Do you want to invest in real estate but don’t know where to start? Michael Episcope is Co-CEO of Origin Investments in Chicago founded in 2007. He and his partner started the company to invest their own capital into real estate. They then brought on friends and family and then continued to grow its investor base. Now the company manages over $1.4 billion in assets through various funds including two QOZ Funds or Qualified Opportunity Zone Funds. They only invest in the QOZ funds when they find a deal that works on its own merits and just happens to fall into an opportunity zone.
Learn more about the tax savings opportunities of investing in QOZ Funds in this episode.
Table of Contents:
- Where To Listen To The Podcast
- 2.3 Billion QOZ Funds
- Who Gets to Raise the QOZ Funds
- People Who Want Growth
- The General Recapture in QOZ Funds
- Building a Class A Portfolio Through QOZ Funds
- Underneath the QOZ Funds
- Recessionary Periods
- How to Reach Michael Episcope
2 QOZ Funds
Darin: Michael Episcope lives in Chicago with his wife and three boys. Prior to starting the company, he was a very successful commodities trader. He and his partner started to invest into real estate with their own capital. After seeing the dramatic wealth-building opportunities, they started to help friends and family. Then they opened up their funds to third parties. They now manage over one billion in assets.
This is actually the first time that Michael and I will get a chance to speak. Somebody reached out on Michael's behalf to see about getting on the show. Most times, I don't do that unless I know the person or the person has been given to me as a referral. But I did review the background. I was floored at the scope of experience that these guys have. I'm very interested to hear more and I hope that you guys will learn a lot out of this. The first question I typically ask is, how many properties and how many units are you guys currently invested in?
Michael: It's constantly changing because we're both buying and selling in today's market. We have somewhere between 40 and 45 total properties. Generally, we're in the Sun Belt states, south of the Sun Belt. We're close to 9000 units tracking towards 10,000 units. Those are both portfolios of properties that are stabilized in some stage of value add or being built under control, etc.
Darin: These guys have transacted 2.3 billion in total deals. In terms of ranking, they are in the top 1% for North American real estate fund managers. They have a ton of experience. How did you get into the space? What were you doing before?
Michael: I was a commodities trader.
How the Financial World Works
Michael: It's a great question and the why and how we began. Going back, this is my second career. I’ve made my wealth here in Chicago, I was born and raised here. I went down to the Chicago Mercantile Exchange at the young age of 19. That was the start of my first career. Today, I can't even believe it. I have a 19-year-old. To think that I was starting my first career at that age was crazy.
But I stumbled upon it and I loved it. I was at DePaul University, I pushed all my classes to night. I burned the candle at both ends to make it work and I loved it. I was studying finance and econ. Just seeing how the financial world worked by working there during the day, ultimately I ended up becoming a trader. I tried my hand at that, I was pretty good at it. For the next nine years, I just worked bell to bell and saved as much as I could.
Then my life changed in a few areas. Number one, when I started trading, I didn't have any money. When I was done, I had accumulated quite a bit of wealth. In the beginning, before I was trading, I was single. Then I got married and had two kids, and one on the way. I was looking at it and my risk profile, it just changed. So I said, "What's next?" I'm a little bit of a restless soul. I don't like to do anything for too long and I needed a new challenge.
Born as a Real Estate Investor, QOZ Funds
Michael: Real estate was something that I was introduced to as a young kid. My grandfather was in real estate, I used to go help him in the summers. I saw the income and the wealth that he had created for him and I was always enamored by it. So I took that opportunity punching out of the Chicago Mercantile Exchange moving into the next phase of my life. Went back, got a master's of real estate at DePaul.
My partner and I had already been working together on various things. We were friends, we really saw the world in a very similar light. He was doing some development projects out on the East Coast. We had gotten together and decided that we wanted to build a firm together and manage our own money. In the beginning, it was more like a family office.
Then what happened was, it just evolved and we brought in friends and families. We were finding interesting deals and that was in '07, '08. In a lot of ways, it was a great time to be starting a firm. Now, if I knew what I knew today back then, I would have fast-tracked. But we've been in this for 14 years. I would say we started hitting our stride about three or four years ago.
It was really that notion of alignment, us investing in our deals, us sitting at the table as investment managers. Hiring the team, looking at this from a different perspective. In many ways, not being from real estate or having that 20-year pedigree, being saddled and thinking about how to grow a firm benefited us.
Thinking and Doing Things Differently
Michael: We pride ourselves on thinking and doing things differently. Then it was just about building a firm for people like ourselves, for individuals, family offices for the clients of wealth managers. You know what really motivates me and gets me up every day is helping people like me generate and really grow.
Protect, generate passive income in real estate and getting the benefits of passive real estate. It doesn't really interest me that much to be working for a pension fund or an endowment or anything like that. People like us, we work hard, we save our money. Historically, when you go back to '06, '07, '08, the market was very different. There weren't a lot of great opportunities out there for individual investors.
We've always had this notion that we wanted to build an institutional real estate platform for the individual investor. We made a lot of great decisions. That's really like fund one, fund two, fund three. Those ended up top ranked funds. Then most recently, we were ranked as a top decile manager. We're actually in the top 2%, of national rankings of more than 2000 investment managers.
So we're very proud of what we've done, our track record, our team, just the way we do business. It's something that we think about not only from the past. We think of how we can continue to deliver that same value today, in the future, especially as we scale and grow.
Darin: First of all, you partnered with somebody that you were friends with. Did you guys work in the commodity space together or was it a college buddy?
