In this episode, RealCrowd Co-Founder & CEO, Adam Hooper, discusses fees that investors will come across when investing in commercial real estate with, Michael Episcope, Co-Founder & Principal at Origin Investments.
Michael Episcope co-chairs the Investment Committee and oversees capital raising efforts and company operations at Origin Investments. He has been an active real estate investor for more than 15 years and has overseen the acquisition and disposition of more than $1 billion of commercial real estate. He cofounded Origin Investments in 2007 as a vehicle to invest his personal capital in private real estate. He has helped Origin become an industry leader through his 25 years of risk management and investment experience.
Before forming Origin, Michael spent 15 years trading interest rate derivatives. He had a prolific career and was twice named one of the top 100 traders in the world by Trader Monthly Magazine. In 2005, he retired from trading with the intention of focusing full-time on real estate investing.
Adam Hooper – Hey, Tyler.
Tyler Stewart – Hey, Adam, how are you today?
Adam Hooper – I’m doing great. Welcome, RealCrowd listeners, to podcast number three. Tyler, what do we have on tap today?
Tyler Stewart – Adam, today, I’m excited, we have Michael Episcope of Origin Investments. Michael’s going to be talking about the different fees you see in commercial real estate.
Adam Hooper – Yeah, Michael is the founder and a principal at Origin. He co-chairs the investment committee there. He’s been active in the real estate world for over 15 years, and has been involved in over a billion dollars of deals. Co-founded Origin in ’07, as a vehicle primarily to invest his personal capital after a pretty long and distinguished career in the commodities industry.
Tyler Stewart – Yeah, Michael’s got a great story, and it’s a story I identify with, trading in the stock market. Michael was an active trader trading interest rate derivatives, where he was twice named one of the top 100 traders in the world by Trader Monthly magazine, and then as certain life changes came about, Michael was looking for investment types with less risk and started his own real estate shop, where he’s grown Origin Investments into one of the more recognized names in the commercial real estate industry.
Adam Hooper – Yeah, it was really interesting, the transition from, which we touched on the podcast, from real-time decision-making in the equities market into a much longer-term perspective in the real estate world. What are a few takeaways that investors should listen for today, Tyler?
Tyler Stewart – Well, my favorite topic Michael covered today was going through all the various fees investors are likely to come across within commercial real estate. Michael described each fee, defined what they meant, when investors could expect to pay those fees, and also, what is the ballpark range for market rate for those fees.
Adam Hooper – One of the things that he talked about, that I think is really important, is fees should foster alignment between the investor and the real estate sponsor. We touch on the difference between transactional, upfront fees and then more performance- and incentive-based fees, and, as Michael will touch in the podcast here, fees shouldn’t be the deciding factor of whether an investor looks at a deal, but it should be more of an indication and a guide as to how aligned the investor’s and real estate manager’s interests really are.
Tyler Stewart – That’s exactly right. Michael described how high fees aren’t necessarily a deal-breaker for him, but fees do a great job of telling the story of the sponsor. And is that a sponsor who is hiding fees throughout the PPM, are the fees hard to understand? Or is that a sponsor who is very transparent and upfront with their fees? Really interesting point that the fees aren’t a deal-breaker, but the story behind the fees could be a red flag as it relates to that sponsor.
Adam Hooper – And we also touched on the concept of risk-adjusted returns, which we will be coming back, I’m sure, with many, many a podcast episode to go over risk-adjusted returns, so, a little tease in this podcast from Michael Episcope today on risk-adjusted.
Tyler Stewart – Yeah, risk-adjusted returns is a huge topic, and it’s one we will cover more in depth in future episodes. That’s a topic that, really, when you look at Michael’s career, transitioning from trading interest rate derivatives to investing in commercial real estate, that decision, for Michael, was really based on risk-adjusted returns, and that start with risk approach, which we write about in one of our e-books. Huge topic, so we’ll cover that more in depth. The topic at hand today is fees, and it’s going to be great for investors to understand the various fees and what to look out for when they’re looking at the fees on a particular deal. So I’m excited for what’s to come.
Adam Hooper – Great, Tyler, well, with that, let’s get to it.
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Adam Hooper – Well, Michael, thanks for joining us today. I’m really excited to talk about fees, it’s a very big portion of what our investors are looking at when they’re trying to analyze these deals, so it’ll be good to get some information out there for them.
Michael Episcope – Thank you, Adam, excited to be here, and I really appreciate you having me on your third podcast.
Adam Hooper – Yeah, we’re getting there, number three, it’s a big one. So let’s go back to the beginning, you started your career in more the traditional finance world, right? Not necessarily in the real estate space. Tell us a little bit about your background in the finance world.
