One of the hurdles that investors often face when considering investing in a fund is overcoming the concern: “I don’t know what I’m investing in. I’m investing into a blind pool.”
While a valid concern, through digging deeper they will find that professionally structured funds have transparent, narrowly defined parameters that investors can rely upon as a guide for what they are actually investing in.
Far from being a license to invest in anything, funds will typically restrict sponsors to identifying assets that fit specific criteria.
These criteria might include geographical restrictions as to where the sponsor can include investments, and debt or demographic restrictions.
Specifically Designed Criteria
Fund manager will articulate these parameters so that investors can benefit from understanding the manager’s investment strategy and can facilitate acquisition in highly competitive markets by preapproving these criteria.
For example, in its Fund II, Trion is mandated to solely invest in properties in the major Western markets of San Diego, Los Angeles, the Bay Area, Greater Portland, Denver, Salt Lake City, and Greater Seattle.
These markets might be preferred by investors because they offer stable, long-term employment growth, and have proven to be more resilient to downturns than other markets.
Other funds may focus on high-growth, secondary markets, or look to different criteria, such as assets less attractive to institutional investors because they are in smaller towns.
Some funds may focus on housing where the sole employer is a governmental agency or a university, for example.
The Debt Factor
Another factor a fund may predefine is the extent to which debt is being levered on a project.
Debt can be detrimental during a downturn when rents may soften or vacancies increase, so knowing that a maximum level of debt is baked into a fund adds further transparency to the investment.
In Trion’s Fund II, for example, the manager is mandated to lever no more than 75 percent of the portfolio value of the assets, which would mean that individual properties could have higher or lower levels of debt provided the fund, overall, never exceeds the maximum stated.
That said, it is important to remain cognizant of the amount of debt put on individual properties, especially in a lengthening cycle, and particularly in an increasing interest rate environment.
Prudent sponsors will pare down the debt so that even if a fund has a preset 75 percent maximum of portfolio value, practically speaking, the manager won’t approach that leverage threshold on total fund assets.
Taking a Nuanced Approach
There are nuances even to this, however.
In some instances, where an investment thesis is for a short hold period of 1-3 years and there is a high degree of confidence that the property can be exited quickly to achieve profit objectives, a sponsor may go with higher leverage.
That said, at the end of a longer real estate cycle such as the one we are in now, that’s something prudent sponsors will move away from, preferring a more conservative approach.
A third degree of specificity that investors will find in a well-reasoned fund structure is the overlay of demographic parameters, which might include historical rent growth characteristics.
For example, the fund manager may restrict their investments to markets that have enjoyed a minimum of 20 percent rent growth over a predefined period of time, and identify only properties that have not benefited from that growth.
The manager will look at what expense is needed to get an underperforming property to market rents.
In some cases, properties that are well below market may be that way largely because they’ve been mismanaged and require upgrades.
If there is potential to increase rents by 15-20 percent through simply improving management of the property and conducting some medium-level renovations, the project may make sense.
Similarly, if there is minimal upside, but there are also minimal capital expenditures required in order to achieve that, it may make sense to look at a deal with less rental upside than otherwise might be expected.
Markets Have Different Profiles
The characteristics of different markets will mirror these kinds of conditions.
For example, the Portland and Bay Area markets are markedly different.
Typically, Portland does not tend to offer as much rental growth as the Bay Area, but properties often do not require as much spend per door in renovations.
For example, Trion recently acquired an asset in the Fremont submarket of the Bay Area, where the existing rents were $1,600 to $1,700 per month, versus market rents around $2,700.
The building consisted of all town home units with two- and three-bedrooms.
It is a beautiful property with a large, highly utilized greenbelt running through it—where kids play soccer, and people barbecue.
On a project like that, where the rents were so far below market, a significant expenditure per unit is justified.
Trion spent around $25,000 per unit because the return on investment was justified by the 65 percent rent growth to reach market rates.
That said, for projects that have been mismanaged and there is only a 15-20 percent upside on rents, the investment will only be made if, to achieve those rents, renovations cost approximately $5,000 a unit.
By having a disciplined, well-considered set of criteria articulated by the fund manager, investors know that not only are they investing in an asset class that is predefined in its major characteristics, but they are facilitating the process of acquisition in a competitive market where quick decision making is important.
As partners in these transactions, investors whose risk tolerance is aligned with the sponsor’s can rest assured that they know where their investments will be made, as well as understand the reasoning behind it.