Michael: No. Actually, we just met through mutual friends and I'll never forget meeting him. We’re just like kindred spirits and we had a lot in common. We didn't know each other in college, we had very similar backgrounds. He was in the commodity space, but he left much earlier than I did. He left around 2000 to start a nonprofit to do some development on that side.
I always say there's two people in my life that I'm very fortunate to have met: my wife and my partner. You don't find people who you cross paths with too often that you really are in sync with. I’m very blessed to have him as a partner. He's incredibly smart and it's been a great 14 years together.
Darin: You said that you saw the world in a similar light. You also said that you're kindred spirits. I've had other syndicators on the show that have talked about, "Yes, you have to have complementary skill sets. You typically focus in different areas and grow with your partners. But you also have to have the same kind of ethical standards. You have to be aligned with that person because you are going to be working with them for a long time. If you look at the world differently, then you might have a lot of friction." That's very consistent with what I've heard from others.
Michael: It's so much more important for your core values to align than your skill set to be complementary to one another. If you don't view the world through the same lens, the integrity, the ethics, and I would say it's not about approving deals or what he does. Skills can be learned and you can automate those and do different things.
Who Gets to Raise the QOZ Funds
Michael: Certainly, there have been some growing pains along the way and some stepping on each other’s toes. But the way we've managed the firm is that David really covers the real estate side of the business. He manages the investment management side, and then the acquisitions team. I manage the investor relations side, the capital raising, the marketing, and then corporate services. We come together on a deal committee, both approving deals. This is a lot of our own capital in these opportunities and we bring different perspectives to the table.
Having a partnership can be great when it works and I know from others, too, it can be really tough. But you got to get the core values right and that's really where we see eye to eye. It's not like we don't fight, we do. But we have a mutual respect for one another. When we disagree, we disagree respectfully. We walk out of the room looking at each other's opinion and say, "Okay, I can see that," or "I can’t see that."
Then there are times there are swords you want to die on. I'll tell you when he comes to me and he wants to die on a sword, I'm like, "Okay, this obviously means a lot to him." I don't have a monopoly on the right answers, I know that and he knows that as well. It's been a great push and pull over all these years.
Darin: What's also different about you guys from a lot of the syndicators I've talked to is when you went to scale, it was a natural order.
Leveraging the QOZ Funds for Bigger Properties
Darin: A lot of the syndicators that I've talked to saw the opportunity to be able to buy bigger properties. They didn't have the capital to do so. So they went and started to syndicate. They leveraged other people's money so that they can buy bigger properties.
But it sounds like from your story, the two of you came together, "Hey, let's just protect and grow our wealth." Then you had people naturally saying, "Hey, what are you guys doing? Are you successful? Can you do some of that for me?" You first started with friends and family and then you grew from there.
Michael: I'll say that when we went to outside capital, it wasn't about doing really bigger deals. I hear people say, "What do you want to do?" "I want to do really big deals." Check your ego. It doesn't matter. "I want to make money for me, our investors. And I don't care if the deal is pretty or ugly or big or small." But it was really about looking at our business. Saying, "Listen, if we want to really hire and attract a team, the team who we want to help find the best deals out there, manage the deals."
There's a lot of infrastructure that's involved. We learned early on that if we're going to do this, we really need to amortize all these costs over larger pools of capital. These are the people who we want to hire. That's what it was about more than anything. I would say in the beginning because David and I had wealth, our investors were paying much better fees than we were. But we also knew that we were building balance sheet value. We were building a company.
No Better Place to Invest, QOZ Funds
Michael: In fund one, David and I were paying 5% annual fees. Everybody else was paying one and a half percent. In fund two, as we were getting money, it was like our investors were paying one and a half percent and we're paying four. But we knew that there was no better place for us to be investing our money. We were building a company out of this. It takes a long time to scale in what I'll call the retail world focusing on individual investors.
So few have been able to do that and that's really why people start with high net worth. Then they would graduate or what they see in their world is graduating into the pension funds because they want the 20, 30, 40, $50 million checks. You can count on one hand the number of groups who have really successfully scaled with the individual investor only.
Darin: That's what you guys focus on? Individual investors only?
Michael: Yes, that's it. The taxable investor. I did a webinar last week and talked about the tax efficiency of real estate investment. It's nice to have a homogenous group of taxable investors. Whether you're talking about a high net worth, ultra high net worth, the client of the IRA, family offices, etc., we're all in the same bucket.
When we think about how we structure funds, how we manage real estate, buy, fix, sell was our old strategy. Now it's more buy, fix, hold, looking at those tax advantages. Well, if we had a hybrid structure and pension funds that were also in the mix, we had endowments and nontaxable investors. They really shape your strategy much differently. We've partnered with them in the past.
Who Makes the Rules
Michael: They don't care about taxes, but I do. All of our other investors do as well. It creates this friction between the two groups. Ultimately, the entity or the individual who comes with the $30 million check is going to make the rules. Everybody else is going to follow along. I love the fact that we are focused. Our group is homogenous, and we're helping people like us.
Darin: You have three or four different funds. Talk about those funds and what type of assets you put in each of the funds. What's the pros and cons of one over the other. I know this is going to get long, but a lot of syndicators are not set up to do funds. They are transactional, they get a deal under contract, they raise the capital for that deal. Then they're on to the next one and they do everything the same way. You started the company in 2007. Maybe 2011, '12 when you started doing funds?
Michael: 2011 was our first fund. A lot of individual investors, they like deals and we do both. We do deals and we do funds. But we do co-investments on sidecars, and I'll get into that in a second. When we started the fund business, it wasn't necessarily saying that this is better for us, we want to do funds. A lot of people have this misconception that funds are better for the manager.
