Highest and Best Use of Capital Part Two: Investing for Scale

The scarcest resource

To find the most profitable return on capital, it requires making timely decisions with limited information and cultivating access in the right places ahead of time.

While it may seem like the most scarce resource in this game is capital, in reality the scarce resource is really time. That’s where we ended up in part one of this series.

With time, you can develop a new relationship that leads to more access and information.

With time, you can model new scenarios.

With time, you can try and fail enough times to adjust your plan and even sharpen your intuition.

Therefore, instead of plowing ahead with day to day work of pursuing the investment opportunities all the time, it’s important to step back and design your systems. Of course Ray Dalio has a entire set of principles describing this, which may be summed up as:

“Design Your Machine to Achieve Your Goals” - Ray Dalio

I’ll use the word “Machine” for the rest of this post in the Ray Dalio sense - it’s not a physical machine or even just software that I’m referring to, but the holistic design of the business as a system that includes assets, software, people, and processes.

Let’s dive in.

Build the Machine

Many real estate investors start off small, taking down a deal by using their own cash that they’ve saved up in the bank. Real estate investing could be their “side hustle” or they may cut the cord on their W2 job to become a full-time real estate investor. The “machine” for those starting off with a side hustle lives in their head, and likely does not yet take in outside Equity capital (but almost always employs Debt).

Further up the market, you’ll find syndicators - they are beginning to create a machine that takes equity capital from other investors and runs it through their investment process, asset by asset, deal by deal. Here you start to see role specialties broken out between underwriting, investor relations, administration, etc.

Look further up the market again, and you see private equity funds and REITs which are truly investment business machines. They have organizational structures, training programs, executives and employees.

But fundamentally these machines all have the same purpose - money goes in to invest in properties, and money eventually comes back out (hopefully with a healthy return) to those investors.

Feed the machine

If capital is the investment machine’s “food”, then data is the machine’s “water”.

Why?

Because capital can be readily attracted based on strong performance, and to scale performance requires more than the real estate knowledge you can cram into your own head. Data is knowledge at scale.

It takes the collection and analysis of data to systematically discover the highest and best use of many properties.

The information required to quickly discover the highest and best use of a given property is pretty varied. It includes location intelligence (remember the initial example about the right parcel in the right neighborhood in a growing town). It also includes the physical characteristics about the structures already on the property (if any), the zoning of the parcel, and the strength of the local economy. Every characteristic is an input into determining the potential income and expenses for different uses of that property in the future. Great investors are like Wayne Gretzky - they “skate to where the puck is going” in regard to location trends.

These can all be considered the “what” of the property information, though very often investment decisions also must include consideration of the “who”.

For investors that are not stepping in to operate the property themselves, the “who”information includes the property management, but could also include the development and asset management teams as well. Large private equity real estate shops and REITs can be vertically integrated and perform their own development, asset management, and property management, but either way the investment committee delegates all those tasks to the right people who are great at those respective functions, whether they are employees internally (vertically integrated), or operating partners.

The process of evaluating the What and Who of every potential real estate real estate deal is the Underwriting process - but underwriting prowess alone is still lacking the final element for successfully generating returns. The machine needs to be connected.

Connect the machine

Whether you are an individual with a real estate investing side hustle, or the leader of a large fund that operates a sophisticated investment machine, you need access to deal flow that filters through your underwriting machine.

To connect the machine to deal flow takes relationships that result in those opportunities.

The brokerage community is one of the most consistent channels for deal flow. A typical Investment Sales broker tries to bring acquisition opportunities to as many potential buyers as possible, unless they are keeping a potential deal “off market” which means their outreach to buyers should be much more targeted and private. A strong track record and well-maintained relationships will lead to more off market opportunities.

There’s also a deal channel for equity partnerships from other investors that have deals under contract or otherwise in-progress. This can be based on a pre-existing relationship between different investment groups, or through Capital Advisory teams/platforms who are seeking alternative capital partners beyond Debt to fill up a capital stack.

Like any relationship business, developing a track record takes time, then pays dividends for years to come. Both the track record itself as well as the relationships formed along the way lead to more open doors, which gives a higher probability of finding the right deals. This is how you maximize the chance of achieving the highest and best use of capital.

Remember, the amount the amount of capital resources an investor has access to isn’t fixed. Offering to invest other people’s money as a syndicator or fund is how investment machines scale. Then, good stewardship of others’ capital is the final way to scale.

The machine is working - so what?

Cool, you nailed it, you built an impressive investment machine, you made lots of money, and now you can afford a nice car or even a boat.

So what?

As widely cited studies have shown, there’s a plateau in how income leads to happiness. At a certain point, you’re going to look back at what you’ve accomplished in this world, and you’ll be thinking about more important things than money.

The scarcest resource is still time. Wouldn’t it be a shame to wait until the end of life to decide whether you were playing the right game?

The industry is increasingly speaking about Environmental, Social, and Governance (“ESG”) initiatives like reducing the carbon footprint of buildings, or critiquing the lack of diversity in the real estate industry. Those are well and good, but they don’t go far enough.

In the third and final post in this series, I’ll dive deeper into Investing for Good.