Alpha Investing has been around since 2014 and I've been partnering with them the last year or so, including meeting them in person at PIMDCON in October. They will be coming to WCICON20 too as a sponsor. A fair number of white coat investors have invested with them in the last year. They have been connecting investors and sponsors for the last 5 years and are now coming out with their first fund. Katie and I are looking at investing and are now doing our due diligence. I figured, why not bring you along for the ride?
In this post, I'll be talking about what we're looking for and then share some of the questions I like to see answered before I invest. Although this isn't a sponsored post (I retain all editorial control), I certainly do get paid advertising fees by Alpha Investing and in fact, serve on an advisory board for the company. I'm still going to shoot straight with you though, and so will Fark Tari, the CEO who provided the answers below to the questions I ask. At the end, I'll talk about our decision-making process.
What We're Looking For
As long-term readers know, our portfolio is 60% stocks, 20% bonds, and 20% real estate. The real estate allocation is divided up 10% equity, 5% debt, and 5% publicly-traded REITs via the Vanguard REIT Index Fund. Up until this year, we've thrown our WCI network blog investments into that real estate allocation because it seemed the best place to put them. But they're really not real estate and frankly they've grown so quickly that they now dominate this allocation. So this year we're removing them from the allocation, which of course leaves us short in the equity real estate department. So it's time to put some money to work in there.
As a general rule, Katie and I prefer funds to individual properties/syndications due to avoiding the hassle of choosing individual investments and the additional diversification. The main downside is a second layer of fees and usually, more complicated tax returns. The purpose of this 10% equity investment is high returns, preferably with any cash flow covered with depreciation. Aside from those returns and tax benefits, we're also trying to earn a premium for being willing to be illiquid for years. These properties tend to be smaller and less stable (i.e. more room for improvement) than the bigger, already stabilized investments you might find in a publicly-traded REIT. We find residential (residential, student housing, senior housing etc) properties to be easier to understand and frankly expect they will do better in an economic downturn since people are MORE likely to rent in a downturn and will need a place to live anyway. So to recap, we want the following:
- Diversified fund
- Depreciation pass through (unlike in a REIT structure)
- Experienced managers/sponsors
- Long hold period
- Reasonable amount of leverage
All right, let's get into our questions and see if this meets our criteria.
Fund vs Individual Syndications
WCI: You have been successfully connecting your network of sponsors with your network of accredited investors since Alpha Investing was founded, now with 43 different syndications. Why are you now changing your business model to a fund? What is the benefit to your sponsors, to your investors, and to you?
Fark Tari, CEO of Alpha Investing: We view Alpha Investing Fund I as an addition to our existing business model rather than just a change. The intention is for the fund to primarily invest alongside Alpha syndicates. We believe that the fund will lower risk for fund investors through diversification, while still allowing us to target similar returns relative to our existing parameters. All else being equal, we believe this generates a stronger risk-adjusted return. It also provides positive benefits to our existing syndication model as well. It is our expectation that the combination of the fund and individual syndications will, on average, allow us to secure larger capital allocations in the opportunities we invest in, which we believe will be beneficial to all parties. Over the course of time, we believe this will yield better investment terms for the entire network.
WCI: What are the downsides to sponsors, investors, and you of moving from the syndication model to the fund model?
Alpha: On balance, we expect the fund and the individual syndication model to be complementary. However, there are scenarios where there could be conflicts between the two. For example, if there is a project where there is a limited allocation, it may not be possible to invest through both avenues. This is the primary potential downside.
WCI: How will you decide if a deal goes into the fund or is offered separately as a syndication? Where will the best deals go? Do you expect to have fewer individual offerings on your platform?
Alpha: We expect the syndication and fund models to be very complementary. Generally speaking, the amount of equity we invest in transactions is only a fraction of the available equity. If we have multiple pools of capital to pull from and can offer certainty of execution to sponsors earlier in the process, we can secure larger capital allocations in these transactions. As such, we do not expect a decrease in the number of individual offerings on our platform. We generally target 8 – 10 equity transactions a year for the individual syndication model. Subject to market conditions, this will not change. There could be scenarios where there is a conflict between individual syndications and the fund. We will manage these scenarios on a case-by-case basis.