Michael Episcope – Yeah, sure, no, I did start in the finance world. Real estate is actually my second career, and I’ve always had an interest in business, and my first career was actually in the commodity pits of the Chicago Mercantile Exchange. So I traded derivatives for about 10 years of my life, but I was down at the Chicago Mercantile Exchange for about 17 years. Business is something I’ve always been interested in, finance, especially on that side, I was just drawn to it at an early age, and it was really, I guess, my grandfather who got me more interested in finance. I remember watching him, as a young kid, he would watch the ticker tape, and he traded stocks a lot and did incredibly well for himself, and it was after my freshman year of undergraduate school, I was studying finance, and I got a job on the Chicago Mercantile Exchange, and it was just fascinating to me to be studying finance during the day, in college, and then be watching how it kind of unfolded in, really, what was the epicenter of the derivatives trading market in Chicago. That was my early career and had just a prolific career. I kind of worked my way up, I would say, through the chain for about six years, got an opportunity to trade, traded for 10 years, ended that career, retired from trading in 2005, but learned a lot of lessons over that, and, you know, some things that really helped prepare me for the real estate world. But I think one of the biggest things that I really found fascinating were the people, and working down there, and I found… You know, today, I really am a student of behavioral finance, and I just love that subject, but what I found interesting, especially down there, where you had thousands of people doing very similar things, but how is it that two people who stood shoulder to shoulder would make vastly different sums of money? I mean, you can have two people with the same information, one guy would make, you know, $10 million a year and the other guy would eek out just a small living. And it was very interesting seeing that, how people with the same information can have vastly different outcomes, and why was it the guy with the high school diploma could actually outperform or out trade the person with the PhD, and it was great, it was really interesting to kind of watch that unfold in real time, and I’ve always been kind of a student of people, and watching that. But, you know, what I learned was, having information is not nearly as important as knowing what to do with it, and so, that’s kind of one of the things I’ve taken into real estate, and in many ways, real estate is also an inefficient asset class, just like when I was attracted to the trading world as well, it was inefficient, and that’s how we were able to make outsized returns and just generate income on a regular basis, so it was a great career.
Adam Hooper – Well, I was going to say, you must’ve been doing something right, because you were named top 100 traders in the world in Trader Monthly magazine, is that correct?
Michael Episcope – Yes, that’s correct. I know, but it’s one of those unintended consequences, that you don’t set out to do that, but, as I was trading, it was all just about making great decisions every day, and it just so happened that I started to trade bigger in those decisions, and I think one of my unique qualities that I had was just to be able to process a tremendous amount of information in a very short amount of time, and when I went into trading, I had spent five or six years on the outside really training my ear and things, and I could remember a lot of information, I could act quickly, I could process information quickly, and my career just took off very, very fast. So I was blessed to have those 10 years that I did in the pits, but in 2005, it was time to leave, the computers really took out that edge, changed the game quite a bit. I was, at that time, married with two kids, one more on the way, and my risk profile had changed dramatically, so I went from, really, building wealth in my first career to looking at, “How do I manage, grow, and protect my wealth?” in my next career.
Adam Hooper – And so that was then the segue from, you know, being down in the pits into getting into real estate, what made you go into real estate versus any of the other avenues you could’ve gone?
Michael Episcope – Well, a couple of things. You know, first and foremost, I was really introduced into real estate as a teenager. I used to work with my grandfather in the summers at his buildings. He operated multifamily in the Chicago areas, in some rough neighborhoods, bought properties out of tax sales in the 1970s, and so he was in real estate and I saw kind of firsthand how that business, how it operated, and what I like about real estate is that it is an inefficient asset class, and it’s one of, I think, the last few remaining asset classes out there because it’s not commoditized. Every building is different, operational, there are people operating it, and as long as there are people operating buildings, you’re going to see them operate differently. It goes back to what I said about behavioral finance, and you can have two people with the same information but vastly different outcomes, and the same is true with real estate. So we see a lot of opportunities on the inefficient side, and from a pure financial standpoint, I really am not… Public markets are tough, there’s a lot of volatility, it’s hard to understand what really drives them, you know, why we’re sitting here today at 21,000 in the Dow Jones, moving up. Many times there doesn’t seem to be a rhyme or reason, I understand that you have to have exposure to equities, and I certainly do, but what I like about real estate is the opportunity to develop outsized risk-adjusted returns, and a lot of people get into real estate because it is this hybrid between bonds and equities. It has the best of both worlds, and it behaves very similar, and it behaves that way because you have in-place long-term leases with escalations in them that help with appreciation with the property as well, so you get the best of both worlds in that, and then you have a physical asset, which, theoretically, should help against inflation. But that’s really what attracted me to it, and the fact that you can buy a piece of property, you can work hard, you can build real value, you can realize your returns, and there’s a complexity to the business but there’s also a simplicity to it as well, and that just made the most sense to me as I was transitioning from my trading career into this. And I had invested both directly and passively for, call it five to seven years prior to Origin, and then my partner and I got together in 2007, and started Origin, more formalized it, rather than doing deals on our own and just sharing ideas, so that’s kind of how I ended up in real estate.
Adam Hooper – Okay, so you were investing your own capital, both as an operator in your own deals and doing joint ventures with other sponsors, then?
Michael Episcope – That’s correct, yes, and you learn a lot in the world by doing, by investing with others and investing on your own.
Adam Hooper – You had a base knowledge of operations, like you said, from your grandfather, earlier on, when you were first getting into this, what are some of those lessons you needed to learn coming from a much more, I guess, lively, in real time, decision-making process that you saw in the pits versus a much longer-term perspective in the real estate space, how was that transition, going from very active trading to more of this longer-term cycle with real estate assets?