The advantage it gives us is permanent capital. It’s the ability to tap in and go to the table when we're competing to a deal and say, "Yes, we can close. We have the money." Not, "Hey, hold on, we can close but we got to cobble it together." Or "We have a track record of that."
The Advantages of Investing QOZ Funds
Michael: There's actually an advantage to individual investors when it comes to investing in the fund. All of the promotions, the performance fees, and a fund, if we have 20 deals in there, all those performance fees are cross-collateralized. So if 10 deals do well and 10 deals don't do well and we return a nominal return, we don't get paid a performance fee.
If you look at those 20 deals and you're building a portfolio through syndications, if 10 of the deals do well and 10 don't do well, well guess what? You're paying performance fees on those 10 deals that do well. There's an inherent distinct advantage of investing through a fund. What we've always said is that we create products that we want to invest in and then we do. Our money is side by side with investors.
We have four funds and it really runs the gamut from lower risk to higher risk, yield to growth. When we think about our strategy, it's only multifamily. We build, buy, and lend. We've done many other categories in the past, but really, it's about specialization. Multifamily happens to be one of the lower risk asset classes out there.
We are in the Sun Belt states in the south so we're in the southeast. The Texas markets, Nashville, and the Southwest cover quite a bit of territory. We have 35 people at Origin. That strategy, when we think about build, buy, and lend, we also think about the consumer. What do they want out of this? Well, on one end of the spectrum, you have people who only want yield. They want income, they want that passive tax-efficient income from real estate.
People Who Want Growth
Michael: Then on the other side, you have people who just want growth. They want to grow their capital, they don't care about income. Everybody has a different perspective. Then you have the middle who want a little bit of growth in income or optionality, they want lower volatility.
That's how we think about our strategy, even though it's a three-tier strategy of build, buy, and lend. Then what happens with those as we put them into different funds and produce a benefit to the investor. I'll take you through the real estate funds because the credit fund is a little bit different. But when we think about our two real estate funds, there's a third out there. I'll get into that as well, but we have the income plus fund.
The income plus fund is a multi-strategy fund that has those three strategies. 20% of that fund is dedicated towards ground-up development, the other 80% is to lending and core-plus. It provides tax efficiency through depreciation, it provides stability through the lending portion of it as well and also yields. That's about a nine to 11% total return. What we're trying to generate is a 6% yield, but with very minimal volatility.
The mixing, generally, when you have something like preferred equity by itself, that's not a tax-efficient investment. But when you pair it with common equity real estate that produces depreciation, that depreciation actually offsets the excess depreciation. It offsets the tax inefficiencies so then you can produce a very tax-efficient yield in that fund with lower volatility.
The Ground-up Development
Michael: The ground-up development, there's a couple of things. Number one, it generates alpha because that's the portion of the portfolio. But when we're looking at today's market, we're not really doing anything in the middle, which is buying real estate. There's always exceptions to the rule. But in today's market we're looking at projects that are 10 to 15 years old. They are trading 10, 15, 20% above replacement costs. We would much rather be building in those markets at a lower basis today. That's a better risk-adjusted return.
In a lot of these markets, when we're looking at Phoenix, Nashville, or Austin, you can't compete when you're looking at core plus and value add deals because there's a wall of capital. We're actually out of that market, we're net sellers. To those individuals, we're selling everything in fund three, in fund two. We're just looking to enter into those markets by building, that's our first one. That's income plus.
On the other spectrum is growth. The growth fund that we're coming out with is going to launch on January 15th of 2022. That is going to be about 10 to 12 ground-up developments that will be paired also with some GP elements. A general partner investment means that you give above market economics. But what it does for us is it also gives us a pipeline into future deals. Working with sponsors over and over and providing that development capital early on in the phase gives us a first look at all those opportunities.
Michael: I was talking about tax efficiency. Now the interesting thing about this fund is it's very short-dated. It's a five-year fund but if investors want to stay in, they can. So it's what we call a build to core. You're taking that development risk. Then you can stay in year after year and you just let us know when you get out. It's a mark of market fun because over the last 10 years, one thing we've learned is that in order to grow wealth, you need to buy great properties. Hold them for a long period of time, and generate.
Take advantage of the depreciation, the ability to refinance tax free over and over and let the upside run. We have deals that we've sold two, three, four years ago that are coming back to us now that are 40, 50% higher. When you look at the most sophisticated investors out there, this is how they invest. This is what we want to bring to the market as well. More often than not, every time we sell a deal we get comments from investors. "Hey, this is fantastic. What do I do with my money now? Where's the next investment?"
Darin: "How do I reinvest?"
Michael: "Right, cool. Why do we sell this? And why couldn't we just get this eight or 9% yield?" That's a page that we've taken out of the book. So rather than being on this hamster wheel of buy, fix and sell, pay your taxes, let your money sit around, take a lot of risk in another deal.
The Strategy to Make More Wealth
Michael: You can actually make a lot more wealth in this strategy, just buying and holding forever. That's true in real estate. It's true in stocks, it's true across really every asset class. That's how real wealth is. You always meet these people who've owned a piece of property for 30, 40 years. Their basis is $300,000 and now it's $8 million. We just don't want to keep making those same mistakes. That's why we've really changed our strategy from buy, fix, and sell to buy, fix, and hold going forward.
Those are what I'll call our two flagship funds. We also have a qualified opportunity zone fund. We just came out with that, our second fund last week. The first fund was about $275 million, very tax-advantaged. We could take up this whole time talking about that. Then the lowest risk spectrum fund we have is called our multifamily credit fund. That is only for qualified investors or qualified purchasers. It's those people who have more than $5 million in investable assets.