Nuts and Bolts and Aligning Incentives
WCI: How large of a fund are you aiming for, i.e. how much money and how many deals? How will you decide when to close the fund and what is your best guess for when that will occur?
Alpha: We are targeting ~$10 million and expect to allocate that capital across 10 – 12 assets. We are limited to 99 total investors and will close the fund when this limitation is reached. We expect that to occur in Q1 2020.
WCI: How much money will the five leaders of Alpha Investing be putting into this fund? What about the sponsors?
Alpha: All Alpha principals are substantially invested in the overall Alpha Investing platform, and also have a meaningful amount of capital invested in past Alpha transactions. Through our first ~20 transactions, at least one of the firm’s principals and/or our immediate family members were invested in each. But in transparency, this is not sustainable for us to maintain, particularly as we significantly increase the size of our platform and the number of investors that we work with, and as we continue to forgo short-term compensation in furtherance of building a long-term, sustainable real estate investment platform.
On this topic, it’s important to note that part of our evaluation of a sponsor is related to how much of their capital they put into deals. Typically, this falls in the 5% – 10% range. Sponsors having skin in the game is of significant importance to us given that they are the ones that are ultimately responsible for the execution of the business plan for any given investment.
[Editor's Note: I have committed $50K to this fund, but may increase that number depending on my own personal finances and opportunities over the next couple of months.]
WCI: What is the investment minimum? How did you decide on that number?
Alpha: The minimum is $50,000. Given that we expect to invest in 10 – 12 assets, an investment at the minimum will yield an average investment between $4,000 and $5,000 per asset. This is significantly lower than our current minimum of $10,000 for individual transactions, so investors will still benefit substantially from reduced minimums relative to the amount of diversification that the fund will provide. In short, we wanted to create a minimum that we believed was still accessible, but that also still made reasonable sense when considering the number of assets the capital would be allocated to.
WCI: What types of investments will the fund invest in?
Alpha: Our representative asset classes are multifamily, senior housing, and student housing. ~90% of our existing equity portfolio has been invested in one of these three asset classes. The underlying rationale and strategy behind this is discussed in great detail in our fund materials. We expect at least 75% of the fund capital to be allocated to investments that reflect our existing investment strategy. We will reserve up to 25% of fund capital for more opportunistic transactions. This could include development deals, or opportunities in other asset classes such as office and retail.
WCI: What states will the fund invest in and how will location affect whether or not the fund invests in the deal? What are the tax consequences going to be for investors? What states are your current sponsors doing their deals in?
Alpha: Our sponsors collectively invest all across the country. To date, we have invested in 18 different states. States, where we have more than one investment, include Arizona, California, Georgia, Michigan, Missouri, North Carolina, Ohio, Texas, Virginia, and Washington. There isn’t a predetermined list of states the fund will invest in, but we would likely expect to see it make investments across 5 – 7 states. Because the fund is expected to invest in properties across multiple geographies, investors may also need to file state income taxes in the states where the properties are located. Investors should always consult their CPA or tax advisor on these topics.
WCI: I understand the fees on the fund are a 2% upfront fee, a 0.5% annual management fee, and an 80/20 split after the preferred return of 10%. What was the process for deciding how much to charge in fees and why did you choose this particular fee structure?
Alpha: This fee structure is the same as our individual syndications. The origination and management fees are used to cover our costs associated with legal, accounting, management, underwriting, and diligence, etc. In short, we try to structure our fees to allow us to make enough money on the front end to keep our lights on, then on the back end, we are only compensated if we can exceed a 10% average annual return threshold for investors. As such, we are incentivized to identify sponsors and transactions that we believe can perform well over the medium and long-term. We also believe that this fee structure is substantially less dilutive than the standard 2% management fee and 20% carry that still exists across many private equity asset classes.
WCI: How does the promote work exactly? Is there a catch-up? i.e. if the return is 20% on the fund, is the promote 2% or 4%?
Alpha: There is no catch-up, the 20% carried interest is only applied on returns in excess of the 10% average annual return.
WCI: I assume these fees are on top of what the sponsors will charge on each individual deal. What are their typical fees?
