By Jeff Toporek
Jeff Toporek is a Co-Founder and Principal at FD Stonewater, with over 30 years of experience in commercial real estate investing and capital markets. Jeff regularly appears on podcasts and is a frequent panel contributor at industry conferences. He has spent much of his career as an investment manager focused on single-tenant-occupied real estate, providing value-added solutions to our investors and tenants through active management in a traditionally passive investment sector. FD Stonewater’s differentiated investment approach utilizes the firm’s vertically integrated niche expertise to generate uncorrelated returns at the asset level, which has resulted in historical performance of 31% net IRRs. Today, Jeff co-leads FD Stonewater’s STAR (Single-Tenant Active Return) Fund, an evergreen vehicle launched in 2022 that focuses on single-tenant mission-critical assets in the US diversified by product type (industrial, government, R&D, and strategic office), credit quality, lease term and geography. For more information on the STAR Fund, please visit https://fdstonewater.com/star-fund/.
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Looking back at the many meetings we’ve had with potential STAR Fund investors over the past 18 months, some consistent questions have come up: Why now? Why FD Stonewater? Why this strategy? What differentiates you from your competition? Why are your targeted returns lower than your track record of 30%+ IRR over 20 years?
These are questions we expected – so much so, they are fully addressed in our offering materials – but we totally understand why they have been consistently asked, particularly during the capital market conditions over the past two years. We address some of these questions throughout this document but through a different lens than in the past, with special thanks to the “Wizard…”
A few weeks ago, I reconnected with an old colleague and mentor, who is also a savant of REIT research, all things capital markets and real estate managers. I won’t name him (let’s just call him the “Wizard”), but he has always been a staunch investor advocate seeking to create value and protect shareholders. He believed so strongly in his convictions that he even left his successful research firm and started a hedge fund in public real estate that only lasted five years…in the best way possible because his investment thesis was proven correct very, very quickly, and he was able to exit.
We talked in-depth about the last 14 years of the real estate cycle coming out of the Global Financial Crisis and where we are now in the capital markets. His views are pretty simple: the bulk of returns that real estate investors made over this period was driven predominantly from financial engineering, low borrowing costs, high leverage, and timing capital market movements. His views were very direct, very succinct, and stated with such conviction that it came across as fact.
The conversation quickly turned to how in today’s market, more than ever before, operators need to prove their value to investors beyond financial engineering. Just moving money (or having a track-record of moving money) in real estate isn’t going to be enough. Managers will have to both illustrate to investors that they are active interventionists who can increase NOI/value at the asset level while also proving that investing in an illiquid asset class is worthwhile relative to more risk-free alternatives. This enlightening conversation with the Wizard led us to a period of introspection and analysis where we asked ourselves two key questions:
Only investment managers who aren’t afraid to see the naked truth will go down this road (but since I ran the “naked mile” at the University of Michigan, I was up for the challenge). The following are the results of our team stripping down our past performance and our current Fund approach to see the naked truth. As we raise money for the STAR Fund today, we are competing with many passive single-tenant investment funds with no active management approach that are aggregating assets, clipping coupons, and will likely sell with some significant lease term remaining with little appreciation. Those are aggregation and market timing strategies where the manager just needs to be a good buyer (skills of asset selection) and a good seller (timing). But that seems to be a highly correlated strategy. What we are hearing almost daily is that investors are seeking managers that will drive uncorrelated returns using their expertise to increase NOI and value at the asset level. Our firm has wanted to have this conversation since our inception, and now there seem to be willing listeners.
Below, you’ll find our detailed answers to the two key questions above. Sometimes, we revert back to the conversation with the Wizard to help tell the story. But first, let me set the stage.
Setting the Stage … for the Naked Truth
Before delving into the detailed naked analysis of our past performance, it’s important to set the stage on the STAR Fund’s investments thesis and approach, how that corresponds to where the capital markets are today, and why we see this time as an opportunity to invest in such a unique single-tenant vehicle.
What is the STAR Fund’s Investment Thesis?
To invest in mission-critical single-tenant real estate to generate stable current yield by unlocking long-term value potential through active management, thereby generating uncorrelated returns relative to the “market” while holding risk constant.
