The term “alignment of interests” is used so often in commercial real estate investing that one could argue that it has become nothing more than a marketing term. Yet its overuse should not diminish the gravity of this fundamental investment term. Anytime someone passively invests in a real estate syndication or fund, it is critical that their interests are aligned with the sponsor’s.
Guaranteeing that alignment of interests is easier said than done.
In this article, we look at how Rastegar’s no-fee investment approach creates an inherent alignment of interests that is simply unheard of among other companies in the industry.
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Creating Mutual Self-Interest
Whenever someone talks about “alignment of interests,” we are reminded of a Nietzsche quote who said:
“I don’t believe in trust. What I believe in is mutual self-interest.”
That resonated with us as we set out to build the Rastegar investment approach.
While the Nietzsche quote might initially sound cynical, it makes all the sense in the world. When we set out to create our business, we decided that we did not want to be in the fee business. We wanted to be in the performance business. This is how we ensure alignment of interests.
What is Alignment of Interests in Real Estate Investing?
"Alignment of interests" in real estate investing refers to the idea that the goals and incentives of different parties involved in a real estate deal (e.g., the sponsor and its investors) should be closely aligned. This ensures, for example, that the sponsor remains highly motivated to achieve the profit margins as originally described in their offering.
There are a few key aspects of alignment of interests in real estate investing:
- Sponsor-Investor Alignment:
In a real estate partnership or joint venture, it is crucial for the interests of the sponsor (i.e., syndicator or operator) to be aligned with the investors (limited partners). This means that both parties should have a shared goal of maximizing the value of the investment and achieving the targeted goals and outcomes.
- Risk and Return Alignment:
Sponsors and their investors should have aligned views on risk and return. This includes a shared understanding of a deal’s risk profile, the target returns, and projected investment time horizon. For example, someone looking for relatively modest but “safe” returns may be more attracted to investing in a Class A, already stabilized and cash flowing asset than they would a ground-up development that is inherently riskier.
- Transparency and Communication:
Open and transparent communication between the sponsor and investors is essential for maintaining alignment of interests. Investors want to be informed about the progress of the investment and any significant developments that may impact their returns. Typically, sponsors are advised to over-communicate. This way, in the event of an unforeseen circumstance (e.g., the Covid pandemic), investors will trust that the sponsor is working diligently on their behalf to resolve the issue to the best of their ability.
- Incentive Structures:
A deal’s incentive structure, such as performance fees or profit-sharing arrangements, can also be structured to align the interest of sponsors and their investors. These structures can do more or less to incentivize the operator to maximize returns for their investors.
- Exit Strategy:
The sponsor should have a clearly defined exit strategy that aligns with the interests of their limited partners. That includes a plan for how and when the property will be refinanced or sold to maximize returns.
Rastegar Goes Above and Beyond to Ensure Alignment of Interests
In addition to the above, which we believe are all important, Rastegar has made a few key business decisions to fundamentally guarantee that our interests are aligned with our investors.
For example, people often talk about a sponsor needing to have “skin in the game”.
Defining skin in the game is arbitrary. Some will argue that a sponsor should contribute at least 5 or 10 percent of the equity toward a deal. Depending on the size of the deal, this may or may not be possible. What truly matters, though, is that the sponsor’s equity investment is meaningful. In other words, if a deal went sideways, it would be painful – even devastating – for the sponsor. Therefore, they will do everything they can to keep the deal on track.
- 100% of our net worth is in the business.
At Rastegar, we take “skin in the game” to the extreme. In fact, 100% of our founders’ net worth is tied up in the business. That is to say: the entire future for our families, for our children, depends on the outcome of the investments we make.
- We do not take any fees.
It is very common for real estate sponsors to take fees for certain aspects of the business—this includes, but is not limited to, acquisition fees and disposition fees, management fees, capital raising fees, and more. The rationale for most sponsors is that they deserve to earn some sort of commission for their active role in overseeing the deal. Moreover, it helps to “keep the lights on” when they have a team of people working on the ownership’s behalf.But we do not take fees. Any fees. None. This means that for us to make any money at all, the deal must result in some alpha beyond the preferred return hurdle for investors. Only when our deals are successful will we be paid. That keeps us wildly motivated to see our deals through to completion, on time and within budget.
