The IRR “Trap” That Costs Investors Everything | EP. 16

0:00 – Everyone in real estate is chasing the next big thing a 22% projected IRR a two-year exit a quick flip
0:07 – It sounds impressive, but when you dig deep you’ll see that the internal rate of return it often rewards something very
0:13 – Dangerous short-term market timing and when the market moves against you those same deals they can unravel very quickly and one bad deal
0:22 – Can wipe out years of gains just look at the multi-family meltdown back in 2021
0:26 – So today we’re gonna unpack why I are our focused sponsors why they got it all wrong
0:32 – And we’re gonna talk about what you should look for when building true long-term wealth
0:37 – Welcome back to the sage investor. I’m Brian Spear and my mission is to help you generate cash flow and build legacy wealth in a tax-efficient
0:44 – Matter because that’s what I’m trying to do for my family and I’m gonna help as many people as possible along the way
0:48 – Let’s share all the wisdom that we’re learning along this journey as I was building out my real estate business
0:54 – I noticed a pattern every sponsor’s pitch deck was built around one number
0:58 – IRR the internal rate of return whether it’s an 18% internal rate of return 22% internal rate of return even a 30% IRR
1:07 – I remember a Bitcoin mining fund that had like a 40% IRR all those sponsors were pitching the same strategy
1:13 – Buy an asset improve the asset sell it in three to five years at first glance
1:18 – It sounds smart right real estate it always goes up in the short term, right?
1:21 – But over time I began to notice something interesting the investors who ultimately built real wealth lasting wealth
1:28 – They weren’t the ones fixing and flipping deals every couple of years
1:31 – They’re the ones that ultimately own great assets for decades if you look at the greatest investors in history
1:37 – We’re talking about Buffett and Munger and Zell all the best investors of all time
1:41 – They were not optimizing for the internal rate of return
1:46 – They were optimizing for compounding generate free cash flow and focus on compounding wealth
1:52 – And those are two completely different games because IRR it quietly encourages behavior that interrupts compounding and introduces risk
2:02 – Let’s unpack why that’s the case like Buffett my favorite holding period is forever
2:06 – It’s no not a slogan. It’s a design principle and how to allocate capital because wealth is built through long-term compounding
2:14 – Not through constant transactions the moment that you celebrate asset several negative things happen immediately
2:22 – You pause compounding you incur taxes you introduce reinvestment risk and you know
2:28 – You end up resetting the compounding machine. Here’s the issue right the metric that dominates the industry IRR
2:34 – It often rewards the opposite behavior IRR is an illusion it measures the speed of return
2:42 – It does not measure wealth creation in fact IRR it can look fantastic on paper right even if the investment ultimately produces
2:49 – nominal dollar amounts of returns it doesn’t create significant wealth right
2:54 – By way of example right you invest a hundred thousand dollars a couple of years later
2:58 – You sell it to make a hundred and sixty thousand dollars cumulatively in distributions. That’s a fantastic internal rate of return
3:04 – But now what now you pay taxes depreciation recapture tax capital gains tax your cash. It’s idle
3:10 – You got a cash drag between when you sell deal A when you buy deal B you got to go search for the next deal
3:15 – You’re incurring a significant amount of reinvestment risk every step of the way and meanwhile, you know
3:20 – You’ve made a little bit of money, but but the other investor that ultimately you know decided to hold a durably
3:25 – Wonderful asset for decades they’re producing dramatically more wealth over time while they’re still receiving
3:32 – Significant amounts of durable predictable cash flow to live life on your own terms again
3:37 – It’s not just the return on investment. It’s also the return on life
3:39 – Well, you’re still kind of doing a job of trying to find the next deal the other individuals are simply receiving cash flow
3:44 – Consistently enjoying life on their own terms and building wealth in a compounding machine along the way compounding favors time
3:51 – Not speed, but IRR
3:53 – You know, it doesn’t just interrupt the compounding it also introduces one of the most dangerous
3:59 – Risks in all of investing most of the IRR driven deals
4:03 – Assume something very fragile. They assume that the sponsor is going to ultimately be able to sell the asset at the perfect time
4:08 – Exactly at the right time in the marketplace, but real estate markets they move in cycles
4:13 – And if your strategy ultimately requires selling in a three to five year horizon
4:19 – Bound by the legal documentation that’s ultimately signed in the operating agreement
4:23 – You’re essentially making a bet on market timing and that is an exceedingly dangerous game because at the market turns before your exit window
