The X-ray Beam: Michael Episcope, Origin Investments
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Welcome to another installment of the X-ray Beam series.
For those who have been following my journey, you know that I am a big fan of adding real estate to one’s portfolio.
Every real estate sponsor on my website represents a company that I have actually put a significant amount of my own money in various investment opportunities.
This year had been incredibly kind to me regarding returns on my real estate investments, highlighted by a true windfall when the medical building I practice in, and had been a ground floor investor of, sold for quite a tidy sum.
The biggest problem was finding quality investments so that I could deploy this cash and eliminate the sizeable cash drag that was occurring on my portfolio.
Fortunately I came across a fund, The Income Plus Fund, by Origin Investments, that really piqued my interest and the more I delved into the details, the more I wanted to be a part of it and subsequently made my commitment.
Michael Episcope, the co-founder of Origin Investments, was kind enough to grant me an hour long phone interview that I think will provide a ton of high yield information to any readers who may themselves be contemplating entering this investing space.[Disclaimer: As previously mentioned, I am an investor in the Origin Income Plus Fund. Origin Investments is also a paid advertiser on this site.]
Can you first tell a little background about yourself?
I got exposed to real estate when I was very young.
It was because of my grandfather and my summer job helping him with his apartment buildings.
I did everything from cleaning to construction work when I was 10 to 12 years old.
I saw the life that real estate afforded him.
Over the next one to two decades, however, I really didn’t touch much real estate.
I went to DePaul University in Chicago, studied finance, and started working at the Chicago exchange when I was 19 years old.
I did quite well and worked my way up through the ranks from a clerk making minimum wage to becoming a broker.
I soon realized that this was not something I wanted to do.
I then moved onto the principal side.
In 1996 I got hired by a hedge fund manager to manage the risk in their futures portfolio.
I was kind of a one man show.
I started trading and did very well.
The 9 years of being on the trading floor offered me a great opportunity and it is where I really built my wealth.
During this time my risk profile changed.
When I first started trading, I was single and had nothing to lose.
By the end I was married and had 2 kids with another one on the way.
I did not want to continue to take on unnecessary risk.
The next phase was therefore sort of a natural evolution.
I am now more of a family guy and interested in preserving, protecting, and growing the wealth I had accumulated.
I enrolled in a Masters real estate program in 2006 and gave up trading for good as I did not want to take on that risk anymore.
What is the origin story of Origin investments?
In 2007 my partner, David Scherer, and I got together to form Origin.
We had already known each other for 5 years and shared a lot of the same views.
We wanted to create an institutional platform that was built for individuals.
We wanted the best of the entrepreneurial world where you could find good quality deals that can generate alpha but at fees commensurate with what larger institutions were paying.
We were not the traditional model where we were trying to do a 95/5/5 structure.
Instead we would typically take 40-70% of the deal and fund it with our own money and then round it out with 30% from the investor pool.
I think people love the idea of “skin in the game,” and with managers that are aligned with you.
It was really important to have this alignment between the investors and everyone at the firm so it creates either a win-win or lose-lose situation.
We did not want a traditional wall street model where heads WE win and tails YOU lose.
The core of our belief is that we will make money when we deserve it but not before we deserve it.
Origin Investments was founded in 2007, which meant that your company experienced firsthand the Real Estate bubble/recession during the early years.
What, if any, lessons were learned from this housing crash and what advantages were gained over competitors who came onto the scene only years after the recovery?
We had a distinct advantage in 2007 because at that time it was only our money at play.
We were very patient during that time and didn’t invest a lot in 2007/2008.
We were just not finding any deals in 2007 that represented a good expected return on our capital.
We therefore started at that time getting into the debt market and looking for ways to protect our capital.
We did start to buy deals direct in late 2008 before the downturn.
The lesson learned was that we were patient for high quality deals and that they were well capitalized.
We thus made it through to the other side unscathed and actually made money on these deals.
However there was one deal that we did end up selling because of what our business plan was and we ended up taking a small loss.
What steps have been taken to minimize the damage of a similar future real estate recession?
In reality you have to be flexible in the world as the capital markets change quickly.
If you have good real estate and it is leveraged appropriately then what you really want to do is hold it until the capital markets come back.