Michael Episcope – Well, Adam, you hit it on the head. I mean, it’s really a longer-term perspective because when you buy a piece of real estate, you’re going to own it for three, four, five years, maybe even longer, and it’s illiquid, and you can’t just hit a button and get out if you decide you no longer want it. It’s also a lot more complex than most people think. There is a simplicity, and there’s common sense that you have to apply to any business model, or any decision-making, but I think, most importantly, you got to get the buy right, and you have to do a tremendous amount of due diligence on the front end, and we spend an inordinate amount of time, you know, months, making sure that we’re buying the property at the right price, that we have a business plan that’s achievable, making sure that we’re avoiding any traps along the way, really understanding the difference between price and value, and making sure that we’re buying it at a price where value and price intersect. So buying right is really, really important in this business, because everything beyond when you buy a property is an assumption, every single thing, so, again, making sure that you have all of the available information and you’re making good choices from day one, and then, more importantly, real estate, it’s all about people, and we learned that early on, and my partner and I have spent the last six, seven, eight, nine years building a great team of people underneath us, because this is a complex business, and it does take a team to buy right, to manage, to execute, to do all that. You know, there’s a saying in this business that you bet on the jockey, and not the horse, and I think that that’s exactly right, and you’d rather be in a good deal with a great manager than a great deal with a good manager, and you know this business better than anybody, but the manager does make all the difference, and you can see, you know, the same vintage, the same manager, the same information, the same opportunities, where one manager will generate a 25% return and another manager will generate a 12% return, and so there’s a big disparity there, but it is all about the people, and so we spend a lot of time not only making sure that we have the right team here at Origin, but making sure that when we buy a building, that we have the right property managers, and the right people in place, and the right communications, and all that. So, those are some of the important lessons, and it is very different, but, a lot of the common sense that you apply to any industry does prevail here. You know, we like to keep things simple, and I think you just keep making good decisions and good things will happen.
Adam Hooper – Good. Let’s get into the meat then today. We’re going to talk about fees, I know that’s something that you guys have a fairly unique and, again, very transparent approach at Origin. One of the things that we see often, since we’re dealing with so many different sponsors, and investors see as well, is there can be a lot of confusion around the fees, you know, some are annual, some are upfront, one-time, some are charged on total deal size, some on equity invested, why are there so many different kinds of fee structures, and how do you make the decisions as to what kind of fees to put into a deal?
Michael Episcope – Yeah, it’s a great question, and I think it’s probably one of the more confusing areas that any investor can encounter, but, the truth, there’s no standardization in the industries, and sponsors, honestly, they use whatever language they feel is best, and the reality is that a lot of sponsors, or a lot of language is opaque, and it’s opaque on purpose because it’s simply better for marketing. I’ll give you an example, right, and we see this, a lot of times you see this stuff in non-traded REITs more than anything, but, if you have a private placement memorandum, and under the fee section, it reads, “The manager will be entitled to receive 1 and 1/2% on invested equity annually.” That’s pretty easy, so if you’re going to invest a million dollars, then you’re going to be charged $15,000 in fees annually, but another sponsor’s language might read that, “The manager will be entitled to receive 1% of the aggregate value of the investment on an annual basis.” And you look at that and you’re like, “Well, 1% is cheaper than 1 1/2%,” but the reality is, if you really look at that language, and you read “the aggregate value of the investment,” and then you notice that investment is capitalized, so, what that means, in a private placement memorandum, somewhere, investment has a definition, and then you go read under the definitions, investment is actually defined as the total dollar value of the real estate. So, if an operator is using two to one debt to equity, that means $10 million will be paired with $20 million of debt, and now you have a $30 million deal, so that 1% becomes 3% on equity, and that’s something that people have to be careful about, and it’s interesting because just a couple of words inside can really make a drastic difference. But it really comes down to the fact that there is no standardization, but those are some of the things that people have to look for when they’re reading, and I would encourage anybody to read. I know the PPM can be the most boring document out there to read, and dig into, but it does tell a story.
Adam Hooper – But it’s fairly important.
Michael Episcope – It’s unbelievably important. But I would also say this, that, you know, to me, fees and language like this, it tells a story, and if you find a manager who is being opaque or using… You know, look, I can say that everything is opaque to an outside investor, because it’s difficult to understand, but if you have to go through and you have to find, you know, three different definitions to understand what they’re talking about, then it kind of raises a red flag, to me, on that side, but, what I think is more important than even the fees, or those, is the structure, and the structure is about who gets paid, when they get paid, and how much, and this dictates, really, what happens with cashflow and how the operator participates. And every sponsor is going to be different in how they charge fees, and there’s a range of what I’ll call fairness in the market, so two sponsors can have totally different structures, and they both might be okay, ’cause they’ll both get you to the same place, but just in a different way. But I think that, broadly, investors should look for structures where the majority of fees are back-ended, they’re performance-based, and fees should be minimal when a deal doesn’t work out, but they should be fair, but they need… You know, a good manager has a lot of infrastructure, and this is an actively-managed business, and it is people-intensive, so fees pay for that infrastructure, and so on the one hand, I know what people want, they want the best team available behind them and they want the lowest fees possible. I mean, there’s a range, and a fairness, but there’s a value behind what you’re paying for. So, it’s hard to kind of pin it down and say, “If there were standardization, this is how it would be.” You also have to look at… You know, when I talk about value, there’s the complexity in the business model. So, if you’re looking at somebody who is in core real estate, where they’re not generating alpha, or they don’t have a staff, or a lot of value to execute at the property level, those fees should be very different than in a value-add or ground-up development project, where you have a tremendous amount of people who are really helping to execute the business model. So, there’s really a range, and I think buyers, they just have to educate themselves in the area and look across the industry at different operators, but there are some ranges that they can look into.
Adam Hooper – I think what you touched on there is, you know, fees should be there to align sponsor and investor, right? Sponsors should get paid well when they get their investors paid well, and I don’t think many people would dispute that, and that’s one of the things that we see is, you know, sometimes, deals are very heavily-weighted with upfront fees versus a more aggressive promote on the back-end. Do you have any commentary on… You know, again, I mean, you mentioned primarily performance-based is better, but what kind of split do you typically see between reasonable, upfront, transaction-rated fees compared to more performance-based fees? Is there a ratio you see there in any way?