Alpha: Correct, because we are capital aggregators, we charge fees for providing access at reduced minimums, doing underwriting and diligence, forming and managing entities, etc. Sponsors do charge separate fees on each individual deal. When vetting a sponsor, we evaluate the economic structure of a sponsor’s deals to understand how the sponsor is paid. While these structures vary from deal to deal and sponsor to sponsor, we seek structures that align incentives (i.e. performance-based fee structures) and require all our sponsors to co-invest in every transaction to ensure better alignment with our investors. A typical structure from a sponsor may be a 70/30 split over an 8% preferred return, with a sponsor investing 5 – 10% of the total equity.
WCI: How much will investors be paid until deals are purchased and where will that money be invested? How safe is that investment? What happens on the back end as investments are liquidated? Does that go back into this investment or will it simply be returned to investors one deal at a time as they are liquidated?
Alpha: All capital will be called at the time the fund closes. During the capital allocation window, Alpha Investing will keep ~10% of the fund capital in cash, and park the remaining capital with Wedgewood Enterprises (“Wedgewood”) through a liquid promissory note. Founded in 1985, Wedgewood is a highly established and successful private real estate firm. As a leading acquirer of distressed residential real estate, Wedgewood has grown to a multi-billion dollar, vertically integrated real estate platform. Two of the founding partners of Wedgewood are investors in Alpha Investing, and originally incubated the firm in 2015. The aforementioned note will pay a fixed 4.5% interest rate. Given that Alpha Investing will keep some of the fund capital in cash, this will allow Alpha Investing to pay investors ~4% on unallocated capital during the fund’s ramp-up period while maintaining the necessary flexibility to reallocate fund capital to real estate assets as opportunities become available.
It is important to note that the Wedgewood promissory note is being created specifically for Alpha Investing Fund I due to our relationship with the firm’s leaders. We believe this allows us to structure the fund in a way that is ultimately more beneficial to investors, given that they will receive an economic return on their capital while waiting for it to be deployed.
WCI: Do you expect to facilitate an opportunity to 1031 exchange this investment into another when the fund is liquidated in 6-7 years?
Alpha: This fund will not be able to facilitate a 1031 exchange.
WCI: Let's talk about your track record. What returns have your investors seen, both IRR and cash on cash? How does that compare to the pro-forma projected returns? How many deals have matched or are matching or beating pro-forma and how many are underperforming pro-forma?
Alpha: There are 38 transactions that represent the 43 properties we have invested in (a few transactions have multiple properties). To date, 12 of the 38 transactions are partially or fully realized.
- Of those 12, seven currently are or have outperformed expectations. One of these seven sold at a 27.1% IRR, and the other six, if sold today at their appraised values, would all yield investor returns in excess of 25% IRR (in some cases, well in excess of even 30% IRR).
- Three of the 12 have been in line with expectations.
- Two of the 12 have underperformed. In the worst one, we returned capital to investors.
Of the 26 unrealized transactions, four of them closed recently enough to where there isn’t enough meaningful performance data to start drawing conclusions yet. For the rest, we evaluate monthly financials and keep a very strong pulse on current performance and future expected performance. With the information we have available now, there are four or five that are on track to significantly outperform expectations. Similarly, there are four or five that will significantly underperform expectations. The rest are on track to ultimately be in line with expectations.
There are two additional points worth making here. First, there absolutely is risk in all the investments we participate in. Everything does not always go according to plan. This is part of the reason we believe that a fund makes sense. Having exposure to a diversified portfolio of transactions can yield a more stabilized return with lower risk. For example, an investor with exposure to all our current investments would consistently be receiving a high single-digit cash-on-cash return, with significant further upside potential from capital events.
Second, these are long-term investments, and shouldn’t be evaluated on a quarter-by-quarter basis. For example, one of our investments made earlier in 2019 has yielded an annualized return of 1.4% thus far, compared to Y1 projections of 2.6%. At face value, this looks like underperformance, however, the investment is actually on track to significantly outperform expectations. The property in question is 488 units in Phoenix, AZ. Through 6 months, the sponsor renovated 84 units (~17% of the property), compared to 36 renovations projected in underwriting. 83 of the 84 units had been leased at 30% rent increases, compared to 27% increases in underwriting. In short, the sponsor has significantly accelerated the pace of renovations due to very high demand and is achieving higher rent increases than underwriting. If one looks only at the cash yield, it looks like the asset is underperforming, but we maintain a much deeper level of understanding as it relates to the performance of the assets in our portfolio, and have an open line of communication with all sponsors that we invest with.
