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At the slightest market turbulence, the income streams supporting most real estate investment firms shrink.

Institutional players like Blackstone have already figured out the secret to building resilient cashflows. They’ve taken a perpetual approach to capital, amassing $396.3 billion in such assets through Q4 2023. This strategy allows them to structure income streams that weather rough patches without being forced into fire sales.

Want to protect your firm against the next real estate reckoning? This is one strategy to create a perpetual cashflow machine that persists through chaos.

How to manage downturns and stabilize income

Real estate firms typically generate revenue through four primary fee structures. But during financial downturns, the stability of these income sources doesn’t just vary – it can disintegrate at alarming speeds. Firms are left scrambling as their essential revenue streams abruptly run bone dry, gasping for cash as profits evaporate.

Asset management fee

The asset management fee, based on equity invested or assets under management, remains stable despite economic downturns. This recurring revenue source allows firms to sustain operations through volatile periods.

Promote fee

Promotes are significantly impacted during downturns. As property values and cash flows decline in recessionary periods, clearing the required profit thresholds to earn promoted interest splits becomes challenging. This performance-based revenue stream dries up when markets constrict.

Property cash flow fees

Economic downturns often lead to higher vacancy rates, reduced rents, and increased tenant defaults. These recessionary pressures directly reduce property cash flows available for potential distribution.

Acquisition fee

Acquisition fees may decrease in frequency and size amid economic downturns. As investor caution rises during recessions, transaction volume declines, which reduces opportunities to collect these fees. Softening property values can diminish acquisition fees if calculated as a percentage of the lower transaction values.

Implementing the perpetual capital model

The asset management fees on the perpetual capital model involves a strategic real estate investment structure that can weather economic fluctuations and provide a stable, long-term income. Here’s how to do it in three steps:

Step 1: Establish equity-based asset management fees

Charge asset management fees on the invested equity amount. Some real estate firms fail to leverage this strategy, either neglecting asset management fees altogether or basing them on revenue rather than equity.

Equity-based fees are a vital recurring revenue stream. Here’s how to leverage this strategy today:

For a $10 million acquisition:

  • $7 million in debt financing
  • $3 million in equity

A 1% annual asset management fee on the $3 million equity stake equates to $30,000 in recurring revenues.

This equity-based fee structure continues indefinitely until the asset’s disposition, providing a predictable income stream regardless of transactional volume. This approach also boosts earnings’ valuation multiples, offering significant financial benefits and reinforcing its appeal for real estate firms focused on long-term sustainability.

Step 2: Remove forced sale periods

The second component is structuring investment partnerships without predefined sale periods or exit timeframes. This open-ended approach prevents premature asset liquidations due to restrictive holding requirements.

During recessions, investors tend to panic and demand an expedited return of capital. Giving in to this pressure often forces managers into ill-timed fire sales.

Eliminating defined exit periods allows firms to:

  1. Avoid selling assets at inopportune times misaligned with market realities.
  2. Ensure recurring asset management fee income continues uninhibited for the full hold period.

Step 3: Align economic incentives for long-term growth

Real estate investors often opt for short investment horizons, around 5 years, missing out on the benefits of patient ownership due to conflicting incentives.

Firms should implement equity multiple hurdles to discourage premature sales and promote long-term value creation. This aligns investor and manager interests around maximizing equity over time.

Under this model, all proceeds go to investors until achieving an agreed equity multiple, say 1.5x investment. After hitting 1.5x, the manager earns a promoted share of excess proceeds, typically 20-30%.

This incentivizes managers to hold assets longer, as each year increases the equity multiple, bringing them closer to promoted economics.

Using this approach focuses decision-making on long-term equity appreciation through ongoing operations – the path to lasting wealth.*

*I like to point out that this structure is generally more advantageous to the GP – but not necessary to include

Conclusion

Cyclical downturns are inevitable, but firms can endure volatility through perpetual capital models focused on maximizing long-term equity values. The approach aligns interests, removes pressures for untimely exits, and secures recurring income streams.

This resilient structure provides steady compounding of ownership value year-over-year rather than reactively timing markets.

Real estate companies looking to last decades need perpetual capital strategies to withstand inevitable destructive market cycles.

Publish Date & Time : 27 May 2024, 08:54 am

Author

Jake Stoutland is the Principal and Founder of Stoutland Real Estate. Before establishing Stoutland, he served as an Investment Manager at LCOR, overseeing asset management and various projects across suburban Philadelphia, North Bethesda, MD, and McLean, VA. Prior to his role at LCOR, Jake was an Asset Management Analyst at Peaceable Street Capital, where he gained valuable insights into the operating practices of top-tier operators across multiple asset classes. Throughout his career, Jake’s experience includes involvement in the acquisition and asset management of commercial real estate assets valued at approximately $2.2 billion.

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