Michael Episcope – Transaction fees, to me, should be minimal. You want to keep the lights on, but you don’t want to make this a profit center. They’re going to be different too, we operate in a funds structure, and those are going to be different than somebody who operates in a deal-by-deal structure. Deal-by-deals are typically going to have an acquisition fee on the front end, whereas a fund will have a commitment fee, and those serve, really, the same purpose at the end of the day, and that is to pay your team while you’re out there looking for deals. The syndicators are the individuals who go deal-by-deal, they’re getting it, you know, once they find a deal, but you have to understand that for every one deal they buy, they probably looked at 10, and they have to pay for that staff, so those are very reasonable. As I start looking through these fees, and I’ll take a fund structure, because I know this well, so there are just best practices, or, you know, in a fund structure, you’re going to have a commitment fee and then you’re going to have an annual investment fee, but I’ve seen funds where then they adopt both the fund structure and they adopt the individual deal-by-deal structure where they’ll charge…
Adam Hooper – At the asset level? Yeah, when you make the acquisitions, right?
Michael Episcope – At the asset level, so they’ll charge an acquisition fee, and then they’ll charge a refinancing fee, and a debt placement fee, and to me, that’s double-dipping, as I call it. You’re already paying a manager, and you’re paying the team through your management fee, and you just want to make sure that the compensation aligns with the investor, in that you’re not creating perverse incentives, and more importantly, you’re not getting into a situation where it’s tails, they win, and heads, you lose. The motivation, I guess is what I’ll say, for the investment is… The sponsor needs to be motivated for the same reasons that the investor is motivated, and not take the majority of their fees upfront. So, you know, as I look through it, you know, if I’m going to give you a range, call it 70/30, 80/20 transaction to performance-based fees. And that’s if a deal works, certainly, if a deal doesn’t work, you’re not going to have any performance fees. So if a deal makes 5%, you’re going to see the fees in the range of one to three percent, and that’s going to be all fees, including your asset management fee, not your property management fees, ’cause those are deal-level fees, so I’m only talking about real estate investment fees. And if the deal does work, and it works well, let’s say a deal generates a 25% return, you’re all-in fees are going to be, call it, a 5% to about an 8% dilution on the IRR. So 25% gross return will net an investor, call it anywhere from 17 to 20% on that side, and that’s a fair ratio on the fees, I think, and pretty standard. But we see fees all over the place, and it was interesting, I had a conversation with an investor, about a month ago, we were having lunch, and he was investing with somebody here in Chicago, who I know very well, great sponsor, and they can pretty much name their own price on their fee structure because a lot of people are clamoring to get into their deals, so, they have a very favorable fee structure to themselves, 50/50 on the investment performance, and I just asked him the simple question, and I said, “You know, you did well on that deal, but did you make any money?” And he kind of had this aha moment, and he said, “You know, not really,” but, you know, he was excited about the gross return to the deal, but when he equated that back to himself, he realized that he really didn’t capture much of the upside in that deal, and so, I think, any investor needs to make sure that they’re paying fair fees, but they’re also capturing as much of the upside as they possibly can, because when things turn around, and they will, they will own 100% of the downside in a deal. So, you know, that’s kind of my two cents on those fees.
Adam Hooper – With all these different structures, in different words, for how these fees are described, as an investor, how can you start to make an apple to apples comparison on these with so many different ways these are put together or worded?
Michael Episcope – Well, you know, when we’re dealing with institutions, they look at one thing, and that’s gross to net. And again, I want to say that when it comes to decision-making, fees are sort of a distant fourth to all of these other things, and fees are easy to quantify, and the value proposition is more qualitative, so that’s more difficult, so I don’t want to give anybody… You know, we’re here to talk about fees but I would not let fees… You know, if you’re talking about a quarter or a half-percent, you know, small fees, really be the guiding decision-maker between doing a deal or not. Now, again, fees on the extreme are something to be aware of. You don’t want to go with the low-cost provider, and you don’t want to go with egregious fees on the end, but, if you really want to cut through it, and understand, and compare one to another, you got to look at gross to net, and that is, what is the return at the property level, the amount of money coming up to the investment management itself, after property management fees, et cetera, and then, how much is going into the investor’s pocket after your asset management fees, after your performance fees, after your debt placement fees, your acquisition fees, whatever fees are in there? And then you get to paint a picture, and you can compare one sponsor’s fees to another, and again, it goes back to what I was talking about earlier, you’re going to have a range, and as long as they’re somewhat in that range, you can… You know, you want to pay fair fees, so I would say 5% to 8% on IRR dilution is very reasonable. It could be that you find a sponsor with a deal where they’ve mitigated so much risk that the fees are going to be a little bit higher and it’s still a great risk-adjusted returns, but, investors have to look at fees, or the returns on an after-fee basis, and ask themselves if they think that on an after-fee basis, they’re generating enough return to justify the risk that they’re getting into. And everything has to be looked on at an after-fee, so, it really depends, and I’m just giving a range. Again, I wouldn’t paint myself into a corner and say, “Well, this person’s at 9%, therefore it’s not a good deal.” It could be that you’re paying, you know, 10% IRR dilution, and you actually have a great deal on an after-fee basis.
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Adam Hooper – You touched on something that is, I think, a very key point there, and could take up a number of podcasts by itself, which we will plan on doing here shortly, this whole concept of risk-adjusted, right? It’s not about just the number, or at the asset level, or the net level, there is risk associated with those as well, and part of that is, again, the business plan, and so if there’s a riskier, or heavier, value-add project, you’re probably going to see a little bit bigger delta in that IRR dilution, maybe in the higher-end of that five to 8% range, versus what you mentioned earlier, more of a core asset, you know, less of a heavy lifts on the actual operations, you’re probably going to trend towards the smaller side of that IRR dilution, right?