Even though the fund is secured by loans of multifamily real estate, it qualifies more as a security than real estate. So when you think about asset allocation, you've got real estate. You got credit and the multifamily credit fund falls in the credit bucket. But it uses real estate to generate the yield in that fund.
Darin: I don't know if we'll spend the whole time on it or not. But I haven't really had many people on here talking about opportunity zones. If you could spend some time sharing what qualifies for a deal in an opportunity zone. What are the benefits, what are the downsides of doing that?
Qualified Opportunity Zones
Michael: I'll try to give you the abbreviated five to seven-minute version here. We've had webinars that have gone hours on this. Qualified opportunity zones came out of the 2017 tax cuts and JOBS Act. It was a bipartisan measure. The purpose was to get money out of the hands of the wealthy. Incentivize the wealthy to actually invest in neighborhoods, moderate to low-income neighborhoods. How do they do that? Well, they created this plan where they mapped out 8700 qualified opportunity zones that are based on the 2010 census.
When this came out, there was a lot of skepticism about it. Number one, what are these neighborhoods look like, are they investable? What happens is, if a wealthy investor has capital gains from any source, it can be from real estate. It can be from stocks, it can be from bonds, whatever shows up on your K-1. If you invest that capital within 180 days into a qualified opportunity zone fund or property, you get three tax benefits.
The first one is really a reduction or it's called a step-up in basis. I'll use very round numbers here. If you have a million dollars in capital gains in 2021 and you invest in a qualified opportunity zone fund, that will be reduced when it comes time to pay taxes to $900,000. So there's a step up in basis. That's the first. Now that only lasts through the end of this year and then that disappears. So it's only if you invest in 2021.
Darin: A lot of people, I'm sure you're aware, had taken advantage of bonus depreciation. But then, when you sell, you've got the recapture.
The General Recapture in QOZ Funds
Darin: Could you end up selling a property in 2021, have the recapture, and then do an opportunity fund so that you don't have to pay back that recapture?
Michael: I don't know exactly about that particular nuance itself. You're talking about somebody coming into a qualified opportunity zone fund if they have to pay the excess depreciation. The general recapture is no, just like you wouldn't have to pay it. If you want to do a 1031 exchange, I'm not sure about the excess depreciation on that.
There's two more benefits. You don't have to recognize the taxable gain until 2026. This is an interest-free loan for the next five or six years and that is only payable in 2027. Now the risk is, if you're paying at today's tax rates and you have a capital gain, you're going to be paying right around 24%, 20% plus the net investment income tax. If in 2026, the tax rates on capital gains are 30%, you'll be paying 30%. That is the risk but it's somewhat offset by the step-up in basis.
All that aside, the best benefit of this program is the fact that if you are invested for more than 10 years and a day, there is no tax on your gain. So if that $1 million grows to two, three, or $4 million, and you take it out at 10 years in six months, you pay zero taxes. When I talk to people about this, I'm like, "Look, if you like real estate and you have capital gains, there is no better place to invest than QOZ right now.
The Wealth You Create Through QOZ Funds
Michael: The after-tax wealth that you create through QOZ fund versus the math on using after-tax capital to invest the same way, is about 75% greater. It's not even close." It's an amazing gift to investors. Some of the misconceptions are from what I said earlier, "Well, I don't want to invest in these low income, moderate-income neighborhoods." Neither do we. You can't make money in those.
We don't look at QOZ any differently than we do our other funds or investing strategy. The way we got into this back in 2018 was doing a lot of research and looking at the markets and where the QOZ areas are. We approach everything skeptical as well. Our job is to look for the icebergs and the holes and where we are going to lose money.
What we found is that a lot of the deals that we were already looking at in fund three and actually owned were in qualified opportunity zone areas. These were transitioning neighborhoods. When you think about how much cities have changed between 2010 and today, it's mind-boggling. It's staggering. If you went to Denver, to Nashville, to Austin, any of these cities 10 years ago, those census tracts were based on the city back then.
I'll give you an example. In Nashville, we have one of the best development sites right now tied up. Not QOZ development sites, but best development sites in the country tied up. It just so happens that it's in a QOZ area. We're working through entitlements, we're working with the city right now to get this through zoning. But it's a phenomenal project.
Competing Against QOZ Funds
Michael: Historically, when we're looking at qualified opportunity zone projects, we're not competing against QOZ funds. We're competing against the pension funds and the endowments out there and institutional capital. They don't care about the qualified opportunity zone benefits. It's just good real estate.
I would candidly say that 95% of the qualified opportunity zone areas, you can't make money. They're not worth investing in. We're really fishing around the edges looking at those 5%. But because we've been in this for three years now, our pipeline is incredibly deep.
Darin: Is there some education component to the individual investors? You talked about how real wealth is hold, buy and hold forever. There's a lot of investors that are still like, "Man, I doubled my money in three years." Is there an education component to get them to say, "Hey, take a piece and lock it down for 10 or 10 or more years?"
Michael: There is to a degree. You have people who have all kinds of different time horizons. An investor said to me, "Michael, I'm not even buying green bananas right now so I'm not even looking at this." But yes, there is. What I always tell people is, "Look, you might be wrong over the next two or three years. But what you will be right is over the next 10 years."
Multifamily real estate, institutional quality real estate, the stuff we're doing 40, 50, $70 million projects has never lost money over any 10-year period. For me, I love the fact that we don't have to constantly talk about the timing of the sale, this or that. Even if we go back to the worst period in '07.
