E317: Why Most Real Estate Investors Optimize the Wrong Return Metric

0:00Andrew Berman:So you worked inside one of the two AQR co-founders, David Cavalier's family office. You saw an opportunity to invest in real estate in a tax-aware strategy. What was your thesis behind starting with EGT?

0:13David Weisburd:Starting with Architel, we are a private investment firm specifically focused on maximizing after-tax returns for a taxable client base. You know, I began my career at AQR. And as you mentioned, you know, I saw how AQR was developing what has now become their tax aware public market strategies. And as you're probably well aware, they've grown significantly over the past several years with the strategy. You know, as as they were growing and incubating those strategies in house, there was an opportunity because AQR doesn't do anything within private markets to try and bring the same tax focused lens into private assets.

0:50David Weisburd:Tell me about the opportunity for tax-aware investing in real estate. Real estate is gifted one of the most advantaged tax codes of any investable asset class in the United States. And I think what will be pretty eye-opening is everybody knows or has an intuition that real estate can be tax-efficient. But I don't think most people understand just how much they're leaving on the table unless they approach it in a very intentional manner.

1:12Andrew Berman:Break that down to brass tacks. What kind of tax savings are we talking about? And does this really move the needle?

1:18David Weisburd:So approaching private real estate investing in a tax focused manner can result in a two times greater after tax net of fee return or basically true wealth creation compared to a tax agnostic strategy. Look at incentives of the managers that are actually managing these underlying private real estate investors investments. They're incentivized to cycle through investments. That's typically how they take payment of their own performance fee. They can crystallize their promote. Well, when you do that, you crystallize the tax consequences, the depreciation recapture, some of the capital gains implications of private real estate.

1:54David Weisburd:So I think, again, you're leaving a lot on the table if you don't approach private real estate investing in a manner where there's alignment of investment strategy with structure.

2:04Andrew Berman:Some listeners might question why I talk a lot about tax and tax alpha. And I just look at the markets very much as mostly efficient markets. In the public markets, I believe in the mostly efficient market hypothesis. And the private markets, it's more efficient than a lot of people think. And tax is one of those parts of the market where you can actually sustain alpha, especially when you're talking about, you mentioned double the post net returns on essentially what I would guess is a similar investment. So you have the same kind of high-level investment in the same property. One is tax advantageous, one is not.

2:43David Weisburd:You might get twice as high a return than a tax-advantaged one.

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4:12David Weisburd:That's absolutely correct. I mean, it's this concept of structural alpha. So again, if you combine an underlying investment strategy and marry it with the right structure, you can get more than a two times after tax total return. It's greater than if you approach it in a tax agnostic manner. And I think this is really critical because when you approach investing as a taxable investor, it needs to fundamentally shift how you evaluate the investment options that are available to you because you're no longer looking at items from a pre-tax basis. So some strategies that can make a lot of sense from a pre-tax return basis no longer make sense once you layer in the after-tax return considerations.

4:47David Weisburd:If you look at a traditional endowment model, they have high single-digit exposure historically to private real estate. They don't get any of the tax advantages that are afforded to it. So when you layer in the after-tax return profile, some of the diversification benefits and the correlation to other major investable asset classes, I would argue that taxable investors on average can tend to be under-allocated to private real estate.

5:09Andrew Berman:So maybe this is a good time to double-click on what it means practically to invest in tax-aware real estate strategies. So I'm a high net worth investor that's investing a million dollars into this strategy. What do I get?

5:20David Weisburd:You should be able to get via K-1s, pass-through depreciation. And by the way, the current administration. Recent legislation has been implemented that makes it very, very, let's say, compelling to invest into real assets because you're able to accelerate a lot of depreciation and take bonus allocations up front. You look at private real estate, whether it's the non-traded REITs or traditional closed-end funds, they have a set life cycle. Maybe they underwrite to three, five, or seven-year target durations. They're cycling through properties. That is how you trigger a lot of the tax consequences that are associated with private real estate.

5:56Andrew Berman:And that's because other firms are not focused on an after-tax basis. So it might make sense for them to sell, to generate DPI, and to show a multiple to investors. You guys are focused on a very different part of the market where you're focused on the taxable investors and what they care about is after-tax.

6:11David Weisburd:There are a couple of factors that drive the cycling mentality that's been traditional throughout private real estate. The first is if you're serving a taxable and tax exempt client base, your mandate to maximize after-tax returns falls because you're also trying to cater to maximizing pre-tax returns, which by the way is how most managers operate. So that should fundamentally shift whether or not it makes sense to sell an asset in a particular moment in time. Again, if you don't have to underwrite what the tax consequences are, that's the first answer. The second answer is if you think about traditionally how most managers get paid, it's through promote, it's through carry.

6:46David Weisburd:And typically carry is crystallized and payable once the properties or underlying investments are sold. That's the liquidity event. And then I think, you know, the third thing is, look, it's people get addicted to liquidity.

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9:09David Weisburd:By specifically focusing on a taxable client base, we remove that mandate of trying to serve both pre-tax and after-tax returns clients. So we can specifically focus on how do we maximize after-tax returns.

9:21Andrew Berman:I want to go back to where we started, which you said that real estate investors, taxable investors can double their after-tax gain versus a comparable investment.

