Why Do Affluent Investors Use OPM?

Successful real estate investors get rich by using other people's money (OPM) to make more money for themselves. They have the contacts and skills to set up arrangements that guarantee a return on investment for their clients. Investors are compensated through both ongoing cash flow and potential gains in value, and the investment manager is given a cut.

Proficient Expertise

Management of investments is a broad discipline with several subspecialties. Managers who are specialists in their field are highly valued by private and institutional investors because they consistently produce superior returns at a manageable level of risk. High alpha managers are those that reliably deliver a favorable risk-return profile for their clients' investments.

Each and every deal sponsor or investment manager aspires to be a "alpha manager." Their ability to recruit and keep reliable investment partners is crucial to their survival. Investors want a boss who can execute their job without interference. All significant decisions must be approved by all partners, but day-to-day operations are left to the deal sponsor.

Over the course of many years of carrying out both straightforward and intricate business strategies, deal sponsors amass the experience necessary to effectively manage CRE investments. Studying failed transactions and dissecting successful ones has given me this level of knowledge. Last but not least, it results from making and keeping connections that enable one to find rare bargains and carry out complex strategic plans.

Locating Expertise

Investment managers that truly excel in their field are easily identifiable. The press in their field adores them because of the high-profile transactions they're associated with. Emerging managers are more difficult to recognize.

Business cycles make it tough to distinguish whether new CRE sponsors were successful because of a solid investment or clever execution. A high alpha manager has the ability to find profitable opportunities in any market condition.

Professional deal sponsors are comfortable with risk. They consciously identify and address possible threats in every aspect of the investment. Risk mitigation measures are well-documented and communicated to every significant participant in the deal.

A good investment manager will be open and communicative with their clients. Expertise does not shy from obstacles.

Seeking Specialists

Specialists are well-versed in a particular field. They recognize that it’s considerably pricier to modify their platform than to seek harder or be more innovative within their area of expertise. With this solid groundwork in place, they may move forward with their business dealings with confidence.

Hotels are a particularly tough asset class to manage. Property and asset management are two different disciplines with a natural, healthy tension. A strong investment manager has separate methods for each discipline that highlights the value enhancement delivered by each.

The marketing and selling that goes into raising money from other sources helps them hone down on their niche. Further, the successful finance of a deal offers another degree of assurance that the company concept is feasible.

Strengths

A physical asset with inherent worth safeguards every real estate investment. That is, the real and personal property are still worth something even if the overall company idea fails. This asset provides reassurance for risk averse investors. It permits them to accept a lesser rate of return in exchange for the right to take over the property in case of default.

Value of Money

A financial pro forma predicts the projected investment return using a particular set of operational and capitalization assumptions. Investors assess returns in absolute – profit and MOIC – and relative terms – IRR and cash-on-cash. Based on these return parameters, investment managers arrange funds for a given project.

The decision to finance a business venture is driven by the cost of capital. There is a focus on risk-adjusted return among lenders and investors regardless of the position of their final dollar. Sponsors care about how much of a premium the predicted return on their investment offers over the blended cost of capital.

Take this as an illustration:

Total Capitalization – $10 million

Annual Net Operating Income – $1 million

Assume the sponsor takes a 70% LTC loan at a 5% interest rate and syndicates 90% of the required equity. The syndication limited partners get an 8% preferred return, and all profits above the 8% is split 50/50 between the sponsor and the limited partners.

$7 million loan @ 5% = $350,000/year

$2.7 million equity partner @ 8% = $216,000/year

$300,000 sponsor equity @ 8% = $24,000/year

50/50 split to equity = $205,000/year each

The cost of capital is 7.71% ($350k + $216k + $205k) on this deal that is returning 10% per year. The deal sponsor takes the remaining 2.29% spread. This doesn’t even account for asset and property management fees to the deal sponsor.

This is an extreme scenario, and it does not consider return of money upon refinance and sale. Still, it is not uncommon for investment managers to achieve significant profits compared to their contribution. Further, most passive investors don’t mind the investment manager’s profitable profits so long as they meet their goal risk-adjusted return.

Note: NOI growth and sale assumptions effect profitability and IRR. Capital costs in a nonchanging environment are not shown here; rather, they serve as an illustration of the simplicity of the scenario.

To Compare Debt and Equity

Other people’s money comes in numerous forms. The two main types of capital are debt and equity, although even these have many subcategories. The major differential between debt and equity comes in the form of rights to the property upon business failure. In the event of default, lenders are granted the right to seize possession of the property and get first priority on any cash flows generated by the loan.

Lenders issue two categories of debt - senior and subordinated. This is because the senior loan is at the bottom of the capital structure and so represents the lowest possible risk. Subordinated debt, often referred to as mezzanine debt, is a more adaptable financing option that falls directly below the senior loan in terms of payment priority.

The risk taken by mezzanine lenders is higher than that of senior lenders. However, they have an opportunity to seize ownership of the property following default so long as they don’t allow a default on the senior loan.

Because of this structure, the senior lender is exposed to more risk. When it comes to loans, many senior lenders won't allow mezzanine debt to linger in the background. Therefore, most projects with mezzanine debt employ the same lender or the mezzanine lender has an excellent connection with the senior lender.

Due to the inherent uncertainty of an equity investment compared to the safety of a debt holding, equity tends to command a higher return than debt does. In the event of a corporate failure, investors are also completely defenseless. Therefore, transaction sponsors extend the loan proceeds as much as feasible to reduce the blended cost of capital.

While debt is more accessible, equity is considerably more flexible. There are two main types of equity, and they are called "common" and "preferred." Preferred equity is more like a mezzanine loan with minimal default protection. Common equity carries the complete risk of the acquisition, but it also benefits from all the reward.

Foundation

Each agreement has a unique structure.

Experienced investment managers provide integrated platforms, sophisticated procedures, and access to unique possibilities. You can only make as many deals as the platform and balance sheet allows, therefore it’s crucial to manage these resources properly. Wealthy managers prefer to invest as little as possible even though they seldom get away with no money down.

Investors enjoy when transaction sponsors give a fraction of the total equity - “skin in the game” – but this is not a necessity. Many developing managers may not have the finances to contribute cash to the acquisition. However, they provide skills and networks that allow them to generate sweat equity.

Joint ventures and syndications are the conventional strategies to incorporate other people’s money.