4:31 – The entire strategy can blow up the investor who owns a great asset for 20 or 30 years
4:37 – They don’t need to time the market perfectly. They can simply ride out
4:41 – The market cycle
4:42 – But short-term IRR strategies. They don’t have that luxury
4:46 – We saw exactly how dangerous that model can be over recent years in 2021 and 2022
4:53 – The federal reserve raised interest rates at the highest pace in decades literally in an entire generation
4:59 – And financing it became expensive and suddenly thousands of deals that were built around short-term IRR exits and decreasing cap rates
5:08 – They found themselves in
5:10 – Trouble you know sponsors who planned to sell in year three or four
5:13 – They suddenly faced a problem
5:14 – You know the market had moved against them in a material way
5:17 – Refinancing wasn’t possible virus all disappeared and many of the operators
5:21 – They’re forced to either sell at a loss or inject new capital some cases they ended up having to you know
5:27 – Lose the property entirely
5:29 – Investors that were hurt the most during this period of time ultimately were the ones that were
5:34 – Writing high using significant amounts of leverage along the way and they were you know implementing that short-term IRR strategy
5:42 – Because their model ultimately required a perfect exit window and when that window
5:47 – Closed the strategy ended up breaking and that leads to the three traps
5:52 – That IRR focus sponsors fall into the first trap is velocity over compounding
5:58 – IRR rewards speed but wealth
6:02 – It rewards patients and every single sale that you have along the way it resets the compounding clock
6:08 – And it forces investors to take on incremental new risk with each individual deal
6:13 – Continuing to increase over time
6:16 – The second trap that folks in face when when trying to implement that IRR model is their ignoring
6:21 – Tax friction IRR assumes a frictionless world in a spreadsheet. It looks really good
6:27 – But investors then a live in a spreadsheet
6:29 – They live in a world where you receive taxes every single sale includes
6:34 – Capital gains taxes depreciation recapture taxes transaction costs
6:39 – You’re gonna have to pay broker fees and defeats and yield maintenance and a little bit of other things
6:43 – But the sage principle that we will continue to refer back to over and over and over again
6:48 – Is defer defer delete
6:52 – defer taxes as long as possible
6:54 – You know and that brings us to the third trap which is sponsor incentive misalignment
6:59 – Sponsors often get paid through transactions. They get acquisition fees disposition fees asset management fees capital transaction fees
7:08 – You know, they often
7:10 – Get paid by doing deals
7:12 – But investors they build well through long-term ownership of assets by holding properties over exceedingly long periods of time
7:20 – And those incentives they’re they’re not always aligned
7:23 – Let me expand on this and just give you an example from my perspective kind of directly for folks investing passively in real estate syndications
7:30 – Oftentimes folks have the opportunity to either invest in
7:34 – Deal specific syndications or fund structures
7:38 – I would take the position that a fund structure is superior
7:41 – I’m obviously biased take it with a grain of salt
7:43 – I can go on and on and on about sharing the merits associated with that
7:46 – I do genuinely believe it afford you better deals in the marketplace if you’re going to a broker
7:51 – And you’ve got tens of millions of dollars on the balance sheet
7:54 – It’s a lot easier to get the best deals in the marketplace than stating with a deal specific syndication
7:58 – Trust me. I’m gonna go raise xyz dollars from partners and once I get this deal under contract for this reason
8:04 – You’re going to get better deals, but the most important thing is not just the deals and cetera and the
8:08 – Optionality that it provides the general partner the most important thing is the incentive
8:13 – Structure between the limited partners and the general partners. So let me give you an example
8:17 – Let’s say you’re going to go do 10 different individual deals, okay?
8:20 – In both scenarios 10 of them are going to be individual deals specific syndications versus 10 deals inside of a fun structure
8:26 – Let’s run what this looks like both of the different
8:30 – Structures have the same exact deals with the same exact individual returns in the deal specific syndication
8:36 – Let’s take the hypothetical example that nine of those deals
8:39 – Perform the way that you would have otherwise anticipated you get some singles some doubles some triples
8:43 – You might even get a couple of home runs along the way. Congratulations
8:46 – But on the 10th deal that deal goes poorly it goes so poorly that the investors end up losing all their money
8:52 – They they have a single zero event the investors lose all their money in that respective scenario
8:55 – Let’s work through kind of how does the limited partners? How do they do?
