Part 2: Real Estate Is The Infrastructure of Our Lives

We are generally thinking about real estate investing in the wrong way. We have to start treating buildings more like infrastructure. After all, isn’t real estate the infrastructure of our lives? Infrastructure is defined as any essential service or facility needed to generally support and sustain society. Based on this definition aren’t homes, apartment buildings, office complexes, shopping centers, and agricultural land all examples of infrastructure? Do they not provide food, shelter, and safety in our everyday lives? The most basic human needs in modern day life are inextricably linked to real estate. In his book The Green New Deal the economist Jeremy Rifkin writes that,

“Buildings are the skin — the semipermeable membranes that allow our species to survive the elements, store the energies and other resources we need to maintain our physical well-being, provide secure and safe places to produce and consume the goods and services we require to enhance our existence, and serve as a congregating place to raise our families and conduct social life.”

But, because we have created a financial system where buildings need to be bought and sold every 5–7 years in order for this system to work, property values and rents are pushed up at an ever-accelerating pace, making the infrastructure of our lives unstable.

The good news is that we already have another investing model that can easily be applied to real estate funds: infrastructure investing. When a city wants to build a new airport, bridge, or toll road they often raise money for the project from institutional investors through infrastructure funds. Once the project is complete, the investors begin to earn income every year from the profits generated by tolls, fees, and other revenue sources. Infrastructure investments are similar to commercial real estate–-both commercial real estate and infrastructure investments are made in physical assets that produce a steady stream of income each year back to the investors. We call these income-producing assets. However, nobody expects an airport to be sold every 5–7 years to new owners. Infrastructure investments are less risky, longer-term bets where annual expected returns tend to be slightly lower than real estate.

The Basics of Real Estate Private Equity

The real estate private equity structure used today was imported wholesale from the general private equity industry, which is focused on buying and selling companies which do not produce income throughout the investment. Instead, you put money in year 1 and then hopefully you get a lot more back in year 7. Real estate, however, is income producing, which is why it is perfectly suited to large institutions that do not need to make such large returns over a short amount of time. It is actually better for them to make less money each year but over a long period of time. This is what they fundamentally need to fulfill their obligations to their members/pension holders. But, we created a real estate private equity industry with layers of fund managers and consultants who all need to make their fees and have the incentive to return funds as quickly as possible so they can raise their next fund.

Fund managers are the people who start real estate private equity funds. They identify a strategy for the fund, raise money from investors, and recruit a small team to help buy and manage the investments. The first thing the fund manager will do is set a start and end date for the fund. For real estate funds, 10 years is the standard lifetime. The fund manager usually spends the first 1–2 years buying the properties. Then for the next 5–7 years the fund will aim to hold the buildings and distribute profits from them. Finally, the fund manager will sell the property and return the money to investors (along with additional profit, of course) before the 10 years is up. The faster, the better.

In this system, the pressure is on the fund manager to quickly buy property, increase rents, increase the value of the buildings, and sell for a profit a few years later. This means the institutional investors who own more than 80% of the global real estate market are actually paying real estate funds to come into our cities and neighborhoods and increase the cost of living and doing business at an unsustainable rate.

To summarize the current system:

• Step 1: Institutional investors, such as pension funds, invest their capital into private equity real estate funds.
• Step 2: The real estate fund managers buy property with the pension contributions of hardworking firefighters, police officers, and teachers.
• Step 3: The fund manager sells the real estate as fast as possible to maximize profits.
• Step 4: Property prices and rents increase to levels that are unaffordable for most working-class people, including the ones whose pensions funded the whole thing.

Luckily, there is a solution to this problem. These same institutional investors are already investing their money in another strategy that could be applied to real estate…

Infrastructure Investing

Institutional investors don’t only supply capital for real estate deals, they are active in several other sectors of the economy. One of those sectors that resembles real estate is infrastructure. Generally defined as essential services and facilities that support society, examples of infrastructure investments include airports, bridges, roads, wind farms, and telecommunication networks. These types of projects are typically longer-term, more stable investments that carry less risk than real estate.

In contrast to real estate funds, where investments are often held for no more than 5–7 years, infrastructure funds tend to hold their assets for longer, often 10 years or more. This longer time horizon has a huge impact on a fund manager’s decision making as the fund is under less pressure to deliver fast returns and can allow asset values to appreciate at a more gradual level. For most institutional investors, like public pensions, the top priority is to earn slow, steady returns so they can make payments every month to retired teachers or firefighters. These investors need consistency and stability, not flashiness and risk. For this reason, institutional investors diversify their portfolios between infrastructure projects, real estate funds, and other types of assets. They spread their money out across many different industries so their overall risk is reduced. With the need to diversify, it makes sense that institutional investors have capital in both infrastructure and real estate funds. But what doesn’t make sense is the different time horizons between the two types of investments. Why expect real estate funds to last only 10 years while infrastructure funds last 15 or more?