Michael: If you would have bought at the high in '07, five years later, let's say the QOZ, opportunity zone, came in '07. You were panicking and you wanted to get out at nine, 10, or 11 or something like that. But you couldn't and you were locked in and you stayed in till '17. You would have made phenomenal money.
In the depth, the fact that we couldn't sell, we weren't allowed to sell, we would trigger this massive capital. We can as a fund manager anyway, because it would violate compliance. But when you hold long enough, what you can be sure about is that replacement costs are going to go up. That rents are going to go up, the property will be worth more in 10 years than it is today. I don't know if that's true in the next year, two years, or three years.
You have to have a long-term outlook when you're investing in this whole short term, "Hey, I want to be in for three years. I want to sell, I want to pay taxes, I want to do this." That's not how you're going to get wealthy. Too many people chase IRR but you can't eat IRR, you can eat multiple.
Darin: The other thing I'm just thinking out loud because I also have a loan trading business. I've been in that space since 2002, single family, multifamily, and commercial real estate loans. In the last recession, where I saw people get hurt is maturity risk. Over 10 years, you're going to be fine. But if you go into a recession and your loan comes due in a terrible economy, cap rates are up, cash flows down. All of a sudden, your valuation is negatively impacted.
How QOZ Funds Make Financing Decision Easier
Darin: The lender tells you they're not going to refi the loan unless you bring in additional capital. You can't raise capital in that type of market. With an opportunity zone deal, it makes the financing decision easier. "Hey, look, we're going to a 10-year fixed rate loan," is that the case or not?
Michael: We do longer. You certainly can't get that on the construction side. But when we think about risk management, something we're very good at is thinking ahead and stress testing deals. The first thing we do which is really important is we're putting in 35% of equity into these deals on the ground-up construction side on a cost basis.
If you believe the pro forma, we're building to anywhere between 30 and 40% margin. When you think about the amount of equity that we have from day one, round numbers, I'll do 100 million. It's easier for me to do the math, we're putting in $35 million.
Darin: You're saying we, you're saying the company?
Michael: Yes. All the investors and clients.
Michael: Right. If we do our job and it's $100 million of cost and we're building to a 35% margin, that means when we're done, the property is going to be worth $135 million. Well, our debt is only $65 million so the loan to value once we're finished is incredibly low. Generally, what we do is we will then resize the loan at 65% of value. Having a lot of equity in the property is the first way that you mitigate downside risk. To your point, fixed-rate debt as well with longer-term maturities and having things staggered.
Floating Rate Data
Michael: When you know you can't sell an asset for 10 years, there's no reason to put floating rate debt on it for three years at a time. There could be a certain portion of the portfolio that we do float. Because historically, fixed-rate debt has been far more expensive than floating rate debt. You can go through history and look at this. There's reasons to do this. But generally, the portfolio has fixed assets and it'll have fixed debt.
Darin: People that put long term debt two years ago, they could sell the property for a pretty penny right now. But they have to pay a huge prepayment penalty so they're stuck.
Michael: We're dealing with a lot of that right now where some of our defeasance on our properties and what we would have to pay the lender is three, four, or $5 million. Now, we've also bought properties because they have this long-term debt on them. Then people change their mind. To us, it's all about the basis. Loans can be refinanced, but you can only buy a property one time at the right basis.
We have some properties that we bought at a really great price. What happens when you have above market debt, it actually detracts from the value of the property so then it becomes lower. It doesn't give you the optionality and flexibility but QOZ, we don't need that. We're bound by the law and we can't change our mind in three or four years and sell a property. It would violate the covenants of the law.
Darin: If I'm hearing you right, the home run is to go in the opportunity zone.
Building a Class A Portfolio Through QOZ Funds
Michael: Yes. I hate the word home run because I don't think about investing as home runs. I think about it as singles and doubles. Maybe you hit a home run within the portfolio every now and then. For us, we're trying to double our money at the property level every five years. If we're wrong, we want to be one, six and if we're right, we want to be at a three or 4X over that time period. It's just about being consistent.
Certainly, I would say the smarter investment move if you like real estate, you don't mind ground up development. You have a longer term outlook, QOZ is definitely the way to go. Keep in mind that after about three or four years of QOZ, what you're doing is you're building a class A portfolio that will ultimately cash flow as well.
So you get the benefits of the depreciation, you get the benefits of the tax, free refinancing, the cash flow, everything in that. It's very much like our growth fund four that's coming out in January except growth fund four doesn't have the QOZ benefits.
Darin: Is the return profile similar between the growth and opportunity zone?
Michael: It's different because if you think about the growth fund, the growth fund that's coming out is going to be very short. It's going to be over a five-year period and possibly even shorter. In that particular fund, depending on how quickly we can raise the capital, we will have a two-year investment period. We'll be done a lot faster than that based on our pipeline and then a two-year stabilization period.
Things That Are Bad About Funds
Michael: It was important to us as we were concepting this fund. There's a couple of things that are bad about funds and I've been in these so I know. One is the fund tail. You can have these funds that are seven-year funds. Then they have a plus one plus one plus one plus one. I have funds that I got into in '07 that are still using this plus one. You're like, "This is a pain in the butt." You end up with these tails.
The greatest thing about this is that this is going to be NAV-based right on appraisal. If somebody wants to punch out in year five, they're getting out 100%. They're not going to have these fund tails where we sell all these individual properties. But what we do as a manager is we just make sure that six months prior to the funds expiration, we understand how many people want to redeem.