WCI: Alpha Investing has been open since 2014 and has done deals on 43 different properties. But only 3 of those deals have fully gone round trip with another 9 being partially realized, and all of this in a relatively favorable real estate environment. While this isn't a bad track record, it isn't a very long one. Why should investors invest with you instead of somebody with a 10-20 year plus track record?
WCI: What returns do you expect investors in this fund to get? What is the best-case scenario? What is the worst-case scenario, both with regards to liquidity and returns?
Alpha: We are targeting a 14% – 17% investor IRR, with an initial cash-on-cash return in the 5% – 6% range, and average cash-on-cash returns over the life of the project in the 7% – 9% range. While it is possible that we could outperform these targets, we are focused on providing a set of return parameters that we believe is realistic given where we are in the market cycle.
While we believe the likelihood of a loss of capital is very small, it is, of course, possible that an investor could lose all their money. As with any investment, losing all of your investment capital is the worst-case scenario. Of course, investors cannot lose more money than they invest (i.e., they are limited liability investors). With that said, an investor should not invest with funds that they cannot afford to go without.
The Market Cycle and Alternatives
WCI: You guys, like many other real estate companies I have heard from recently, seem somewhat cautious about where we are at in the real estate cycle. You say, “We are now in a more mature stage of the market cycle where rent growth and real estate appreciation are expected to be more moderate compared to prior years. Furthermore, we are seeing numerous mixed signals related to the overall macroeconomic conditions.” Given this, why should we invest in real estate at all? Why not invest more in stocks and/or bonds?
Alpha: We are of course cognizant of the fact that we are in a much more mature stage of the market cycle. However, we still believe there is a positive foundation for commercial real estate investments. Our focus is to align ourselves with high-caliber sponsors and invest primarily in what we deem to be need-based asset classes. More comprehensive information on our investment strategy and the benefits of investing in private real estate can be found in our fund materials. With that said, it’s very important to note that we are never trying to convince anyone that they should invest in real estate as opposed to stocks, bonds, or other investment options. If someone isn’t already interested in investing in real estate, we likely are not a fit for them. It’s not our role to talk an uninterested party into investing. However, we have found that there are a lot of individuals proactively looking for a way to access private real estate opportunities. We are interested in forming new relationships with such individuals, sharing what we’re doing, and allowing them to decide whether the Alpha Investing approach makes sense within the context of their individual investment strategies.
There are many common themes from the conversations we have. People often feel that they have too much exposure to the public markets and are looking for ways to further diversify their portfolios. People are looking for more tax-efficient investments. People are often interested in getting passive exposure to private real estate investment opportunities, as opposed to actively managing real estate on their own. We also find that there are a lot of people that have a genuine interest in private real estate but are sometimes hesitant to put too much capital into just one deal because they don’t feel that they have enough of an understanding of the investments. Alpha Investing’s approach can be very beneficial to such investors, because we take the time to build individual relationships with our investors, and we are happy to walk through case studies, answer specific questions, and help someone develop a deeper understanding of the types of transactions we participate in. And now, we are developing a fund vehicle that will provide a greater level of diversification.
Alpha: Again, we don’t believe our role is to tell someone that make an investment with us in lieu of other options. Rather, we are interested in connecting with investors that already have a genuine interest in getting exposure to the types of opportunities we provide. Our goal is to build individual relationships with such prospective investors, them ultimately allow them to decide whether what we’re doing is a fit for them.
With that said, there are some factual differences that we can point out between a private real estate fund like Alpha Investing Fund I vs. the Vanguard REIT Index Fund. An index fund is a diversified, liquid investment. But it is also correlated with the public markets. In addition, a REIT does not have the same tax benefits that exist in private real estate. A private real estate fund like Alpha Investing Fund I is not liquid. However, it is also uncorrelated to the public markets, and can therefore provide a greater degree of diversification in one’s overall portfolio. The investment opportunities within the fund are also generally expected to receive preferential tax treatment due to the use of depreciation, which often allows current distributions from investments to be tax-deferred.