What We Need to Do

Institutional investors should not stop investing in real estate funds, they should start treating real estate investments more like infrastructure investments. This means holding the properties for a longer time and reducing unrealistic expectations for appreciation. The switch could be made without a reduction in profits. By adopting a longer-term time horizon, it would be possible to actually maintain the same level of returns while letting the properties increase in value at a slower rate. This can protect many of our neighborhoods and communities from the short-term private equity investments that are precipitating the affordability crisis in this country.

It’s always challenging to change a system that’s remained the same for decades. The good news is that these conservative investors are already investing billions of dollars into infrastructure-focused private equity funds. The funds already exist. This means there is already a playbook that both institutional investors and fund managers can easily wrap their heads around. If we start structuring real estate funds accordingly the result would be what I’m calling a REfra fund. REfra funds would hold onto investments for a longer period of time compared to traditional real estate funds.

Investors would be willing to accept lower annual returns over the life of the investments, which would alleviate pressure on the fund managers to raise rents and quickly sell properties for a profit. This system would better align the incentives of the fund manager with the long-term interests of the community.

On a national level, one thing we could do is create a mandate saying that institutional investors must hold all of their real estate investments for a minimum of 10 years. This has been one of the main goals with the creation of Opportunity Zones, where investors are provided with attractive tax incentives if they hold investments for more than 10 years in certain disadvantaged areas across the United States. In general, it’s a push in the right direction, but there is more we can do.

Additionally, REfra funds would focus on deploying their capital in a more local, decentralized way. This could be achieved if institutional investors required fund managers to open satellite offices or set up new programs to invest small amounts with several local, remote fund managers. When fund managers are given the opportunity to do business in their own communities they are much more likely to take a long-term approach than out-of-town fund managers.

Why Hasn’t REfra Caught On?

The REfra model hasn’t flourished (yet), and there are a few reasons why.

First, in the current system fund managers do not have the incentive structure to take a long-term view. The managers are rewarded for driving up the price of the property as quickly as possible. They are compensated two primary ways:

1. Management fees — to cover the fund operations. These fees are paid as a percentage of money that is managed. The more money they manage, the more fees they make.
2. Performance fees — to reward the fund manager for successful investments. These fees are paid as a percentage of the profits earned from the investments. This compensation structure encourages the fund manager to invest and return money to their investors as quickly as possible so they can raise another fund and make more in management fees.

Second, institutional funds are simply not set up to deploy capital in a decentralized way. They have to invest billions of dollars, and a $20 million investment in a private equity fund takes the same amount of time as a $1 million investment. Thus, the system is set up to favor larger investments in bigger funds.

Third, real estate funds have traditionally shied away from making investments in their local community. The theory is that local economies are too small and provide limited opportunities for diversification. If a pension plan collects its dues from the salaries of Texas teachers, it’s thought to be safer to invest the money in real estate funds in other parts of the world to spread out the risk. This argument stops many pension fund managers from investing in their local communities. The truth, however, is that’s is completely possible to maintain an adequate level of diversification while still making much more capital available in local communities. For instance, in 2017 the Dutch minister of Economic Affairs publicly criticized the Dutch pension funds for shying away from local investment. At the time, only 12% of pension fund assets were invested directly in the Dutch economy, whereas insurance companies were investing 40% of their funds in local assets. This Dutch economic minister publicly called for the pension funds to bring themselves more in line with the insurance companies.

Moving in the Right Direction

Over the last several years, many larger institutional investors have started to bring investing activities in-house through direct investment or co-investing with other institutions. In both scenarios, these investors are bypassing third-party fund managers and hiring talent in-house to identify and execute investments. This creates an opportunity for these institutions to invest in a more local, decentralized way. A 2017 BNY Mellon survey of 350 global institutional investors found 55% are looking to increase their direct investment activity. But even if we don’t completely get rid of the fund managers, we need to change the way we pay them.

I am not advocating for some type of utopian future. Fund managers are completely entitled to make a nice living, but in the United States alone $9 billion worth of investment fees are paid to private sector contractors by public pension plans every year. (Typically, the annual management fee is 2%. So, if you manage a $1 billion fund you make $20 million per year. YES, $20 million per year in management fees!) We need to shift the culture so that managers cannot become rich through fees. A more reasonable management fee structure with longer term investment horizons would make a big difference in helping to better align the incentives of fund managers and the neighborhoods and communities they invest in.

Additionally, America’s two largest private equity firms, Apollo and Blackstone, recently revealed that they now have $250 billion in permanent investor capital. This means the fund managers do not have to return investor money within a specific time frame. Blackstone has reported that approximately one-fifth of its entire portfolio is now perpetual capital, while for Apollo it’s close to half. Permanent capital allows fund managers to adopt a long-term mindset with their investments.

These are examples of steps in the right direction.

With a bit of financial innovation and creativity there is a lot that can be done to make the system work for everyone. We have to start viewing real estate as the infrastructure of our lives and usher in the era of REfra.