Importance of a Good Origination Platform
A key element of all successful SBRE entrepreneurs is their capacity to originate and/or acquire attractive assets consistently. What methods, mechanisms, and systems do they have to dependably originate and/or acquire their deals? What is their platform to do so and what makes it effective, differentiated and sustainable? While there are any number of different ways of doing this, most people attempt to execute similar origination strategies by copying (intentionally or not) what others are doing. For the most part, people tend to do things the way everyone else does them. The natural human tendency is to believe that doing what many others are doing must be the best way to do something. It feels safer. It seems proven. The irony, of course, is that the truth is often exactly the opposite. Invariably, doing what everyone else does creates more competition rather than differentiation. Although differentiation creates lasting value, going one’s own way can be very difficult. Innovating is painful, but worth it. When you have nothing that truly sets you apart, people tend to make decisions based on price. This often erodes either margins or underwriting quality, or both. Either way, it makes success difficult to achieve consistently over the long haul. For these reasons, we believe it is very important to have an intelligent and differentiated – ideally unique and powerful – origination strategy and platform in order to reliably attract deals that do not require the SBRE entrepreneur to stretch standards or compromise underwriting criteria in order to win and close deals. We strive for this ourselves and we look for it in others.
Part of the reason this is important from an investor’s standpoint is that there is a very real danger that if an SBRE entrepreneur is successful at raising investor capital, which can often be the result of effective marketing, personal charisma, or other such factors, he or she may feel compelled to invest that capital in whatever deals are available, whether they meet prudent underwriting guidelines or not. In a perfect world, the SBRE entrepreneur only invests in high quality, well underwritten deals with very attractive risk adjusted returns. The world is not perfect, however, and finding such deals is the Holy Grail that everyone is pursuing. Since many people often use a similar or identical origination strategy to find them, as more and more players jump in, they all chase the same deals as markets heat up. This drives prices upwards, yields downward, and pressures underwriting standards. If the SBRE entrepreneur does not possess a well-built origination platform, quality deal flow gets harder under such circumstances. He then faces a choice to either not accept the capital (if he is very disciplined, as refusing it will be to his own short-term detriment due to less fees being earned) or, quite often, he simply accepts more risk for his investors for the same (or lower) return, even as he makes a greater income for himself in the short run by being more aggressive in the deals he chooses to deploy money into. For many, the only way to attempt to deploy capital (and earn greater fees) and to maintain yield is to take greater risks, which the market may very well cover up in the short run. Ironically, he can often then attract even more capital in the short run and the cycle repeats itself. This is a fundamental misalignment that can exist between SBRE entrepreneurs (both fund managers and syndicators) and their investors which can be quite difficult to resolve. Integrity in a manager is extremely important, of course, as is alignment of deal structure, but money can do funny (or scary) things to people in the moment of truth.
Let me give an example of this dynamic in one sub-segment of the SBRE industry, the bridge lending business. I am not picking on this sub-market but rather attempting to illustrate my point in simple terms. In times like today where virtually all markets are seeing strong appreciation, it is very difficult to lose money in the bridge lending business no matter how sloppy the underwriting may be. In fact, I believe this to also be true in the fix and flip business, the value add business, and many other sub-strategies within the SBRE industry in the current environment. While markets like this are easy for people (including us) to have strong results in the short run, a disciplined underwriter will also try to be very conscious of the potential impact of today’s investment tomorrow on an assumption that markets may soften considerably. Unfortunately, in the current environment, many new operators flock into the market and make loans at ever increasing advance rates (loan amount as a percentage of the property’s value or “LTV”) and ever lower interest rates and fees. Property appreciation is currently covering up almost all carelessness in underwriting and/or over-aggressive lending practices and thus most people look very smart right now even if they may be laying the groundwork for their own problems that will not be noticed until market conditions deteriorate. If deals go full cycle in a timely manner, things work just fine. And so more and more players come in and exacerbate the pressure on LTVs and rates, which makes it more difficult for the diligent underwriter to originate product, and all seems well until property values eventually stagnate or drop. This may not happen for quite some time yet (I personally believe there is a lot of runway still which will lead to more of what I am describing), but when equity in the property securing the loan eventually erodes or disappears, borrowers lose their incentive to pay and these lenders experience greater delinquencies and defaults. Depending on a variety of factors, including but not limited to their capital structure, they will then experience challenges ranging from moderate to severe and even, for the most egregious of practitioners, to life threatening. When that inevitably transpires for some people, however, it will then represent new opportunity for other SBRE entrepreneurs pursuing different strategies and the cycle of SBRE will continue in new form.
One of the fascinating dynamics of SBRE as we define it is that there are a wide variety of different strategies and sub-strategies, markets and sub-markets, and niches and sub-niches within this industry, not all of which move in the same direction or at the same speed at the same time. It is therefore very hard to make generalizations or blanket statements about SBRE without significant qualification of those statements. A question we get all of the time from investors is “a rising tide lifts all boats, so what happens to your funds when the markets turn?” People have a tendency to automatically assume that if the market softens, this will always result in negative consequences. This will of course be true for some deals, some funds, and some entrepreneurs, as it very well could be in the hypothetical (but very real) example I describe above. But it will absolutely not be true for other deals, other funds, and/or other entrepreneurs pursuing different strategies or who have greater underwriting discipline. One of the great challenges for fund managers is to devise and execute an investment strategy that enables them to originate or acquire a variety of asset types at various times in the market cycle without getting outside their areas of expertise. Figuring out how to build one’s origination platform in a way that will afford him or her looks at quality opportunities of different types as markets gyrate is not easily achieved. Thus, both a reasonably broad investment strategy and a strong origination capacity are important elements for us as fund investment managers to consider when working with SBRE entrepreneurs. We believe it should be for investors as well.
Matt Burk is founder and CEO of Fairway America, LLC, and SBREfunds.com, and Chief Investment Officer of Fairway’s two proprietary nationwide small balance real estate (SBRE) asset based pooled investment funds, Fairway America Fund VI, LLC, and Fairway America Fund VII LP. Fairway is the nation’s premier consulting, advisory, and investment firm in the SBRE private pooled investment fund space, providing a full spectrum of practical, real world products and services (including capital) needed for true success for SBRE entrepreneurs all over the U.S. Matt is a highly regarded adviser, consultant, and mentor to dozens of SBRE fund managers and author of a widely read blog followed by serious SBRE entrepreneurs and investors. For over 20 years, Matt has led Fairway’s deal underwriting as well as capital raising efforts in Fairway’s seven proprietary funds and individual trust deed investments, resulting in more than $250,000,000 in capital raised from accredited investors through more than 1,000 SBRE deals. He is currently working on multiple SBRE fund consulting engagements nationwide, authoring a book on how to raise capital for and effectively manage pooled investment funds, and dedicating his efforts to create greater awareness and drive more capital to the many high caliber and deserving SBRE entrepreneurs around the U.S.