Matt addresses the challenges of investor accounting, reporting and communications.
I have spent most of my adult life in the real estate finance business, the past 25 years running my own company. During most of this time, I along with my team have worked extensively with private investors providing alternative investment opportunities secured by real estate. I have had the opportunity to experience up close and personal the benefits and challenges of everything that goes into originating, acquiring, and managing these investments, both on the asset side and the investor reporting side. What is the primary operational challenge to an SBRE entrepreneur of providing these real estate asset-based alternative investments to individual high net worth investors? From an asset performance perspective, I believe the quality and discipline of the underwriting is the single most important component to strong results. For the moment, however, let’s set aside “underwriting quality” as a topic and assume that it is good. Let’s also assume for the sake of this discussion that our SBRE entrepreneur has been able to create an infrastructure that allows him to originate in a proprietary way a significant number of real estate deals on an ongoing basis that meet his stringent underwriting criteria (not an easy task, by the way) which require him to raise capital from investors consistently. If he has done these two things, the primary operating challenge for most become investor accounting, reporting and communications.
If you are an investor in Fairway America Fund VI or Fund VII or, for that matter, just about any other SBRE fund or syndication around the United States, the weeks of late March and early April leading up to the tax filing deadline demonstrate the net effect of how these underlying operational challenges become manifest in the investor experience. They reveal themselves in the manner and timeliness of financial reporting – financial statements, asset level reporting, share price calculations, capital account statements, and, especially, delivery of K-1s. It is the whole of the investor relations and communications component of the business and all that goes into it that, for a variety of reasons, provides significant challenges for many SBRE entrepreneurs.
There are literally tens of thousands of SBRE entrepreneurs all around the United States engaged in some form of real estate asset-based investing that requires them to raise money from private investors on a repeated and ongoing basis. High net worth investors – people like many of you reading this material – are drawn to these investments because they can provide attractive risk adjusted returns secured by hard assets (real estate), typically not very well correlated to the broader equity markets. There are trade-offs for the investor to these investments, of course, but done well they can produce returns superior to many other forms of investing. These SBRE entrepreneurial shops are usually small, typically anywhere from a handful of people to maybe 25 or 30 at the most. Often they have a total of only maybe 8-10 people or so to do all the work associated with 1) originating, underwriting, closing, managing and disposing of assets, as well as 2) dealing with investor subscriptions, onboarding, financial reporting, distributions and communications. Of those two general categories, by far the more interesting to them is the former (the asset side of the equation rather than the investor side). This truth is at the core of the issue and nearly all the difficulties I describe stem from this reality.
People who become SBRE entrepreneurs do so because they love real estate. They love everything about it – the thrill of finding a great deal, walking the site, negotiating the terms, closing the deal, leasing the space, arranging the financing (OK, maybe they don’t love that part as much – but they still like it better than accounting), and so on. Real estate is in their blood and if they can spend most or all their waking hours working on real estate deals only, they would do so happily. However, the more deals they can originate that meet their underwriting criteria, the more capital they need to do it (as real estate is a capital-intensive business) and this fact requires them to take on more investors to participate in more transactions. Early on, when they only have a handful of investors, this doesn’t seem very daunting and they do not mind it so much. As the number of deals they do increases, so does the number of investors and so does the complexity they must manage when it comes to accounting, tracking and reporting.
At the property or asset level, this accounting, tracking and reporting is reasonably straightforward and standardized. There are multiple off-the-shelf software programs that will track rents or loan payments collected, property level expenses, and produce asset level financial statements. Even at this relatively simple level, the ability to produce this information timely and accurately varies widely from one SBRE entrepreneur to another. However, to complicate matters considerably, there is a big difference between property or asset level financial tracking and investor level financial tracking and calculations. Depending on the underlying capital structure of any individual investment and the number of investors involved, it gets significantly more complex. For example, a typical syndication deal might have 8 or 10 or 15 individual investors in it, each with differing investment sizes (and perhaps even having come into the deal at different points in time, requiring different income allocations). The operating agreement of that deal may call for a preferred return to the investors at some level, which is almost always different than the actual net income realized at the property level, then a return of capital (sometimes after a manager “catch-up”, sometimes not), and then a split of the profits above that preferred return (and catch-up, if appropriate). Often, there is a second tier or hurdle IRR (internal rate of return) after which a different split applies. (And this is a simple example – a pooled investment fund consisting of multiple assets and multiple investors is an order of magnitude more complicated.) This investor level capital structure and priority of payouts is often called a “waterfall”.
Now let’s say our SBRE entrepreneur is successful. He does several such deals over the course of a year and now has 3 or 5 or 10 such syndications outstanding with 6 or 11 or 22 investors in each, some of whom are the same from deal to deal and some of whom are different. He may have, for example, 15 outstanding deals with a total of 200 or more unique investor accounts spread across those deals and each deal is likely a bit different in terms of the capital structure, preferred returns, hurdles, and splits. His challenge is that he must be able to take the property or asset level financial results, which usually are not fully finalized until some amount of time has passed after the end of a given accounting period (a month, quarter or year) and translate them into investor level results according to the individual operating agreements. He needs to be able to convert asset level performance into investor level results after running them through the relevant waterfall which requires completing a second, more convoluted set of financial calculations. Then he must be able to produce entity (or investor) level income and expense statements, capital account statements, and other information to reconcile the asset level and entity (or investor) level numbers, and then produce whatever statement(s) he can produce (most often manually) to reflect this information accurately to his investors. Performing all this work is not his strong suit, which is a colossal understatement, nor his desired way to spend his finite time, I can assure you.
Virtually no SBRE entrepreneur I have ever met, myself included, and we work with hundreds all around the country all the time, personally understands how to perform any of the calculations I just described. Neither do the vast majority of investors understand how to do it. Most SBRE entrepreneurs and their investors understand conceptually how the waterfall is to work, of course, and are able to negotiate together to come up with economic structures that can be agreed to in an operating agreement in order to attract the capital in the first place. But, by and large they both have no notion at all of how to perform the actual administration and calculations of whatever structure they have arrived at. These are complicated accounting calculations that require very specific knowledge of accounting principles to perform accurately. That is someone else’s job to figure out and it is widely overlooked and underappreciated by both the SBRE entrepreneur and their investors. Unfortunately for him, it is the SBRE entrepreneur’s responsibility (not the investor’s) to produce this information and he has few good or viable options to deal effectively with this responsibility. This goes to the very heart of the pain that the SBRE entrepreneur experiences operationally and the subsequent pain that the investors feel when they are unable to get the level of reporting they have come to expect with more traditional investments. It is an SBRE epidemic and not one that is easily solved, but improving this capacity and standardizing the reporting will go a long ways towards easing the operational challenges to the SBRE entrepreneur and the frustrations of the investors who provide the capital.