This is a guest blog post by Michael Episcope, Co-founder of Origin Investments. Don’t miss Michael’s panel discussion at Crowd Invest Summit:
? 12/08/2016 1:00 pm
Panel Discussion “Real Estate Crowdfunding”
Michael Lewis recently came to Chicago to speak at our annual investor event. The theme that dominated the conversation was about how data and process can exploit the flaws of human bias in systems where personal judgment is used to make decisions. This was the subject of Michael Lewis’ best-selling novel, Moneyball, that featured how the Oakland A’s rebuilt their team in a year that seemed doomed by a limited budget. After losing their best players in 2001, management employed an unconventional system called sabermetrics to find undervalued players overlooked by professional scouts. What the Oakland A’s quickly discovered was that scouts often passed on good players if they didn’t look like a good player or if their mechanics were slightly off. Instead, management focused solely on statistics, taking bias and judgment out of consideration. In 2002, the Oakland A’s pieced together a team with no known superstars and ended up winning a record best 103 baseball games that year. It forever changed the way teams approach the game. But the concept itself, applying data and process to make better decisions, applies to every industry, especially investing.
Successful investing is about having a disciplined process. Timing the markets and picking deals are popular investment strategies, but these practices have proven to be unsuccessful. This is human bias at work. They are based on nothing more than personal judgment and opinion. Asset allocation, a portfolio strategy that involves setting target allocations for various asset classes, and periodically rebalancing the portfolio back to the original allocations when they deviate, is the pillar of modern portfolio theory today. It works because it is based on process and takes personal decision-making out of the equation.
David Swensen, Chief Investment Officer of Yale’s endowment, bases his approach on this strategy and has helped Yale’s endowment outperform the market averages for more than 20 years. In public equities, Yale gains exposure through low-cost index funds. In the alternative space, they allocate through best in class managers.
Private real estate has been a large component of the Yale portfolio, accounting for between 10% and 30% of the entire endowment over the last 20 years.
Private real estate has been proven to enhance the risk-adjusted returns of a traditional investment portfolio comprised of 60% stocks and 40% bonds. It has low correlation to bonds, public equities, and even public real estate, and it is also far less volatile than public securities. Consider the most recent stock market episode, Brexit. The stock market took a tumble of nearly 20% but private real estate values were largely unaffected.
In general, individual investors should have 5% to 20% of their portfolio exposed to private real estate, assuming they can afford the illiquidity and it fits their risk profile. This allocation should be maintained through all market cycles. Over the long run, adhering to a strict allocation yields better results than jumping in and out of the market.
Gain exposure to private real estate through a private equity fund. Fund managers follow an asset allocation strategy and diversify capital across a large number of deals. Outsourcing the portfolio construction and selection process to a good fund manager is a great way for any investor to stay disciplined. Investing in individual deals might work for some, but they are at a severe disadvantage from a process and structure standpoint. In a fund, a manager’s incentive fee is dependent on all of the deals doing well. If one or two deals go wrong in a fund structure, the compensation to the manager will be severely impacted. This benefits the individual. In a deal by deal strategy, this is not the case. An investor who does individual deals, even if they are with the same manager, still pays the manager if one deal does great but another does poorly. This is a heads they win and tails you lose situation and, over time, will deteriorate investment performance dramatically.
Accessing the alternative space is certainly more challenging than accessing the public markets. Information is often opaque and difficult to obtain. Not all managers are created equal either. The graph below shows the difference between a top quartile manager and a bottom quartile manager. Good managers outperform in all cycles. They capture more upside in bull markets and know how to protect the downside in bear markets.
I’ve been investing in private equity for nearly 20 years and co-founded Origin Investments 10 years ago to focus on private real estate investing. My partner and I are the largest investors at Origin and we create structures based on what’s best for our personal capital and acquire deals that help us protect and grow our wealth. We’ve adopted best practices across the industry from risk management to reporting, and our last two funds are both tracking top decile performance. That’s not by accident or luck. We underwrite risk, not upside.
We adhere to institutional underwriting standards and subject every deal to rigorous standards. We don’t know where interest rates will be in the future so we assume they will be higher. We don’t know where capitalization rates will be in five years so we assume they will be higher, too. This has been our process over the last ten years and it will continue to be our process going forward.
No one can tell you with any accuracy where the market is going to be next month or five years from today. We understand that projections and opinions are wrong, and we get it wrong too. To illustrate my point, two of our portfolio deals that were purchased right around the same time in 2012 had very similar projected return profiles. The outcome was anything but similar though. One happened to be the top performer in the portfolio and the other held the spot of being the worst performer. The outlier to the upside generated a 56% IRR and a 4.6x multiple on equity. The other deal realized a 9% IRR and a 1.1x multiple on equity. Looking back, there is no way that I could have, or anyone at our firm for that matter, could have predicted this outcome. Because of our allocation policy, the fund was equally exposed to both deals so together they exceeded our fund’s return target. This is the power of diversification and proper portfolio construction at work. Process and approach is how we’ve consistently beaten our own biases.
Building an optimal portfolio takes time and discipline. Decide what your optimal portfolio looks like and maintain that allocation through all cycles. Navigating the private markets certainly is more difficult that navigating the public markets. Information tends to be opaque and difficult to obtain. Spend your time finding the very best managers. The risk of private investing really lies with the people with whom you entrust your money. It’s better to be in a good deal with a great manager than a great deal with a bad manager. It’s even better to be in a lot of deals with a great manager. As Warren Buffett says, “only when the tide goes out do you discover who’s swimming naked”. There are plenty of managers out there today swimming naked. It’s your job to ask the right questions and make sure their interests are in alignment with yours. Visit our blog at www.origininvestments.com/blog to learn more about how to vet managers and private real estate investing.
About Michael Episcope