We did quite well during the 2009 downturn.
When you have a deal and it is producing cash flow and you have proper leverage on it you can withstand/weather any storm.
Is there a particular real estate niche that Origin investments concentrates on? And if so, why?
It has been an evolution.
Fund 1 (2011) was very opportunistic.
At that time the edge in the market was just having available capital.
If you had capital and you found deals, it was a great time to be able to negotiate price.
With Fund 2 the market started to normalize.
We then started to focus more on the operational side with a more regional model.
Fund 2 and 3 was more of an operational focus on just multifamily and office.
Today we focus on multifamily assets which to us is the least risky asset, the most predictable, and with the least amount of volatility.
It is an asset we know well.
We buy it directly.
We do value add.
Our operations are focused on one asset class so we can be best in class and build to scale around that.
When you build to scale you get efficiency throughout the chain.
Our entire office is not only built around sourcing multifamily but also managing and operating it from an asset level.
We don’t do property management.
What we do is asset management.
Investors can somewhat be fractionated on what they like to invest in.
There are those that are pro stock market, and those that are pro real estate.
If you had to convince a stock market investor about the benefits of real estate, what would be your main points of contention?
There is very little volatility day to day from real estate assets.
It has high cash flow and it is not correlated to the stock market as well.
Over a 10 year period, institutional real estate has never lost money.
When you couple that along with the fact that you have a hard asset with a lot of cash flow, in uncertain times that’s where you want your money to be in.
Being in a hard asset, where replacement costs continually increase, you are going to get appreciation and cash flow and a lot more of it, and in a more certain way, than you would via the stock market.
When you think about a piece of real estate it is more like a series of bonds, that’s how the leases act as.
As a physical real estate asset, because of inflation, these “bonds” continually increase in prices.
Your return profile has historically been greater than equities.
You are taking less risk than equities and historically real estate has outperformed equities.
It has therefore been a superior investment class to invest in.
There has been a major emphasis on reducing costs/fees by the personal finance community, which explains the popularity of index fund investments by these individuals.
Can you explain the fee structure that Origin Investments charges its investors and why you feel it is still considered a good value for an investor?
This goes back to efficiency and making sure that we are building to scale and that we are aligned.
The way our fee structure was adopted was looking at the institutional framework.
In the income plus fund we have a 1.25% asset management fee, which is really at the low end of the market.
We also have an upfront administrative fee depending upon how much you invest, between 0-2%.
In this fund there is zero committed capital fee.
Because there is no committed fee you have eliminated the “J-curve” in investing that you would find in traditional real estate funds.
It’s more than just the fees.
It is when and how much the fees are charged.
If you were in a fund with a committed capital fee, you would be paying fees the entire time while we are out looking for deals.
By the time you actually invest your capital, you might have 85-90% of that original capital to invest.
We have implemented a 50 basis point acquisition fee at the property level itself so that at the end of the deal we actually do get paid something for the time spent.
It is paid upon success of putting money to work instead of paying fees while we are looking for deals.
Lastly is our performance fees.
We have a 10% performance fee that I feel is fair for the unit of risk we are taking.
It comes down to what is the net return, the return that investors should be achieving, for this unit of risk.
When we look at the income plus fund, 9-11% for this unit of risk is a reasonable return.
We sort of worked backwards in our fees and that’s how we came up with this fee structure.
One of your most recent offerings, and one that I have a commitment into, is the Origin Income Growth Fund.
This is a truly open ended, hold indefinitely type fund philosophy.
This is a different approach than your previous funds.
Can you explain the rationale for creating this fund model?
The idea behind this fund is that real wealth is created by holding assets forever.
Not selling in and out of them.
What are the benefits of having a fund that acquires assets and holds them indefinitely?
One of the great benefits of being in real estate are the tax benefits.
The depreciation, the ability to defer gains pretty much forever, and have your money continue to grow in one vehicle.
What we have learned from our past funds is when you have a Buy->Fix-> Sell model, the sell might take risk off the table but it also causes 2 problems:
- It is a taxable event
- You have to redeploy that money.
Money that is sitting idle produces a tremendous amount of cash drag on the portfolio.