Michael Episcope – Yeah, of course, and risk-adjusted, I mean, we could definitely spend an entire podcast on this, but there are really, what we view as, three risks. There is business plan risk, as you pointed out, you have core deals that are stabilized, maybe you’ve got a 20-year triple net lease on there, then on the other end of the spectrum, you have land development, or ground-up construction development, and in the middle is where we operate, in sort of the value-added spectrum, and then you have core plus, and you have all over the map. So you have business plan risk, but then you have financial risk as well, and that is your leverage. How much leverage is the sponsor using? And so, where I think investors have to be really, really cautious about when they’re looking at leverage risk, and I’ve seen this, where a sponsor will layer on preferred equity, things like that, so they might be looking at an after-fee return of 17 or 18%, but taking an extraordinary amount of financial risk, and then that leverage really magnifies the risk substantially, so, you know, looking at and making sure that when you’re comparing one sponsor to another, if one’s using 65% and generating a 15% return and the other one is using 85% and generating an 18% return, well, the math is pretty easy, the 15% is actually much better on a risk-adjusted basis, because leverage is exponential as you move up, and I would also say that the other risk is just sector risk. Things like multifamily have less risk than hotel, retail is a different animal in and of itself than multifamily, so, they all have different risk characteristics. So looking at those three, though, and qualifying that, and making a decision around that risk-adjusted return, it’s part science and also part art.
Adam Hooper – Yeah, I agree, and hopefully we’ll get you back on here and we can dig in to that a little bit deeper, because that is something that, again, I think for new real estate investors, isn’t really understood, the concept of risk-adjusted. You know, a lot of times we see the biggest numbers are the ones that sell-through the best, without, necessarily, a full understanding of what the risks are to get to that number, so we’ll be sure to get back on the next one with you and dig in deeper on that. Let’s go through, if we can take a few minutes, and talk through some of the typical fees that people are going to see, both in funds and acquisitions. Maybe we can just talk about what you would see, maybe, as market for those, qualify whether it’s typically an upfront or an annual fee, and just go through a list here of fees that we typically see on that platform, does that sound good?
Michael Episcope – Yeah, great.
Adam Hooper – You mentioned, when you’re setting up a fund, a fund formation fee, or what would be, in syndication, maybe an administrative fee, what do you see typically in fund formation fees?
Michael Episcope – A fund formation fee is typically all of your early stage, your legal fees, your marketing costs, your travel, your due diligence, everything, and those fees are standard across the industry in funds. They will be, depending on the fund size, anywhere between 1% and 1 1/2% of total equity commitments. But, yeah, that’s a standard fee, and that’s fully acceptable in the market.
Adam Hooper – And those are paid by the investor when?
Michael Episcope – They are, they are, and that’s a one-time fee, upfront, so, you know, think about it, it might sound like a lot, but it’s a one-time fee, and if it’s a 1 and 1/2% fee, and that fund lasts for seven years, well, you can amortize that on an annual basis, just linearly, and it’s, you know, call it 35 basis… Is it 35? Yeah, right around 35 basis… No, it’s a lot less than that, sorry, 20 basis points a year to 25 basis points per year, so it has a really negligible impact to the IRR. But it’s necessary.
Adam Hooper – It is, yeah, because again, like you said, those are actual costs that are incurred before that fundraising starts, right? So that’s preparing the offering, getting everything filed, accounting, legal, travel, with getting that fund actually set up, and those are actual costs to the manager, which is completely reasonable to get reimbursed for, for a lot of that. Administration fees, where do you see those coming into play and what’s a range, ballpark, on those?
Michael Episcope – So, this term is used… It has a couple different definitions in the market. There’s a fund administration fee, and then there’s an upfront administration fee. So I’ll talk about the fund administration fee, so, nearly all fund managers have an outside administrator who handles cash and does capital calls, distributions, we have one as well, and that’s an annual fee that is anywhere from 10 to 20 basis points per year. That’s on top of the fund fee. So that’s an ongoing fee. And then you have upfront fees, and we have an administration fee, and that’s really our technology, our marketing costs, et cetera, so for us, we only charge that on investments less than $500,000, and it’s really our way to recoup costs that we put into our infrastructure. So, today, we have more than 350 people who invest with Origin, and there is a lot of staff, extra staff, that’s required, so as we’ve lowered our minimums, we’ve invested in technology, we’ve invested in back office, and we just have to have a way for ourselves to be able to recoup those costs in some way, so we’ve kind of created that function to do that, and just simplified it in the sense that it’s a one-time, upfront fee on the investment. And other companies might call that a technology fee, a marketing fee. I think in the world today, it’s more common than it was 10 years ago, when deals weren’t being syndicated online.
Adam Hooper – And sometimes, in a syndication, we would see that referred to as an organization fee, or something along those lines? Again, some of those hard costs that are attributed to getting that fund or getting that syndication set up, and raising the capital, essentially.
Michael Episcope – Yes and these fees, I mean, they can be zero, in some cases, some sponsors don’t charge these at all, and they can be up to 2% on equity.
Adam Hooper – How about acquisition fees? You mentioned that before, typically seen more so on the deal-by-deal basis, not necessarily as much in the fund world, where do you see acquisition fees in the market right now?