9:32David Weisburd:Walk me through that. So let's take an investment that is underwritten in a tax agnostic manner to a five-year time horizon. Again, that may be consistent with what you see in a lot of private real estate funds, some direct investments. Think about what happens. So you make an investment. Hopefully, there's yield that's getting thrown off, depending on what that investment is. You do generate some depreciation so that yield can be tax shielded as it's coming out to you. And then the asset is sold. And for the purpose of this illustration, a 1031 exchange is not utilized. So you actually have a taxable event at that moment in time.

10:05David Weisburd:Well, through a combination of some depreciation recapture, so the depreciation recapture can be broken out into several different buckets. Some is taxed at actually ordinary income tax rates. Some is taxed at a more advantaged cap 25 % federal rate. But between the depreciation recapture and the long-term capital gains, and I'm being generous here, assuming that the investment is held for several years, so you're not falling into a short-term capital gain scenario, you're paying tax drag at that point. And that blended rate can be, depending on your state of residency, if you're a New York City resident, as you are, that effective tax rate can be well north of 35%, combined state, federal, and potentially city.

10:44David Weisburd:Compare that to a strategy where you remain invested. So you continue to get yield off of the underlying investment. Maybe there's some refinancing scenarios that allow you to very tax efficiently continue to get your capital out from the underlying investment. And you stay invested and continue to compound. Well, in addition to deferring the depreciation recapture and the capital gains event to the long-term capital gains event that I just referenced, what you're also able to do is if you've generated depreciation from that investment and you've banked these passive activity losses, this tax asset on your books, you can actually free up and utilize that tax asset if you pair it with other passive income generators.

11:18David Weisburd:And then what you can do is you can actually, again, increase the after-tax return across that second investment, whereby it significantly increases the value of the first investment you made.

11:29Andrew Berman:And do you also look for 1031 exchanges within your strategy, or do you just rely on holding for a long time?

11:35David Weisburd:So the 1031 exchange is a gift from the IRS. It's an incredible tool to be able to rebalance or trade out of an asset and continue to defer the tax liability. So to continue to defer depreciation recapture, continue to defer the capital gains of that at that moment. Our strategy specifically, we're not reliant on the 1031 exchange. We're actually underwriting to 15-year pull periods. You know, at that moment, once some of the tax benefits do start to diminish, as you think about working your way through a depreciation schedule, we have the ability to utilize a 1031 exchange to tax efficiently rebalance our portfolio.

12:08David Weisburd:But the strategy itself is not predicated on the use of it. I think that's one thing. Look, I want to highlight this. Again, it's a gift. It would be wrong of me to try and say it's not a gift from the IRS. But we find it's overused. It's too prevalent. And if it's used incorrectly, by the way, so you have managers that are cycling out of assets and are justifying their tax efficiency through the use of the 1031 exchange, I would still then ask, okay, how much are you paying away to frictional costs, even separate from taxes? There's a lot of data that suggests that if you're a 1031 buyer, because of the time pressures that are implemented on you, you tend to overpay for the replacement property.

12:43David Weisburd:Not to mention, by the way, some of the fees that a lot of 1031 exchange facilitators will charge to the underlying client to execute a 1031 exchange.

12:51Andrew Berman:You obviously built this with a billion dollar family office in mind, David Kavler. Other family offices, when they come to you, what problems are they looking to solve?

13:00David Weisburd:There's two different kinds. So you have a family office that's of scale and has the in-house capabilities to go and implement direct real asset or private investing themselves. So I would say off the bat, if you're of scale to bring a team in-house, you go in and you can build a diversified portfolio where you're the only investor you control buy and sell decisions yourself. That's the optimal way to invest, right? And you can actually layer in tax considerations from other parts of your portfolio to inform when it may make sense to actually trigger sales of those underlying investments. What we have found is that a significant percentage of family offices, whether it's because they're not of scale to actually bring that team in-house or candidly, some that just don't want to take on the operational complexity of executing deals directly and then managing those investments.

13:42David Weisburd:You know, an outsourced solution can be very compelling. And by the way, that's really what Architel was founded for. It's how do we become an outsourced solution for, you know, ultra high net worth taxable investors? Do you find that you have to sell the post,

13:58Andrew Berman:the net of tax strategy with every new client?

14:00David Weisburd:The answer is yes. And I mean, I'll even take a step back as we were launching Architel several years ago, you know, looking at how competed, the private real estate industry is. Most investable asset classes, you've been talked about, alpha gets eroded. Everybody's going to say they have smart investment teams and they're smart and thoughtful with underwriting and risk management. Given how competed and commoditized the space was, our North Star to really differentiate in a sea of sameness was how are we more thoughtful about tax efficiency? How do we specifically focus on serving a taxable client base to the best of our abilities in a commingled structure?

14:33David Weisburd:So for us, that has allowed us to get into business and to keep growing our business in this really commoditized and competed space. I think we're still in very early innings of the tax story here. I mean, you look at the incredible traction some firms like AQR have gotten as they've grown their tax-aware investing business. I think if you're a taxable investor, the metric that matters is what your after-tax return is. And I think that is going to continue to proliferate across the investment industry. And if you're an RAA or you're a family office or a multifamily office, how do you differentiate and provide value to your clients?

15:08David Weisburd:How do you provide alpha that won't get eroding, structural alpha? It's really through how are you smarter about tax? How are you more thoughtful about the structure and the strategies that you're marrying?

15:19Andrew Berman:You have a unique vantage point where you are helping the co-founder of AQR who built the largest really franchise in tax-aware investing. You now deal with tax-aware investors all the time. What do you attribute to the rise of tax awareness in this entire trend?