Our model is to put all your money to work at one time in high quality deals.
It is better to get 10% on 100% of your money than 15% on 10% of your money.
We are trying to create vehicles that generate more wealth for people.
An IRR is not something you spend.
A lot of people chase IRR but they don’t factor in the taxes AND the downtime of that capital between deals.
The reality is you are much better off leaving your money all in at 10% growing at that rate than to continually trying to chase high IRR deals, paying taxes with each exit, and taking on that unit of risk.
For us it was easy.
We take a lower unit of risk and earn more money.
And that is the definition of a better product, delivering a better risk-adjusted return.
It is the way the wealthiest people in the world invest their money.
They buy real estate and hold it forever.
If one of the contained assets in the Income Plus Fund was to receive an over-market offer, would the fund be able to capitalize on this circumstance or is it bound to never sell?
We have the ability to sell assets in the fund.
We would utilize a 1031 exchange in that instance.
Therefore, within that fund structure we have the ability to recycle capital.
That would not create a taxable event for that investor.
It gives us flexibility to get into an asset that we may like for the next 3-5 years but not necessarily like it as a hold forever asset.
We can then still entertain, invest in, and take advantage of those opportunities.
Are there any disadvantages that you can think of that this fund would present when compared to a more traditional syndicated transaction in which a typical property is purchased, value added to, and then sold in 7-10 years?
This fund, as we evolve maybe 5-6 years down the road and as we scale and get bigger, will have more exposure to beta rather than alpha.
Over the first 3-5 years there will be more alpha in the fund and idiosyncratic risk that we are taking on with new deals.
Every fund that we have built has been an evolution and an improvement over the funds before.
Had we held all of our assets in Fund I, II, and III we would have done much better today as investors than selling those assets like we did originally.
We had good quality real estate, it was cash flowing and our investment bases were well protected.
We could have held them for many more years.
One of the main benefits of real estate is the ability to use depreciation to offset income.
For commercial properties the depreciation schedule is 39 years.
Thus, in year 40, there would be no ability to offset income from a property that is fully depreciated.
This of course would not have any impact on funds that typically sell these properties every 7-10 years or so.
However, with an indefinite hold fund like the Origin Plus Fund, this may indeed have financial consequences.
What are your thoughts on this scenario and are there any countermeasures against it?
The reality is that we are a buy forever fund.
I can’t imagine, even though the fund is perpetual in life, that all the assets in the fund will be held forever.
Certainly, some of the assets will indeed be held for 40 or more years.
I think in that situation you may run out of depreciation.
But in reality a building is a depreciating asset and it needs to be “capped up.”
What that means is you need to put more money into it every several years so your basis in the asset increases.
I would imagine over 40 years you are putting the equivalent of the original basis in terms of improving the building and keeping it up.
As a manager you have to continually put money into the building which brings up your basis and expands your depreciation schedule out further and further.
I believe I speak on behalf of other general investors like myself when I say that it raises my confidence level when I know that the principals in the company have some, “skin in the game.”
Do the principals at Origin Investment put their own money at risk in these funds?
Our initial investment between the two principals in the Origin Income Plus fund is $10M.
David and I both use Origin as a means of protecting and growing our wealth.
We designed these funds with our own needs in mind.
We designed these funds so that even if we didn’t work at Origin we still would invest in these funds.
What our capital raising team loves about our structure is that investors, no matter how much they dig into the details of the PPM, will not discover any “gotcha” moments.
You might find a “gotcha” moment in other funds.
But in our funds, we put everything up front and center because we want our investors to understand exactly what they are getting into and not finding stuff out 2 years later in the fine print that they did not understand.
To us, it is very important that there is a meeting of the minds and that the investors understand what they are getting into.
We are building products that we feel proud to put other people’s and our own money into.
One of the biggest concerns of an investor is losing the original capital.
In the history of Origin has any investors lost any capital in a deal?
In your entire fund portfolio, what has been the return of the poorest performing fund?
We had a loss dating back to 2010.
We bought a distressed condo deal in Chicago and ended up finishing it out and selling for around a 10-12% loss.
It was our one and only loss and we bought it in 2008 and sold in 2010.