Michael Episcope – Acquisition fees, what we see are more on the deal-by-deal basis, but they can be in funds, but I would say this, that if there’s a committed fee and an acquisition fee, that’s kind of egregious, right? To me, that’s really acting in the same capacity, but, you know, the smaller sponsors out there, they have infrastructure, and they have to figure out a way to be profitable earlier to pay their staff, so, you know, unfortunately, that sometimes, they have both fees in there, because they need to pay their staff. We only charge a commitment fee, we don’t charge acquisition fees or other fees, but very common in syndicated deals, and perfectly acceptable as well, in those. And I would say it’s going to be 1% to 2% of deal size, and that’s one thing that investors need to understand. So if you have a sponsor who is leveraging two to one debt to equity, 1% on your acquisition fee can be 3% of your equity, or if it’s 2% on deal size, that’s going to be 6% of an upfront fee on equity, so you want that fee to be a minimum. What we’ve seen, especially on the bigger deals, and I think even 1%, I mean, I would kind of couch that 75 to 1 1/2%. You might get 2% if the deal is really small. If you have a $6 million deal, a 2% fee is reasonable, but if you’re dealing with a $15 million deal, then it should be 1%, or even less, on a deal like that.
Adam Hooper – That, again, is a one-time, upfront fee, not paid recurring, or anything like that, acquisition fee…
Michael Episcope – That is a one-time fee.
Adam Hooper – Debt placement fees, that’s typically going to go to a third-party mortgage broker, essentially, correct?
Michael Episcope – You know, it can. This goes back to reading the PPM, in a lot of organizations, they’ll use an outside broker and they’ll take an internal debt placement fee themselves. I personally am not a fan of that. I think that the asset management fee, or what you’re paying the manager, that’s why you’re paying them, and that should just be part of what they’re doing, but I also get it, because when we’re doing a refinance of a property, there’s a lot of work and effort that goes into that, but again, I don’t love that fee, myself, but I know that a lot of operators charge that out there, and it should be minimal, it should be a quarter point. And if you’re going to be using an outside broker, typically, that market rate fee for that is about 50 basis points, but I would just caution, you know, if you’re using an outside broker and you’re getting an internal fee, that’s kind of one in the same, but a market rate fee.
Adam Hooper – Debt placement fee versus a refinancing fee, debt placement fee would be when the time the asset is acquired. That’s going to be paid, again, hopefully, just the outside broker, but potentially to the manager as well. Refinancing fee, that would be if in your three-year project, you’ve added some value, you’re going to refinance that original debt going in, do you see fees typically charged on refinancing?
Michael Episcope – Typically, yeah, I guess I do. I mean, more so than not, you know, but I’m thinking it’s, you know, like, 60% of managers might do that out there. Again, this fee is nominal, it’s 25 to 75 basis points. I don’t think this is where an investor wants to fight the fight, but my personal opinion is that this is what you’re paying for in the annual asset management fee, and you’re paying for their staff, and this should be part of it, so we don’t charge this but I also understand, again, why other people do. There’s a lot of time and effort that goes into doing this, and it’s kind of negligible at the end of the day, but you have to understand that 50 basis points on the debt, again, if the debt is 20 million and your equity is 10 million, 50 basis points on the debt equates to 1% on the equity.
Adam Hooper – Right. Now, all these fees that we have been talking about thus far have been on more of your kind of private ownership, LLC structures, limited partnership structures, when we look at REIT vehicles and non-traded REITs, and distribution that typically goes through some of the broker/dealer channels, a lot of fees in those deals, right? You’ve got the wholesale marketing fees, you’ve got selling broker fees, you’ve got the managers, themselves, taking fees, can you comment a little bit on what you see, typically, in the non-traded REIT space, since that’s, you know, before RealCrowd existed, and companies like this, that was a way a lot of people had access into real estate investments, either through publicly-traded REIT vehicles or non-traded REIT vehicles. What’s your take on fees in those scenarios?
Michael Episcope – You’re going to get me on my soapbox here for a second. I could go on and on about this industry. It’s fee-crazy, I mean in the non-traded REIT world. So they have your wholesale marketing fee, they have your syndicator fee, but they are just really fee-egregious, and, typically, I mean, the most efficient REIT that I’ve seen out there, I mean, you can get different structure, but when they use the broker/dealer channel, you’re talking about 12 to 18 cents on every dollar goes into that, so the investor’s going to be down 20% on day one when they invest in a deal, so it would be the akin of, you know, if your broker came to you and said, “Hey, would you like to buy the Dow Jones today?” And we’re at 21,000, he said, “You can get in at 25,000,” I mean, that’s the kinds of egregious fees you’re talking about, and that’s really the impact, at the end of the day, so, yes, you’re getting into real estate, but who wants to get into real estate at a 20% premium? So, yeah, these are terrible vehicles. We were just doing some research on these recently, and I was reading some data, and public-traded REITs, you know, they’re essentially in the same arena, they’ve returned about 11.3% over the last 30 years, and the non-traded private REITs have generated about a 5.8% return. You know, the numbers aren’t right, but the delta’s going to be about the same, and the only thing that you can really equate that delta to are fees, and that’s the biggest difference, is that publicly-traded REITs are very, very efficient. Typically, your management fee is across the board because they have so much scale, they’re multi-billion dollars, they’re going to be one to 2%, and they have good boards, they’re operationally-efficient, they’re accountable, they’re transparent, where the non-traded REITs have zero transparency and they are just fee machines, and my personal take is they’re just huge, huge transfers of wealth from hardworking Americans to the people who run them.