8:59 – Well the majority of the limited partners they’re actually feeling pretty reasonably well
9:03 – They again single double triple did pretty well the investors in the 10th deal unfortunately
9:07 – We’re in a very precarious situation
9:08 – How does the general partner feel about the situation? Well the general partner they actually feel pretty solid
9:13 – Why because they made millions and millions and millions of dollars on the first nine deals and in the 10th deal
9:19 – Well the investors the limited partners ended up losing all their money
9:22 – But the general partner feels pretty good. It was more of a heads
9:25 – I win tales you lose scenario from the general partners perspective
9:30 – Now let’s look at the inverse scenario with those same exact deals are inside of a fun structure
9:35 – Let’s assume that nine of those deals are doing well single double triple a couple of home runs whatever the case
9:39 – Maybe but one deal goes to zero in that scenario what occurs now granted the investors give up the grand slam or the home run
9:46 – They don’t get those massive
9:47 – Returns but also on the flip side the investors on the back end. They don’t lose all their money
9:52 – They avoid the single zero event and what happens is the return kind of reverts closer to the mean
9:57 – And maybe those returns aren’t massive grand slams
10:01 – But they end up kind of reverting they likely get all their money back
10:04 – Maybe they make a very phenomenal return along the way
10:07 – But again, no single zero event. They just do okay along the way now. What’s is the general partner?
10:13 – Do what is the GP? How does how does he feel about it? Well the general partner he probably didn’t make anything
10:18 – He probably worked for five six seven years and made zero dollars on the investment
10:23 – From my perspective that is a significantly better alignment of interest along the way
10:28 – General partner should be incentivized by performance
10:31 – Not by taking incremental risk and what this structure ends up setting up it incentivizes
10:37 – If you’re going to do deal specific syndications versus the fun structure
10:40 – It heavily incentivizes the the sponsor in the individual deal specific scenario to take inordinate and massive amounts
10:48 – Of risk to try to drive the highest internal rate of return
10:51 – But in doing so you’re introducing significantly more risk into each individual investment
10:57 – Why because obviously the higher the internal rate of return when you get into the promote structure
11:01 – The general partner receives more of that down stream
11:05 – So they’re incentivized to to do so however the the general partner inside of a fun structure
11:10 – Does not end up benefiting in a material way by taking that significant incremental risk
11:14 – Why because they are more likely to lose
11:18 – Their entire promote by taking that level of risk because they’re introducing too much risk and ultimately
11:24 – Could adversely affect the entirety of the outcome of the fund and it is for this reason that that perverse incentive
11:31 – Drives the behavior that it does from general partners and limited partners and what you really are trying to ultimately ensure
11:36 – When you’re investing with a with a with a sponsor is that you have a as the purest alignment of interest that you possibly can
11:44 – Along the way at the end of the day the individuals that have been doing this the longest they will always understand and refer back to
11:51 – Our sage principle of bet on the jockey they understand. It’s not about the individual deal
11:56 – It’s not even about the individual niche. It is about the human being that is ultimately managing capital
12:01 – From my perspective that is far superior than the niche in which you invest or the individual deal in what you invest the human being
12:08 – Managing the capital and how they’re choosing to manage the capital reigns supreme. That is the number one aspect
12:15 – It’s kind of like Brian Tracy back in the day would talk about core values and and uh, you know these businesses
12:21 – What have these various different core values and you know you’d have five six seven of them
12:25 – You know you had to be determined you got to have drive you want to continue to
12:29 – To to to learn along the way and then they have a core value that would be plopped up that would say integrity
12:34 – Brian Tracy would make the contention that which of these individual core values are the most important
12:38 – Um and integrity was always the number one because integrity was the
12:43 – Core value that insured all of the other core values
12:48 – Regardless um, you know if you the individual is determined and focused and xyz all the various myriad of things
12:54 – If they did not have actual integrity all the rest of it was completely irrelevant
12:58 – And it’s why betting on the jockey is the most important and profound aspect
13:02 – That uh that lp should be focusing on when when determining where to place capital with whom to place capital
13:07 – I believe the best possible way
13:11 – That i’ve seen a capital allocator share
13:16 – With the uh business owner who’s ultimately making the decisions for the business the best way to ultimately manage that
13:23 – Business and manage that respective capital the the most prudent advice that i’ve ever seen provided is from Warren Buffett