Myself and the other principal had personally invested in about 70% of the total capital.
The Origin that you see today really started in 2011.
That is when we started out our fund business.
Prior to that, in the beginning, it was more like friends and family.
In the history of all of our funds we have never lost money.
Our worst performing deal was a student housing complex in Tallahassee we invested in for Fund I in 2011.
We got in and out of that deal in a year and made 10%.
Syndicated real estate investments are often considered illiquid.
Investors deploying capital should anticipate not accessing this capital for many years.
In a fund such as the Origin Income Plus Fund, when can an investor request payback of capital and are there any penalties associated with such a request?
If there is a financial hardship scenario, what options does an investor have if they want to tap into the invested capital?
For the first 5 years there is an early withdrawal penalty in our Income Plus fund.
When people get into real estate, they should have a 5-10 year outlook.
They are in an illiquid investment.
Real estate is not the market that you can easily time.
The frictional costs of getting in and out of real estate will destroy your return.
If someone has a hardship, we will always work with them.
We have had investors in Fund III who committed to the fund but then could not honor their commitment when there was a capital call.
This has happened to us only three times.
Something happened in their life.
We have had to deal with deaths and divorces.
Although there are penalties listed in the PPM for not funding, those are things that are considered legalese.
Then there is the way you want to do business.
So what we have done for those people is that we have 100s and 100s of investors who are looking to get into those funds and we just call them and ask if they are willing to take over the exiting position.
We find a way to get hardship investors out as whole as they can.
We work with the individual to get them out at the best price possible so that it is the least damaging to them.
However, we also don’t want people to just get in and out of that fund and that is why there is a penalty in the first 5 years.
We want long term investment partners who understand the value of having real estate in a portfolio over the long run.
Real estate, like the stock market, tends to follow a cyclical nature.
Many real estate pundits have been warning about the possible end of the current real estate market highs, citing CAP compression and rising interest rates as indicators for diminishing future real estate returns.
How is Origin positioned to handle these predictions?
This goes back to risk management 101 and some of the things we have learned by watching the people who have successfully navigated the last downturn.
We intentionally have constructed the portfolio so that we are in 10 of the fastest growing cities in the United States.
That is the type of markets where you want to be.
Because even if there is a downturn:
- We have diversified across those 10 cities.
- When there is a recovery, you are going to have winds at your back in these cities.
We also position ourselves in sub-markets with high quality assets anywhere between class B and better.
We focus on an individual who is a renter by choice.
A renter by choice is someone who is generally white collar, has a college degree, and is least likely to get laid off.
They have high credit scores, they care about their credit, they don’t default on the rental payments.
From the financial side we make sure that we are leveraged appropriately with non-recourse debt.
The fund does not take recourse debt.
We also ensure that there is plenty of equity so that if the property does go down between 5-10% we are not going to be handing the keys back to the bank.
We don’t take excessive financial risks.
Lastly, just being in a multifamily asset class is going to experience the least amount of volatility in a recession versus any other asset class such as retail, office, or industrial.
Filing taxes can be a tedious and/or expensive process.
With properties spanning multiple states in each Origin Fund, does every investor have to file multiple state income tax returns?
All of the tax returns roll up to the fund level and then Origin files them.
Investors only get one K-1 for their investment.
In the Income Plus fund we have constructed a REIT blocker.
This is a great advantage of investing in this fund instead of individual syndicated deals.
Within the REIT blocker structure you are investing into the fund through an LLC.
The LLC then invests that in a REIT below it and that REIT is kind of a shell that doesn’t do anything.
But for tax purposes the income is treated as a REIT.
So what it does is for anyone who is investing through 401ks, self-directed IRAs, etc. is that they don’t get hit with UBTI (unrelated business tax income).
As you can see, there was a lot of incredibly high-yield information Michael shared with us about Origin and the latest fund, The Income Plus Fund, during this phone interview.
We actually continued the phone conversation and discussed another exciting offering that Origin has, the Qualified Opportunity Zone (QOZ) fund which will be further detailed in next Thursday’s Part II concluding post.
If you are interested in checking out previous individuals that were brave enough to expose themselves to the beams of the X-ray, please check them out here.
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