By Stephen J. Duffy, Managing Director, Moss Adams Capital LLC
“The shift from operator to investor can be quite fulfilling and enjoyable if the transition is sound and the timing right,” says Duffy.
IRVINE, CA – Do you know any retired real estate principals? Really? Does anyone believe that a real estate principal ceases to participate in our industry at some particular age?
I suggest that what really happens is a shift from “operator” to “investor.” The real transition for senior principals is a shift away from day-to-day-execution activities to purer asset management of a personal real estate balance sheet. But this nonetheless poses a succession challenge at many real estate firms: Who will replace the senior principals in their day-to-day responsibilities? What are the business’s strategic alternatives? And why is this particularly important now, as economic expansion is in full swing?
Today’s challenge is based on two simple concepts: Cycle timing and age. We’re all too familiar with the length of the Great Recession and the current real estate recovery. When we look back across multiple cycles, we can see that recoveries and expansions range from five to seven years. Downturns and recessions have ranged from three to five years. This cycle arithmetic suggests what we should expect.
Assume we have five years of real estate industry expansion ahead—great news. Now assume that the peak, say 2019–2020, is followed by three down years, the short end of the negative side of cycle duration. Now add eight years to the current age of senior real estate principals to get to the next hypothetical cycle bottom. Consider your own organization and all the real estate operating companies you know with the age and timing of this hypothetical example for the senior principals. It’s pretty remarkable to see the issue in such a basic way.
Consider too that the enthusiasm to go through those three (minimum) years of the next downturn and recession might not be very high. The negative side of the cycle is uniformly complex, difficult, and disturbing given equity loss, debt restructuring, capital calls, overhead shortfalls, layoffs, etc. If you’re in your 60s and beyond right now, why would you want to go through another recession five years or so down the road?
Three California real estate CEOs I know well had transitioned over to the investor side before and heading into the Great Recession. One has morphed his interests into a personal private equity shop that favors co–general partner investments with a bias toward housing. Another has transitioned to being an investor in the family’s industrial investment business at the same time as building one-off custom homes on special infill locations in high-end communities. A third has turned the operating business over to his son while remaining a co-investor in the core business. I’ve never seen these three former driven and active CEOs happier than they are today.
If you assume that many of today’s senior principals won’t want to be an active operator when our industry cycles
into the next downturn, the succession clock has already started to wind down. How many senior real estate
principals would like to transition from operator to investor on or before the coming peak?
Here are five things to consider in planning a transition:
• Crossroads decision. Decide whether to hold and transition or sell the business within the next five years
(obviously, pre-peak).
• Future leadership. Identify future leaders and increase their responsibilities.
• Guarantee entity. Create a guarantee entity to replace the personals from the senior principals.
• Recapitalization. Sell or recapitalize assets with existing or new long-term partners.
• Post-transition strategy. Establish a post-operator investment strategy.
Let’s take a closer look at each.
Crossroads Decision
Make sure you have specific reasons to pass up the usual merger and acquisition phase of the cycle before the
peak. The next downturn and recession will be challenging to one degree or another. Multi-cycle experience
has shown us that senior principals who have shifted out prior to a peak routinely get pulled back in during
difficult times.
Perform a candid personal ownership assessment of economic, risk, timing, and other goals. Compare the fit of
these goals to the potential enterprise sale or merger versus staying the course. Consider both the quantitative
and qualitative results. While there’s no assurance as to which is the best financial choice, you really want to
be at peace with the decision to continue the business through the next peak and into the next downturn.
Future Leadership
Who are the next generation of senior principals, and what experiences and behaviors do they need to take
the reins? In the pre-transition period, consider cross-training by increasing responsibilities. Is there an
investment committee, executive committee, or internal or external board? If so, make sure the next
generation of leaders is actively participating in these forums and helping to tackle the big strategic and
operational issues of the day.
Guarantee Entity
There are three basic forms of recourse: bad boy, completion, and repayment. Personal guarantees for
bad-boy behavior are ever-present. Completion guarantees exist when the development cycle is active.
Recourse guarantees exist in some form for most of the cycle except when things are roaring, which tends to
be the pre-peak phase.
Who are the guarantors, and what collateral are they providing to the requesting party? The usual guarantors
are the senior principals. When you’re planning a shift from operator to investor, the guarantee support needs
to shift. This can require a transitional period, compensation for continued guarantee support, creation of an
entity with selected property equity, etc. The shift requires thought and action, which can be complicated if it
occurs late in the cycle.
Recapitalization
Capital relationships have a lot to do with the senior principals. A big part of their “promote” contribution and compensation is the capital investment relationships they’ve attracted to the enterprise over the years. Since the experience and presence of the senior principals are generally critical to efficient capital availability, a transition can be challenging.
A going-concern, non-sale strategy requires continued capital support. The time to put the future capital channel in place is pre-transition. Consider using existing balance sheet opportunities combined with pipeline activity to create new relationships for the successor principals.
Post-Transition Strategy
The shift from operator to investor requires a reassessment of the principal’s personal investment strategy. Reconsider an investment strategy with specific elements, such as capacity, equity versus debt, current yield versus equity creation, active versus passive, term, etc. The investment strategy for the transitioned senior principal can be quite different from the behavior as an operator. The “action” can easily remain robust. It just might be different for some very good reasons, and each CEO or principal will have his or her own objectives and time horizons.
Some years ago I offered to Ken Leventhal an investment opportunity in a 10-year multifamily fund. As one of Ken’s partners at his firm Kenneth Leventhal & Co., I thought of him as ageless. But by this time he was in his 80s, and he laughed and told me his investment horizon had shortened to a focus on Treasuries. He passed away two years ago at 91.
Senior real estate principals don’t retire in the classical sense of society’s view of retirement. It’s a shift. The shift from operator to investor can be quite fulfilling and enjoyable if the transition is sound and the timing right. Given where we are in the current real estate cycle, the time for many principals to get busy on transition activities is now.
Steve Duffy leads the real estate investment banking business for Moss Adams Capital, an affiliate of the accounting and consulting firm Moss Adams LLP. A 32-year industry veteran, he has been a partner at both Kenneth Leventhal & Co. and Ernst & Young LLP and has held operational roles as COO, principal, and managing principal in the multifamily and institutional private equity sectors. Based in Irvine, CA, he’s an advisory board member of the USC Lusk Center for Real Estate, the Marshall School of Business Center for Real Estate, and the University of California, Irvine’s Paul Merage School of Business Center for Real Estate. You can reach him at (949) 623-4178 or steve.duffy@mossadams.com. The views expressed in this column are the author’s own.