13:29 – In his 1998
13:31 – Shareholder letter over at Berkshire Hathaway
13:34 – Whenever he buys a business, you know Berkshire Hathaway’s got tens of thousands of employees across the country
13:39 – But at the corporate office they only have about 20 different people in Omaha, Nebraska
13:43 – So when they’re allocating capital they’re betting on the jockey they’re betting on the owner the CEO of geico
13:49 – They’re betting on the owner the CEO of c’s candies and they’re allowing them to run the business and they’re getting out of the way
13:55 – They’re they’re trying to hire mark maguire and not teach mark maguire how to swing the bat
13:59 – But they’re as a prudent capital allocator finding the right
14:03 – Business to invest in and letting them do their job and he says look i’m not going to get in your way
14:07 – I’m not going to
14:08 – Tell you to to to to run your business right you know more about it than i do boots on the ground
14:13 – That’s why i’m allocating capital with you however
14:16 – I’m only going to ask you these three things for any manager that i have in the business. I asked them three things
14:22 – I just want you to run the business as if and i i literally have this printed the 1998 chairman letter printed on my desk
14:29 – Just run the business as if one you own 100% of it
14:34 – Two it is the only asset in the world that you
14:37 – And your family have or ever will have and three
14:41 – You can’t sell it or merge it for at least a hundred years because i can promise you
14:46 – Referring back to the deal specifics indication in the fund structure
14:49 – If that deal specifics indicator
14:51 – Was acting in the manner that Warren Buffett has has stated and they were acting as if they own the businesses
14:57 – The only business that they own and it’s a hundred percent of their respective capital
15:00 – They would not be taking the inordinate amount of incremental risk on those individual deal specifics indications
15:05 – They would be operating it in a more prudent fund structure trying to drive the best risk of just the returns for their family
15:10 – And this is why from my perspective a fund structure is far superior than an individual deal specifics indication
15:17 – And it all simply refers back to
15:19 – Sponsor incentive misalignment. You’ve got to ensure that you’re betting on the jockey and not the horse along the way
15:25 – So let’s go back to the individual deal specifics indications and we’ll introduce the concept of time
15:30 – Okay, let’s say that you were the single individual that was investing in the first deal
15:35 – Then the second deal then the third deal etc all the way through deal number 10
15:38 – This is often the case when when a general partner and a limited partner are working together in individual deal specifics indications
15:43 – Let’s say somebody invest a hundred thousand dollars into that respective transaction and deal number one
15:47 – The deal goes well. Let’s say they double the money into five years whatever the case may be
15:51 – And now you’ve got two hundred thousand dollars
15:53 – Well oftentimes the limited partner thinks this individual is obviously wonderful. He’s an exceptional
15:59 – Investor he’s done a great job on this one individual transaction
16:02 – I want to try to double down keep the chips on the table
16:04 – Make sure that we we we we try to double again right invariably the general partner will find another deal because they get paid by doing deals
16:11 – And so another deal presents itself and let’s say that the second deal. Oh my gosh
16:15 – It goes well in the same vein the capital moves from two hundred thousand dollars to four hundred thousand dollars over time
16:20 – Congratulations
16:21 – This individual is so wonderful
16:23 – Oftentimes, you know friends and family are abroad and involved along the way and let’s let’s all pile in now that we’ve
16:29 – You know proven track record over the course of three four five different transactions
16:33 – Um, and then eventually market timing occurs where I don’t care if you’ve gone from a hundred thousand to two hundred thousand
16:40 – two hundred thousand to four hundred thousand four hundred thousand to eight hundred thousand at some point
16:44 – Somebody somewhere is going to miss time the market. They’re going to run into a deal that introduces incremental amounts of risk along the way
16:50 – Reinvestment risk and that entire amount no matter how large that amount goes in one fell swoop any number no matter
16:56 – How large multiplied by zero is zero and that’s why there’s so much more risk associated with investing in individual deal
17:03 – Specific syndications compared to a fun structure
17:06 – When you introduce that additional market timing risk where you’re doing the fixed and flip model invariably in a deal specific style
17:12 – That is going to occur over and over and over and you’re willing to accept the market timing risk
17:18 – Over and over and over and over and over eventually you will miss time the market
17:22 – It is an inevitability
17:24 – You do not know when that is going to occur
17:25 – Everyone’s crystal balls broken my crystal balls broken and yours is two
17:29 – But it is an inevitability that you will miss time the market and investors will end up with pause distributions capital calls and sometimes