Approach and Historical Performance – Why is there a gap between FD Stonewater’s historical returns and the STAR Fund’s targeted returns?
While we are targeting levered IRR of 11-13%1 NET to investors, our discipline, and active management approach focused on total return has resulted in historic returns above 31% net. We target 11-13% because that is what is generally achievable within the four corners of the lease alone (and, therefore, what a passive investor would generally achieve). For example, if a tenant has a 5-year renewal option, that renewal is all we allow ourselves to underwrite for our base case scenario. However, our objective through active management is to create opportunities (such as expanding the building’s footprint or renewing the tenant early and/or for a longer period of time than the lease contemplates at acquisition) that actively create value for the tenant within the asset itself and actively generate value for our investors. Our core belief is that if we can do something to benefit the tenant’s business, they win, and we win. It should also be noted that our initially underwritten returns often presume significantly longer hold periods, but as an active investor, we often create opportunities to execute business plans in significantly shorter timeframes, which reduce our projected hold durations, positively impacting overall returns.
The chart below illustrates how we have successfully generated our outsized historic returns, increment by increment3,4. The light gray is the underwritten IRR at deal award (again, this can also be presumed as the passive investor’s expected return). All the blocks above the light gray illustrate the returns driven by active intervention (lease extension, expansions, early renewals, increased NOI through rent increases, etc.), along with the transparency of any cap rate compression we achieved. It should be noted that the chart below illustrates just the partial naked truth as it still includes leverage:
Q&A with the Wizard
The Wizard asked: “Despite the recent Fed cuts, rates on commercial mortgages haven’t come down much, and are still high. Your cash yields don’t look like a big spread to work with over borrowing rates today, which begs the question: is the added risk of leverage even warranted?”
Response:
Fair question. So, let’s talk about the debt markets. First, a few things to note related to leverage and spreads:
As an active acquirer who certainly utilizes leverage, we must play the cards the debt markets make available to us at any given time. Thus, over the past couple of years, we have been putting on 3 to 5-year financing on assets (even on those we expect to hold longer term) with the plan to refinance when rates are lower. We also took advantage of putting in place favorable swaps, when the forward market curve was out of whack. We will continue to look for opportunities to lock in more accretive spreads based on windows in the capital markets.
That said, our primary investment thesis is that you must only buy an asset you have conviction about and where you are comfortable with your unlevered pricing. The concept of stripping away leverage works both ways. If you strip it out during times of great debt terms, then you also need to strip it away for periods of weak debt terms. If both situations are temporary, the only constants are your acquisition price and the value you can add along the way – irrespective of debt terms and capital markets. Most critically, if you actively add value at the asset level during a period when the capital markets are not cooperating, you will still perform better than any passive investor that created no value in similar asset classes, thus insulating investors from weaker returns.
As a footnote, there are deals we are evaluating purchasing unlevered because the financing is not accretive. I also view those situations as temporary but good asset purchase opportunities. It obviously begins to limit purchasing power in an equity-constrained environment.
The Wizard asked: “Real estate equity investors have enjoyed 14 years where cap rates were materially higher than borrowing rates. Now it is reversed. Is being a lender better in today’s environment?”
Response:
Simply put, our past and future performance has not and should not be directly correlated to the market, unlevered or levered. While broader capital markets have some impact on returns, positive or negative, the preponderance of our success stems from our operational expertise and relationships at the asset level. There will be times when asset performance is fantastic, but the capital markets don’t cooperate and vice versa. In either case, we are clear and transparent on how our returns are derived at the asset level. Performance generated by pure leverage, cap rate compression, or other capital markets movement outside an operator’s control should be heavily discounted.
The Wizard asked: “Arguably, one could ask if it is worth investing in single-tenant real estate with cap rates where they are today and with leverage being in the zone of marginally accretive to neutral to negative, if it is worth investing in single-tenant real estate when more risk free cash yields can earn a similar return? Could you buy bond ETFs that are investment grade with no prepayment risk showing similar yields with no fees?”