Adam Hooper – I think that’s one of the things that we’re trying to change, quite frankly, is bringing direct access, where you don’t have to go through those traditional channels, and be subject to, you know, again, what I would completely agree with, are very egregious fees in some of those more traditional structures. Let’s talk a minute about invest management versus asset management fees. Investment management fee typically is going to be ongoing operations at the operating company level, correct? Whereas asset management fees are going to be more costs that are associated with managing that specific asset, is that correct?
Michael Episcope – That’s correct. An investment management fee is, again, it’s one to 2% on your invested equity, at that level, and I would benchmark that against the complexity of the business plan. If it’s a core deal, you’re going to be closer to the lower end of that range, you’re going to be in 1%. If it’s a value-add, heavy lifting, things like that, you’re going to be towards the higher end of that range, 2%, but what you shouldn’t be paying is both an investment management fee and an asset management fee to the same party. The asset management fee, yes, is typically at the asset level itself, and sometimes those can be very interchangeable, whereas if an individual sponsor syndicates a deal, they might call it an asset management fee, and it really has the same impact to the investor, but you wouldn’t pay both on those.
Adam Hooper – Now let’s spend just a few minutes on the more performance end of it. You know, we’ve talked about a lot of these fees are more fixed-cost or fixed fees, they’re not necessarily variable based on the performance of the asset, so now that we start talking about performance fees or incentive fees, what we typically, in the real estate world, call promote to the sponsor, how do you see those playing out? And we’ve seen a bunch of different ways, right? No two deals are structured the same, we’ve got some that are just straight preferred returns, where there’s no promote to the sponsor, we’ve got a simple promote, which would be, you know, 20% goes to the sponsor after you reach a certain hurdle, we’ve got multi-tiered waterfalls, we’ve got catch-ups, we’ve got clawbacks, let’s take a minute to kind of just run through some of the different structures that are out there, going all the way from a straight preferred return up to a multi-tiered waterfall.
Michael Episcope – Most sponsors are going to be investing for that promote on that back-end, and then that’s one thing investors want, is they want that alignment with the sponsor to make sure, again, this goes back to why are they doing the deal, what is their motivation, are they aligned with you? In typical, waterfalls would be anywhere from eight to 10% preferred return, depending on the market. I think in real estate, I have never seen a deal you might have where there isn’t a preferred return, and the preferred return, really, what it does is it protects investors, in that saying that, you know, “If we don’t generate this minimum preferred return, we don’t make any upside. You are going to be guaranteed,” not as an interest rate or anything like that, but, you know, “If we don’t generate an 8%, 9%, 10% return, we don’t get paid on the back-end,” and to me, that aligns interest to make sure that the sponsor is truly trying to create value, or generate alpha, outsized returns, for the investor, themselves. Now, that preferred return, again, when we go back to business plan risk, when we go back to sector risk, when we do all this, it’s going to matter substantially. I mean, the goal of the sponsor is to generate a return above and beyond that, and there are ways to manipulate that, and we talked about that earlier, about, you know, using more leverage. Well, if you use more leverage, inherently, that preferred return should go up, but it really doesn’t. So that’s one of the things to look for. But the way the waterfall works is that the investors, in all cases, should get their preferred return, then get their capital back, and then, only then, should the sponsor participate in the upside. So, there’s a couple of different structures you see. Sometimes, it’s very simple, where the sponsor gets 20% after an 8% return, sometimes, it’ll be 30%, in some cases, that I mentioned earlier, it’ll be 50%, no preferred return. You know, it’s a little bit all over the map, and then you have what are called these tiered waterfalls, where the sponsor will get, you know, between an 8% internal rate of return and a 12% internal rate of return, they’ll get 20%, and then above 12% to 20%, they’ll get 40% of the project, and then above 20%, they might go to a 50/50 split. So, you’re incentivizing them to get a high IRR, but, I also want to caution people that, you know, real wealth in this industry is created through a multiple on equity, and sometimes, IRR motivates… It really places you, I guess, or creates a conflict of interest in the sense that IRR is time-based, and multiple is just a multiple on equity, when you put in a dollar, a two-multiple means you take out $2, and IRR and multiple work against one another, so the sponsor, then, is really incentivized on turning a deal really quickly and generating a high IRR and getting out that profit, whereas the interest of an investor is holding a deal longer, taking a dollar, turning it into two, $3 at a time, but they play against one another, so it’s hard to have both a high multiple and a high IRR. It happens, but it’s challenging. And then you have what’s called the catch-up, as well, so the catch-up is typical either on a deal where, let’s just, for simple math, you have an 8% preferred return, the catch-up would be that the manager either gets 100% of the next tier, just to catch them up… So in our case, we have a catch-up in our fund, and we get 20% of total profits. And what that means is that our investors, the first 9%, they get their capital back, then we have a 100% catch-up, so that essentially, what it works out to, is that we are getting 20% of all profits, so long as we do our job. So, we get about 100% of the next 2%, and then it’s 80/20 after that. And catch-ups can be 100%, they can be 50/50, but they’re also fairly typical in the market, but, as you’ve noted earlier, there’s a wide range, and again, I would use gross to net, look at things on, you know, what happens if the deal makes 30%, what happens if it makes 0%, what happens if it makes 10%, and what does that look like in all those scenarios, and it turns out, in a lot of situations, you’re going to get to the same place, or a very similar place, it’s just there’s no standardization and everybody uses what is comfortable to them.