Then we will sell enough properties to redeem them. Maybe a little bit more to have a little bit of a cash cushion but that's how we would manage it. If we have 12 properties in there and we have to sell three to redeem these commitments, we will. You start to see the multiple build and you also see the IRR start to maximize in that. Over time, as you hold longer, you're going to be maximizing the multiple but sacrificing IRR. Those move in different directions.
Darin: So all of these funds are geared towards accredited investors.
Michael: Accredited, and the minimums are anywhere between 50 and $100,000. Except for the multifamily credit fund. It’s only for qualified purchasers who have $5 million of investable assets or more.
Investing in Growth Funds
Darin: What about the opportunity zone? Is it a minimum of 50 or 100 on that one?
Michael: 50. That's for the accredited.
Darin: I'm investing in a lot of multifamily deals but no opportunity zone deals so we will talk about that. Help me understand. One of the things that's a little confusing with a fund structure is, you're buying multiple assets. Say, I'm an investor. I'm going to invest in the growth fund and you're going to buy 10 different assets. If I invest my money right when you open the fund, that is more risky because you don't have any cash flow yet.
Then somebody else invests after two deals are purchased and yours of ground-up development. But let's just assume that somebody simply buys into it after there is positive cash flow. Well, they have less risk. Are they coming in at a different price point than me if I got in originally?
Michael: I should caveat that there's some nuances about these funds. The income plus fund is actually an open-ended fund where you do invest all of your money on day one. You are diversified across a pool of assets. Growth fund four that we're coming out is a call capital fund. Everybody commits capital in a call capital fund but we don't call your capital until we actually find a deal.
If you think about it very simply, if we have 100 investors in that fund and everybody contributes a million dollars, everybody will be a pro-rata owner of 1% of the fund. So if we find a deal for $10 million, we call $100,000 from everybody.
Michael: Everybody has an interest in that fund. In closed-end funds, you have multiple closings, you might have one every three months. In those later closings, the later investors have to really pay earlier investors a preferred return. They also have to pay their management fees and other things. It's as if everybody came in on day one.
Some people like to be in on the first day because they like to start earning their pref and putting money out. Some people like to wait. They're like, "Look, I want to see how the portfolio is shaping up. I want to get a look, to see the first three or four deals. I'm okay with paying those few percentage points back to the earlier investors to get that look." It all depends.
In a fund like this, we'll be out to market for about six months. So there's not going to be a huge difference in terms of the preferred return. Also, the management fees that are going to have to be trued up from the investors who come in at the end or the beginning.
Darin: Your example was 100 investors at a million a pop. In the first deal, maybe you get a pro-rata call of 100 grand each. What if somebody just wanted to invest 100 grand? They didn't want to invest a million, so then they just had a $10,000 call. Is that how it works?
Michael: Yes, their pro-rata ownership would be much lower. It'd be 0.1% versus 1%. Investors can come in. We have investors who come in at the minimum for these funds at $50,000. Then we have investors who come in at 10, $15 million dollars for these funds. So it just depends.
Michael: Obviously, you're going to be more exposed to the individual deals the more you come into these deals.
Darin: On the call feature, is there a penalty? Or if you go out for the call and somebody says, "You know what? I changed my mind." Or "I don't have the money," or "I lost money. I was going to sell stock and I lost money and I can't do it now." Do they have any kind of financial downside for that early commitment?
Michael: They do. As a fund manager, we need to make sure that when people make commitments to us, we're able to run the fund. We have the money, we have the strategy. People aren't trying to time, things happen, that's our job out there. But if somebody commits and we haven't called capital, there's no teeth in the deal. If we've already called 50% of somebody's capital and they can no longer fund, then there would be penalties.
Now, when we think about the world and the way we operate, there's what's in the PPM and then there's life. Everybody has a different story. If something happens to somebody in the past, this has happened to us, we bought them out. We've allowed somebody because there's always people who want to get in later, take over those positions, or do something. It's an investor by investor choice but there's always exceptions to the rule.
Darin: So the agreement is that, they've got a penalty and then life is life. You may waive that depending on circumstances. You guys have done a lot of transactions. What's been the performance of the portfolio? What are the returns typically?
Underneath the QOZ Funds
Michael: On realized deals, I know those are constantly moving. I want to say from an IRR standpoint, this is underneath the fund because I can go back. Our fund realized returns, if I go back to fund one, that was a 2.1 multiple of 23% IRR. Fund two was around two zero multiple and a 21% IRR. Fund three, we're actually selling that right now. There was a 2016, '17 vintage. That multiple will shape up to be about one six to one seven. Right around a 12 to 13% IRR in that particular fund.
Then in the income plus fund, we've had a great year, that's actually 17. Granted, income plus is supposed to be nine to 11% annualized return over the last 12 months. That fund has been 17% IRR over that fund. Then the QOZ, it's too early. In that fund, those deals, we have two deals that are up and going right now. Then the rest are in construction and growth fund four is coming down the pipeline. The growth fund four, we're targeting 14 to 16%, net IRR and a one six to one seven, multiple on that fund.
When you look at the world, we always tell people, "Don't expect the same returns you've gotten for the last five to seven years." We believe that there's still good returns to be had. But, our realized deals, we've generated over two multiples. We've generated high 20s returns on the individual deals. But never in our history have we ever gone out to market and said, "Hey, we want to generate three multiples on a deal or four multiple on a deal." Everything is very consistent.
The Worst Performing Deal
Michael: That's also what I find interesting about this market. What things look like on Excel and you're handicapping these deals. You're underwriting them and you're massaging 100 different variables. But you might look at a deal and there's plenty out there. Our worst-performing deal was a 105 multiple. I should also say we've never lost money on any deal in a fund so that was one of our deals. But we underwrote that two X returns. Well, life happens, it didn't happen.