Response: Value/Risk Return of the STAR Fund relative to Fixed Income Alternatives
Real estate asset cash yields certainly provide stability and are a fair comparison to fixed income products, but that is only one part of the STAR Fund investment opportunity. Bond ETFs and even Treasuries are cash yield alternatives but provide little upside or appreciation. To be clear, the STAR Fund isn’t merely a ‘clip a coupon and hope for the best’ approach like more traditional passive single tenant strategies. In that instance, it is absolutely correct for investors to focus primarily on cash yield because their operators are not intentionally creating value at the asset level. Those returns should have a higher correlation to bond and Treasury ETFs. However, STAR is much more focused on increasing asset values and total returns, which are largely decorrelated from capital markets fluctuations, through an active (and time-tested) management approach. When comparing single-tenant investing to fixed-income products, a big differentiator is that our yield is NOT fixed: most of our leases have contractual rent escalations, which will cause the spread between fixed-income yields and those leases to increase over time. (Note: the one exception in our portfolio would generally be government leases that are flat, but that is factored into pricing for that product type at the front end and into portfolio construction). It is also important to note that the yields on fixed income ETFs are only temporary. And, when those yields drop, we not only continue to enjoy yields that increase with contractual, locked-in annual rent increases but also offer additional protection against yield leakage from operating risk impacts, as most of our leases are triple net for expenses (biggest exception again here is government leases).
Most importantly, fixed-income ETFs simply do not have the same total return potential, particularly when investing alongside an active manager who has an empirical track record of increasing value at the asset level. To prove this out, we generated an unlevered return chart comparing our past deal-level performance relative to i) 10-year treasury yields (at the time of acquisition), ii) initially underwritten returns (as a measure of market return for the risk), and iii) actual annualized inflation (during hold period). And, while one would expect a premium for illiquidity (historically 200-500 bps), the results clearly illustrate a significant spread in our return performance relative to all, with our realized spreads over treasuries ranging from 800-1700bps (significantly above the industry margin of 200-500 bps). The chart below shows the 10-year Treasury adjusted for inflation in dark gray, our underwritten returns prior to acquisition in dark gray (this can also be used as a proxy for what a passive single tenant investor would underwrite), and our realized returns in green. Now, we’re starting to have more clarity on the naked truth.
It is worth noting the ‘Defense’ deal noted above is a currently owned deal that merely projected out the forward Treasury yields adjusted for inflation and our base case underwritten scenario, which shows a 450 bp spread, which falls into the historical illiquidity premium range of 200-500bps. Meaning, this is effectively underwriting what a passive investor should be able to achieve. That still makes it a good deal on a relative basis unlevered. However, what cannot be seen in the chart is that there are three expansion opportunities for the existing (investment grade) tenant that would dramatically increase the total returns. This is precisely the difference between a passive and active strategy, particularly one managed by a vertically integrated operator who can independently execute the value creation. We did add a light green area that shows what the upside outcome could look like if we achieved just the 50,000 square foot expansion and early renewal with the tenant. Quite simply, the STAR Fund would not be satisfied with a ‘good’ outcome at the high end of the target range, as it seeks to outperform that with active asset management strategies and works closely with the tenant to maximize the potential of the facility.
The Naked Truth
This was the scary and fun part of our introspection. Beyond responding to the Wizard’s questions, we felt like there was still much more to uncover and here is where we get to the fully naked truth.
How did each of our historical deals look over their hold period on an UNLEVERED basis relative to purchasing a 10-year Treasury at the same time (inflation-adjusted) and relative to the no-fee bond ETFs?
For simplicity, we put together charts to generate the outcomes between $1,000 invested on an unlevered basis into each of our historical deals relative to both a corresponding 10-year Treasury investment and the BND ETF over the same hold period. It includes cash yield, capital invested (the dips), and appreciation upon sale. Below is a subset of this deal-by-deal analysis. We selected deals based upon different time periods we have invested in, including post–GFC, deals we purchased post-pandemic, and deals acquired during the most recent capital markets reset.