One other potential consideration relates to transparency of information. REITs are sometimes criticized for their lack of transparency and high fees. Informational transparency is critically important to our approach and investors will have access to a full diligence room along with quarterly reports and the financial performance for each investment. Our team is also available to answer questions about specific properties and their performance. This is typically not available through a public REIT.
Ultimately, it’s up to every individual investor to decide what investment opportunities make sense for them. Alpha Investing is simply interested in building relationships with individuals that have a preexisting interest in the types of offerings we provide.
[Editor's Note: REIT distributions are now eligible for the 199A deduction, but that only makes a very tax-inefficient investment slightly less tax-inefficient. I still generally recommend REIT investments be placed into a tax-protected account. Equity real estate, on the other hand, passes depreciation through to its investors, often shielding a significant portion or even all of the income from an investment from immediate taxation, especially with the new accelerated deprecation rules. Equity REITs also tend to invest in larger properties in a later stage of the development cycle. This generally means lower, but more stable returns.]
WCI: Where can investors learn more?
www.alphai.com. For any non-member who is interested in learning more, please request access to schedule a call to speak with one of the firm’s principals. An introductory call is required before an investment can be accepted.
My Thoughts on Alpha Investing Fund I
So I've reviewed the fund materials and asked all the questions I was left with afterward. Now we get to the point where the rubber hits the road. Let's talk about what I like and what I don't like.
What I Like
- Good track record – I'll be plenty happy if they can produce their projected returns and exceedingly pleased if they get anywhere near their past returns. I like seeing track records that match or beat pro-formas.
- Appropriately aligned interests – Most of the manager's return will come from the carried interest. If they don't perform, they don't get paid very well.
- Invests in the asset classes I am interested in – Mostly multi-family and other residential property
- Annualized fund fee of ~0.75% – Much lower than many other funds and crowdfunding platforms.
- No catch-up on the preferred return. They get 20% only of the return above 10%.
- Relatively low minimum – only $50K for the fund, but if that's too much, the individual investments on the platform only require $10K.
- I like that my money is earning 4% while waiting to be deployed. The other acceptable alternative to me is to call capital only when you have an investment ready to be deployed, but that can result in some very long time periods when you have money committed but not invested.
- A fund I have a business relationship with. I try to get every company I invest with to invest in me and am pleased when they do. So far, Vanguard keeps turning me down.
What I Don't Like
- Going to require multiple state tax returns. Not unique to this fund, but could be avoided by picking individual syndications in Utah, the seven tax-free states, and other states where I am already filing returns.
- Two layers of fees. Another standard downside of a fund. At least they're lower than usual.
- Blind asset pool. You don't yet know the exact properties you will be investing in. Essentially you're buying the fund manager, not the properties.
- Short track record for fund managers. It would be nice to have a fund manager who has managed through an entire real estate cycle. This is becoming harder and harder to find each year as we get further away from the 2006-2010 debacle.
- Minimal fund manager capital invested in this particular investment. As a general rule, I think it aligns interests better when managers lose real money rather than just potential carried interest when an investment goes bad. I do agree with them that the sponsor co-investment probably matters more though and I understand that we all have limited capital.
Katie and I are going to invest at least $50K in this fund. If you'd like to invest alongside us, you know what to do. As always, you must be an accredited investor, there are no guarantees, and this is an introduction, not a recommendation. I had someone ask me recently, “Would the 2011 WCI invest in these sorts of investments?” The answer to that is no, because the 2011 WCI wasn't an accredited investor. It just takes a certain amount of money to be able to maintain appropriate diversification with investment minimums of $25K, $100K, or more. Consider someone with a 10% portfolio allocation to real estate. If minimums are $50-100K, you would need a portfolio of at least $2M in order to split that up into at least 3 different investments. It just isn't practical with a six-figure nest egg. Luckily, these investments are always optional. You do not need to invest in them in order to reach reasonable financial goals if you combine a physician income, a decent savings rate, and a reasonable portfolio of boring old index funds. But if you find the returns, lower correlation with stocks/bonds, and the tax benefits to be an attractive combination, take a look.
What do you think? What questions do you ask before investing in a private real estate fund? What answers do you like to see? Have you invested with Alpha Investing yet? What was your experience like? Comment below!