On the other hand, same vantage, very similar process, we underwrote another deal in the West Loop of Chicago. That ended up 2X return on paper then ended up being a 4X. This is the advantage of being in funds, being spread across multiple deals. We don't even know being close to the business. But when you miss and you're wrong, you want to be wrong to the right side. Not to the downside but to the upside.
That's why we've always underwritten conservatively looking at these opportunities. I don’t know. That's a long-winded way to answer your question about track record.
Darin: When you started the company, it was you and your partner and you were already wealthy. You already made a lot of money in the commodity space. How has the real estate space been in terms of wealth generation compared to what you earned in the commodity space?
Michael: It's apples to oranges. I'll say this that this next phase of my life was not about creating wealth. That's what the first phase of my life was about. This is really about keeping what I've built and continuing to grow it and continuing to have passive income.
Real Estate Is One of the Best Tools
Michael: What David and I have built, we’re really proud of Origin Investments. But most people, when you think about real estate and portfolio, sure, you can get wealthy. A lot of sponsors use high leverage, leveraging their money, other people's money. That's not really what this was about for us.
Real estate is one of the best tools that you could possibly use in lieu of stocks and bonds to grow your wealth, to generate passive income, and cash flow. We've studied a lot not only the private real estate but also the public real estate side. Real estate has outperformed stocks over the last 20, 30, 40 years. It certainly has outperformed bonds as well. The interesting thing about it is it's a hybrid between bonds and equities. You have fixed leases that make it act more like bonds and give it stability. But then, you have replacement costs that continue to increase. You have lease escalations that help increase as well.
When you think about efficient markets, your equities should be the ones that are outperforming because of the risk you're taking. You've got the real estate asset that should end up somewhere between stocks and bonds, but it hasn't. It's actually outperformed.
I've read your website. It's been a huge wealth builder for so many families. As we were studying this, too many people are under-allocated to real estate in their portfolios. Even wealth managers, sometimes, when you talk about public REITs, they see those as alternatives. But when you start to look at the data and the information and how they have performed relative to the rest of the public equities, it's not even close.
A Real Estate Portfolio
Michael: Really, you should have a portfolio of real estate with 5% being in other stocks. You would have outperformed everything on a risk-adjusted and an absolute basis over the last 20, 30, 40 years.
Darin: But there's a lot of people that don't know how to do it. They haven't developed a relationship with somebody like Origin Investments or another syndicator. And they don't want to spend the time to go out and do it themselves. It's a shame because stocks just don't have the tax benefits. They don't have the leverage that you have in real estate.
You also talked about the leases. My son's a junior in college at A&M. I was at a Parents Weekend and met a gentleman. He's done very well in the industrial space, the company he works for, and industrial properties have been on fire. They've done very well. But even he was like, "You're in a better spot," because we have locked in five years, 10 years' worth of rent bumps. But with multifamily, they're typically annual leases.
Michael: A lot of turnover, yes.
Darin: If all of a sudden there is rampant inflation, you can adjust the lease accordingly or based on supply and demand. With those other properties they're not able to because the rent bumps are locked into the contract.
Michael: Office is in real trouble for that reason. But also because of what's going on in the demographic changes, the work at home environment. Now, I’m always concerned because the office is the new retail in certain areas. Retail has been getting pummeled for the last 20 years. It just continues to be on the ropes. All the money is flowing into multifamily and industrial right now, and some self-storage.
Michael: Those are really the areas where the fundamentals favor those for the next four or five, 10 years. We're keeping an eye out because you have to be careful when all the money flows into one sector as well. It's like, "Hey, we're here first." But candidly, when we see what's going on, on the for sale side, the existing product, and it's trading so far above replacement costs. It's a great time to sell. If they're right, then our build strategy is only going to be better. But one of the reasons, if they are right, then we're going to do fine.
You have to manage your risk at every point in the cycle, but no tree grows to the sky. That's the power of diversification and being in good quality real estate as well.
Darin: You guys have shifted from buy, fix, and sell to buy, fix, and hold. You're focused more on new development versus buying existing properties. I've seen a lot of syndicators that in the last year and a half, two years that have been focused on trading up. Some of them are just moving from C class assets to B plus and A assets, some are getting into new development.
On the new development side, how do you manage the inflation of raw materials to build? Do you adjust rents accordingly if all of a sudden, like last year, lumber costs went crazy. It's come back down. But if you have a run in commodities prices where it wasn't in your budget, are you readjusting the leases when you want to come up to lease up?
Revenues and Expenses
Michael: Well, you have revenues and expenses that you have to factor in. So in a development pro forma, you're going to know what your costs are going to be. We generally get a guaranteed max contract, a GMP, and that contract. You're starting on day one, you know what all the line items cost. Then the builder is locking those in with the subs, etc.
Now, interestingly enough, we had a deal where when lumber went $1600, the deal still worked. But we said, "Look, we're going to underwrite this at $1600. But we want to leave these line items out," and we left that lumber out. We're able to price it at that 1600, $1700. Now, we're not trying to trade but you look at it. You're like, "This can't sustain," or else the world is stopping.
You just can't make new housing work at $1600 per board foot of lumber. What happened is then lumber came all the way back down to 450, $500. We save millions of dollars on the project for doing that. But today where lumber is $700, we're not going to do that because the risk-reward is not the same. It could go back up to $1600. What are we going to save? A couple of $100 if it goes back down. But those are some of the ways we get creative.
But everybody's really concerned about costs and rightfully so. What I tell people is, the cost you pay today to build a multifamily is more expensive than the cost a year ago. That's true. The cost a year ago was more expensive than the cost the year before. I could keep going with that and that's just the fact in multifamily.
