post-tax basis. And, the addition of debt creates a more stable return without sacrificing upside in today’s lower return investment environment.
Bottom line, the role of debt and equity in a portfolio allocation is different for every investor, based on their tolerance for risk and financial goals. Equity investments have the greater upside: their potential for long-term appreciation makes them a powerful way to accumulate wealth. But debt investment can play a key role in generating income to meet personal investment goals and temper the risks of equity investments. The best strategy may be for investors to strike a balance between both types of investments in their portfolios.
The views expressed herein are exclusively those of Michael Episcope, are not meant as investment advice and are subject to change. This information is prepared for general information only. It does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person. You should seek financial advice regarding the appropriateness of investing in any security or investment strategy discussed or recommended in this article.
Explore several Houston real estate submarkets with Origin Principal Dave Scherer and VP of Acquisitions Matt Ozee. We look at an opportunity zone site in East End, discuss the rising Energy Corridor, and find out why you can never trust a rental car.