17:35 – Total loss of capital by implementing that that more risky business model from my personal perspective
17:40 – The lesson here is simple one data point does not a trend line make
17:45 – So if you’re focused on one individual data point one individual metric in an investment such as IRR
17:52 – That does not provide the holistic perspective that is necessary to prudently allocate capital
17:57 – Nor does one data point a trend line make in regards to the track record of a given individual sponsor
18:05 – Just because one deal went well doesn’t mean that that is a an exceptional allocator of capital
18:11 – The truth is somebody has to prove their merits over multiple cycles exceedingly long periods of time
18:16 – In my humble opinion to be trusted as a prudent steward of capital starting small and then growing over time
18:22 – Using your own capital to prove the track record along the way and then incrementally
18:28 – Bringing on friends and family and then eventually after you’ve proven your track record and craft over a decade
18:35 – being willing to
18:36 – explore
18:37 – bringing on some additional
18:39 – Partners to come along for the ride with you
18:42 – But just because somebody did a deal one time well and the rate of return was solid one data point does not a trend line make
18:50 – Much more needs to be put into that analysis to ensure that that jockey as it were is actually an exceptional steward of capital
18:57 – A great investor as opposed to a lucky idiot and that’s the truth
19:02 – So if you’re not going to focus individually on IRR if you’re not going to focus on that one individual data point of IRR
19:08 – What should be what should you be focused on right disciplined investors sage investors they focus on a handful of things
19:15 – The first is durable assets assets that can be owned for decades
19:20 – Durably wonderful businesses supply constrained essential use real estate recession resistant
19:29 – Durably wonderful businesses that have been thrown off cash flow for decades that are thrown off cash flow today
19:35 – That are going to throw off cash flow per decades to come and wonderful and that they’re likely to increase in value over long periods of time
19:42 – Durable assets focus on that secondarily you’re going to focus on long-term compounding
19:47 – You want an asset that’s producing as an example 8% yield on an annual basis and 4% growth
19:54 – That’s 12% compounding you’re focusing on
19:57 – Quality risk adjusted returns that can compound over exceedingly long periods of time
20:02 – And what we’re trying to achieve is modest
20:05 – Double digit compounding returns with exceedingly
20:09 – Diminimous risk over decades that math becomes extraordinary
20:14 – One of the pillars that we have of the capitalist strategy is assurance of outcome in a perfect world
20:18 – I’d be betting on a sure thing of course
20:20 – There’s no guarantees in life
20:22 – But we’re minimizing risk to the best of our ability in every step of the way
20:25 – I’m unwilling to bet my family’s financial future on something that I don’t perceive to have an exceedingly high assurance of outcome
20:32 – And along the way if we can do so by taking a very
20:36 – Diminimous amount of risk and generate quality double digit compound returns over time
20:41 – I feel very good about that scenario
20:44 – And the third piece of the puzzle is selling only when the signal is actually real
20:49 – You know, selling should be rare
20:51 – It should not be a routine piece the default should be to hold assets
20:55 – And the valid reasons why you might sell would include
20:58 – You got a broken investment thesis
21:00 – Something materially has changed
21:02 – Or you’ve got a vastly better opportunity in the marketplace that can generate significantly higher compound interest
21:08 – Than that what you are currently generating
21:10 – Or third what Sam Zell fondly refers to as a godfather offer
21:15 – A price that is so irrational
21:16 – Somebody’s want to pay you some sort of absurd number that you have to take it
21:20 – But if you sell simply because the pro forma said
21:24 – This is a five-year hold or a three-year exit
21:27 – And we need to sell after we hit this internal rate of return or this number
21:30 – That’s not discipline
21:31 – That is a habit that introduces exorbitant amounts of risk over the long term
21:37 – To a capital allocator strategy
21:39 – Most investors they think that the goal is to find the next deal
21:43 – But the real goal is to find an asset that is so good
21:47 – That you never have to find the next deal
21:49 – That you never have to sell it
21:51 – When I’m 85 years old and I’m looking back at the end of the rainbow
21:54 – Right, I doubt that I’m going to regret having held durably wonderful businesses for decades
21:59 – Having held too long
22:00 – But I know that invariably I will regret those deals that I have sold
22:05 – Where I have interrupted decades of compounding
22:09 – Just to chase a headline in turn or rate of return
22:14 – Because IRR it measures speed
22:17 – It measures speed
22:18 – But wealth it measures time
22:21 – Hold is the strategy
22:23 – Selling is the exception
22:25 – And forever is the default
22:28 – All right guys with that we’ll get out of here
22:29 – We’ll see you on the next one
22:30 – Until next time
22:32 – Keep it right