Michael: Generally, real estate is that every year you go out, you're going to have inflation in materials. Do you have these recessionary periods where people are slow when it comes down and you might save 10% at recession? Sure, right. The offset to that, though you have to look at the revenue as well when you have revenue as the equalizer. That's the multiplier effect. When you look at cap rates, a four cap rate is the same as saying you have a 25 multiplier on your earnings. There's a lot of leverage on that side so you don't need much.
When you have a 20% increase in costs, you only need a corresponding $75 per month increase in rental rates per month in some of these people's properties. Don't quote me. It's not exact, but it's pretty close when we do the math. When you have places like Phoenix that are growing 17% year over year right from the depth and those rents are growing at 250, $300. The way the calculus works out is that your development margins. Even though you've had costs that have run-up, they're actually getting bigger than they were in 2018 and 2019.
Your revenues are just soaring far ahead of costs. There's two sides of that equation and everybody is focused on costs. But you can go back into the history of real estate. Every year, you're going to have higher costs. What really exacerbates this is just the magnitude of those costs in the last year. But keep in mind that we're coming off a very low, low. What we have to really concern ourselves now is these supply logistics.
Plans for Expansion
Michael: Even though we're entering into these GMPs, can people get the cabinets, the studs, the drywall, everything else on time into the property so we can lease it on time as well.
Darin: You guys have done so much. What's the next big stretch goal for you?
Michael: We're actually having a meeting with our team leaders in about a week from now. They're going to present the plan for their individual divisions. They all do a SWOT analysis on Origin. We want to continue to grow and deliver the same quality that we have for the last 10 years. That's hard to do especially as you scale. When you go from managing 300 or $400 million of equity, then you go to a billion, and then you go to $2 billion.
How do you build the engine to be able to deliver the same quality? In the investor relations department, still that high touch, the returns on the ground, everything. We're expanding. But one thing David and I have always done well is we've grown at a measured pace. We're not afraid to say no, to turn capital down, to turn deals down, to do things that make sense in the long run.
One of the roles of a CEO is that you not only have to understand where you're going in the next 12, 18 months but really be looking out at the horizon five years out. We're going to be at 10,000 units probably this time next year. That's not even a stretch goal. We have about 2000 investment partners today who we proudly serve. That was a stretch goal. We look back five years ago and we had 100 investment partners.
Delivering the Same Quality
Michael: We've grown the business, that goes back about six years ago, from 100 investors to 2000. We'd love to get up to 10,000 investors at some point in time in the future. But, it's doing more of the same and making sure that we're delivering the same quality to the market.
Darin: What do you like to do outside of work?
Michael: Today, it's pretty miserable so I'm not doing anything. I'm in Chicago right now. It has been pouring.
Darin: So golf?
Michael: Yes, I golf. I have three boys. I've been married for 21 years. My boys are 19, 17, and 14, soon to be 15 in another couple of weeks. They keep me busy. I love to snowboard.
Darin: Where do you go?
Michael: Out west, everywhere. You name it, I've been there. But Whitefish is a new place for us to be going. That's the untapped resort in Northwest Montana. I go to Big Sky, Telluride, Breckenridge, Vail, Aspen, all over. Tahoe, I'm going again this year. I'm happy wherever there's snow and good friends.
Darin: Three boys, 19, 17, 14. I'm guessing that they're probably snowboarders too, if dad is.
Michael: No. They started on skis. We're the backwards family. My wife and I snowboard and the boys ski. It's funny because when I started snowboarding, I was a skier before snowboarder. I took it up in my early 20s and that was the time that snowboarding took off. But when you think about skiing back then, it wasn't as fun. So all the kids who wanted to get in the snowboard park and go to the halfpipe, they all got on the snowboard.
Michael: What happened was skis took a page out of the snowboard book. They started shaping them and making them more fun. All of a sudden, the skiers were in the park, they were in the halfpipe, they were doing this. There was really no reason for kids to transition. You saw a mass adoption of snowboarding in the '90s and maybe going into the early 2000. But that's fallen off quite a bit.
Darin: That's the opposite. I'm a skier, my wife's a skier, and my kids ski. But they're like, "I want to learn how to snowboard." I always thought it was the younger generation that liked to do it.
Michael: What I like about it too is it's what I call active meditation. I was telling my wife about this. It's like my happy place. When I have trouble sleeping or having anxiety, I just close my eyes and think about going down the mountain. Endless powder below your feet and just riding. It's like surfing and you're not thinking about anything at that moment in time.
Whether you're skiing or you're snowboarding, it's all great. You need those moments where you're not looking at your phone, you're not around. You're just thinking about the 30, 50 feet in front of you and taking in the fresh air. I love it and everybody needs to recharge.
Michael Makes It Easy to Connect
Darin: You got a good one there. If somebody wants to reach out to you, what's the best way to get to know you guys more?
Michael: origininvestments.com. You can go right to our website. We make it super easy. You can connect with anybody in IR right there, you can also email them at email@example.com. All of our materials are downloadable so we really leave it up to the investor if they want to have a conversation with us.
I highly recommend going to our website. You have to fill out some forms but you can download our deck, you can read about us, and learn whatever you want. Then if you're interested in taking the next steps, just reach out to somebody in IR. They'll be happy to answer any questions you have.
Darin: Michael, I appreciate you coming on the show. Listeners, I hope you enjoyed that one. These guys have a ton of experience and I'm just glad we got a chance to hang out and talk. Hope you guys enjoyed that one until next week. Signing off.