- Our structure ensures investors are repaid first.
Not only do we not take fees, but we do not take any share of the profit (distributions) until our investors have been paid. This puts our investors’ interests ahead of our own. Investors get their money back first, plus their accrued or paid preferred return, and then there is some split of the profits thereafter (and to this point, investors do not have to trust us, they just need to look at the investment documents where this is spelled out and legally binding!).We built this alignment of interests into the inherent structure of how the investment distributions function. Investors win. We win. In that order.
IRR vs. Equity Multiple as a Return Metric
Many sponsors use the concept of the internal rate of return, or IRR, as the metric for measuring performance and delivering results.
- What is “IRR” in Real Estate Investing?IRR, or the internal rate of return, is a metric used to evaluate the profitability of an investment over time. It represents the annualized rate of return that an investor can expect to earn on their investment, considering both the timing and magnitude of cash flows. A higher IRR generally indicates a more attractive investment opportunity as it suggests a higher rate of return. Calculating IRR is complex and is often done using financial calculators or software.
However, we believe that IRR is an antiquated mode for evaluating returns. While IRR does account for the time value of money, that same factor can cause reported IRR to become skewed.
For example, if a sponsor purchases a piece of land and then rezones it, that instantly increases the property’s value – often, exponentially. Without having built anything, the IRR becomes infinite.
IRR should not be discarded in its entirety. However, investors are best served by using IRR in the context of how much cash flow they are earning from a deal, and that investment’s timeline.
At Rastegar, we do not like our money to be tied up for too long. This is directly correlated with the fact that we do not take any fees; we need to exit our deals in order to make our money.
True performance, in our opinion, is best evaluated by looking at the equity multiple and the conglomerate cash flows on an absolute basis.
- What is “Equity Multiple” in Real Estate Investing?
Equity multiple is a metric used in real estate investing to measure the return on an investment relative to the amount of equity invested. It is calculated by dividing total cash distributions (such as rental income or sales proceeds) by the initial equity investment. For example, if an investor puts $50,000 of equity into a property and receives a total of $100,000 in cash distributions over the life of the investment, the equity multiple would be 2.0. This means that for every dollar invested, the investor receives $2.00 back.
At Rastegar, we aim to double investors’ money in that investment horizon discussed above. We are not looking to sell for a short-term capital gain; we are also cognizant that there are some macroeconomic factors outside of our control that may influence when we exit a deal. However, in general, we aim to achieve a 2x equity multiple within that timeframe. Sometimes it is more; sometimes it is less. This is why we typically encourage investors to do multiple investment as a way of mitigating risk and diversifying their portfolios.
Using the equity multiple also allows investors to evaluate deals on a risk adjusted return basis; they can benchmark these opportunities to other investments. For instance, if someone is trading liquidity by investing in a real estate deal, that deal best be performing the market.
Building in Downside Protection
Forbes once referred to us as the “Oracle of Austin,” as though we are some psychics who can predict the future. While we appreciate the recognition, we believe that our ability to outperform the market is directly attributed to the thorough research we do in the markets where we invest.
Our robust due diligence period helps to ensure that we protect investors’ capital. Our first objective is always “Don’t lose money!” Making money will always be secondary to us. But we believe that if you understand the downside property, it increases the probability of making money on the back end.
Conclusion
There are countless real estate sponsors with whom someone could invest. When evaluating these opportunities, prospective investors should really take the time to understand what is motivating that sponsor to act on their behalf. Do they have real skin in the game? How and when will they be paid?
Too often, investors are lured in by crafty salesmanship that clouds the details of the partnership. Just as sponsors must conduct robust due diligence on their deals, investors should conduct equally robust due diligence on their sponsors and the terms of their agreement. Understanding the structure will help you determine whether your interests will truly be aligned.