Adam Hooper – I think you just kind of glanced over equity multiple there, that’s something that we’ve started to put more of an emphasis on, because, I agree with you, that is much more of, I think, an indication of the wealth that you can generate, right? If I put a dollar in, over X period of time, how many dollars am I actually getting back, versus the IRR, which you said, if you have a super short hold period, you can inflate that IRR, you can get a 40% IRR, but your equity multiple, you might only be like a 1.3 or 1.4X, versus if you have a deal that’s maybe a little bit longer-term, you’ve got more cashflow, maybe that same, similar deal is in the 2X range, and so that’s a metric that we’re starting to try to explain a little bit more, and I think is foreign to a lot of investors that aren’t used to typical private equity investments, or access to deals like this. Equity multiple might be a very foreign concept, but at the core of that concept, I think it’s a much easier estimation of the wealth that you can create in this asset class, versus something like IRR, that’s a little bit more complicated. You know, it can be gamed a little bit, if you will, depending on the hold period which you’re looking at over the lifecycle of that asset.
Michael Episcope – Yeah, and you nailed it, multiple builds wealth, so our goal here is to take a dollar and turn it into $2. We always give the example, you can generate a 30% IRR, but if you’re doing it in a six-month time, you’re not really making any real money. So if you give somebody a million dollars and they generate you a 30% IRR, you’ve got a million, 150 back, you got to pay short-term taxes on that particular investment, and you really haven’t done anything, and so, you’d rather have your money out for three, four, even five years, generating a lower IRR, but having it being put to work for quite a long period of time. And I remember somebody, a long time ago, had said to me, which I thought this was funny, but, “If somebody’s going to give me 12% on my money, just don’t ever pay me back on it, I just want to keep earning 12% for the rest of my life.” So, just chasing IRR, it feels great and it sounds good, but I would just, to your point, investors would do better in the long run kind of looking at this combination of IRR and multiple together, and how they play off one another, so we have always been kind of focused on multiple, and it’s been an education process as well, but I think our investor base understands that. But this is, to us, it’s about investing our own capital, and what we want to make out of it.
Adam Hooper – Good andand thank you. That’s a pretty good overview of a lot of the fees that we see. As investors are looking at these fees, and we kind of touched on this earlier, is there any terminology, or hidden tricks, or gotchas that investors need to look out for, or be careful about, when they’re looking at fees across different sponsors?
Michael Episcope – I’ll go back to investors really should read the PPM. Again, as how boring it is, but, it tells a story, and you look through it, in the fee section, and you have to kind of follow the trail sometimes to understand the complex web of fees, and sometimes, they’re very simple and open, upfront, and they’re easy to understand, but not hidden tricks, there’s just more best practices and standards in the industry, and the more you read, and the more you understand this industry, the more you see things sort of cluster around the middle. So, you know, again, reading the PPM, that solves a lot of problems in understanding it, and then, leaning on people, maybe within their network, who really know the business, where they can say, “Hey, is this fair?” And that’s really what it comes down to, are the fees fair and justified, and are the investors making a good risk-adjusted return net of fees?
Adam Hooper – Yep, and risk-adjusted, let’s definitely, again, we’ll get you back on and dig into that much deeper, ’cause I’m sure we could take a few hours just to talk through that, alone.
Michael Episcope – Yeah, and the only thing, I mean, I already mentioned this earlier, but looking at the difference between is it on invested capital or is it on total deal size, and that’s something that, you know, you can see right through in a lot of these PPMs, so, just watch out for that.
Adam Hooper – Good. Wee like to wrap these up with just some general commentary on, you know, where we’re at in the market, where we’re at in the cycle, you know, when you guys are looking at deals out there, what’s your take on where we’re at in the cycle, and how do you see 2017 shaping up for acquisitions this year?
Michael Episcope – In terms of where we are in the cycle, that’s anybody’s guess. We were worried about the cycle in ’13, and ’14, and ’15, and we’ll be worried about the cycle in ’19, that’s kind of who we are in our DNA, and we just had our annual investment meeting the other day, and I heard an economist say this for the second time, is that expansions don’t just die of old age. You know, there’s got to be a catalyst in the market, and nobody is really, that I’ve spoken to, understands or sees a catalyst out there that’s forming that would kind of ruin the party, as we say, right now. We’re still finding good deals, we’re seeing good opportunities out there. There’s certainly been a softness from the elections, maybe interest rates running up, and I have to think that interest rates, with this 1% increase we’ve seen, ten years now at 2 1/2%, and borrowing costs are up. There’s an impact to pricing out there, because that is one of the functions when you’re looking at leveraged real estate, is the debt price. So, you know, just anecdotally, talking to brokers, they’ve seen slowdown in the market, we’ve seen a slowdown. I know that there was some repricing of assets, kind of, at the end of last year and the beginning of this year, but I’m excited about 2017, and our platform just continues to improve, and we’re seeing good, quality deals, and we’ll continue to just do our best to find those deals that make sense out there.
Adam Hooper – That sounds great, sounds like a good strategy.
Michael Episcope – Thanks.
Adam Hooper – Yeah. Alright, Michael, well, that’s a whole bunch of really, really good information for the investors, and fees, as we said, are something that comes up a lot. You know, key takeaways to me from what we talked about today would be don’t let fees necessarily drive your decision as to which deal you’re going to invest in, as long as there’s some consistency or, you know, market quality to those fees. A lot, like you said, you pick the jockey, not the horse, so the team that you’re investing with is really crucial, and as long as their incentives are aligned, and they’re being compensated fairly for the work that they do, and the value they create for investors, could be a pretty good scenario.
Michael Episcope – I think that pretty much sums it up. Thank you so much for having me, Adam.
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