ATK…Orbital Sciences…Northrop Grumman
The ATK deal was a defense contractor building in Dayton, OH, acquired with a short lease term remaining in 2013. While we enjoyed exceptional cash flow for the first several years, we remained true to our total return ethos, looking for early opportunities to drive value for the tenant. The tenant was chasing a government contract and needed additional capacity, which could have been located in our facility or a similar one in Utah. Our development team gave local ATK leadership free advice for nearly two years on how to expand and streamline the facility. We also provided a capital solution to the C-Suite. In the end, we successfully expanded the building by 37,000 square feet and extended the tenant on a long-term renewal. We also achieved a tenant credit upgrade after ATK was acquired by Northrup Grumman (lucky or good?). The expansion was 100% financed (no equity). The asset was sold during the peak of the pandemic to a regional private investor at a 7.13% cap rate. At the time, Northrop Grumman had a contract backlog of nearly 10 years and potentially needed to expand further.
Alside
We purchased this asset in Yuma, AZ as a near-shoring manufacturing play post-Covid, with a short-term lease in place at below-market rents to Alside, a sub-investment grade tenant. It was clear when touring the asset that the tenant needed to expand by a minimum of 25,000 square feet to bring inside the raw vinyl and glass materials that were being stored outside in 120-degree heat. The FD Stonewater development team immediately became part of the asset management team, providing the tenant with design options and pricing. When we learned during diligence that this facility provided the tenant with a huge competitive advantage of a reliable, consistent, cross-border labor force, we realized there was even more potential at the facility. We met with their PE firm in New York and pitched the idea that, given the labor dynamic, this facility should be a signature manufacturing site for the company. After doing some internal analysis of their national manufacturing footprint, they agreed, and we restructured the lease to expand the facility not by 25,000 square feet but by 100,000 square feet and extend the term significantly. The process of providing advice, presenting to the board, designing, pricing, and restructuring the deal, took over two years.
The Alside deal projection below is based on the 100,000 square foot expansion (under construction with delivery slated for May 2025) and the long-term executed lease extension recently completed. The appreciation portion is based on BOV’s recently received for an intended sale next year (again, unlevered, noting the current financing rate is at 14% for half of our debt stack, as it was sourced 18 months ago). Note that the 10-year Treasury purchased at acquisition would have lost value, even inflation-adjusted. It is also important to note that the capital market environment dramatically shifted (against us) during our ownership period and there will be absolutely no cap rate compression. In fact, there will be cap rate expansion. In an environment where there are capital market shifts (always), generating value at the asset level insulates investors from risk and generates positive returns in a challenging environment.
Defense Contractor
The Defense Contractor (investment grade) deal is in Huntsville, AL, and was purchased with 10 years of lease term remaining. It has annual contractual rent increases. The returns only contemplate a renewal at the end of the lease and do not consider the potential 50,000 square foot expansion of the existing facility (plans already drawn) that would accompany an additional lease extension. There is also additional development potential for two additional buildings on the site beyond the initial expansion. The point is simply to illustrate that projected contractual rent increases with a credit tenant outpace the 10-year Treasury projection. So, even on a cash yield basis, the lease should significantly outperform a fixed-income alternative. The potential of future value creation opportunities could be similar to the previous examples. While there is a long-term lease in place, we are proactively having conversations with the tenant regarding longer-term plans. These business plans take time, effort, and significant vertically integrated expertise.
Why is any of this relevant to you as an investor in this prospective new environment?
The real estate landscape is changing rapidly. The business of moving money will consolidate to the largest players because they provide economies of scale (at the expense of generating outsize returns through active management). There is certainly a place for that business, but generally, it only provides for large-scale corporate plays. What we are hearing from investors is that they are seeking managers that are vertically integrated, who are investing in niche strategies, and have true operational expertise to increase NOI and generate value. FD Stonewater is focused on middle market transactions and dedicated to generating value at the asset level, not just making capital market bets. The expertise to accomplish that only comes from a seasoned team that has dedicated their careers to generating value for investors. Being a truly vertically integrated real estate operator and developer with both leasing and capital markets expertise in a generally passive investment class should generate outsized returns relative to our competitors. While our target returns show 11-13%1 net to investors, those are what a passive single-tenant investor should be able to achieve. Through our active asset management approach, we believe the STAR Fund should be able to remain uncorrelated to both our competition and the overall market, insulating investors from dramatic capital market shifts by generating value at the asset level. We have positioned the STAR Fund as a value-add fund simply because our expectation is to actively intervene in the passive lease cycle and create value for our tenants and our investors.
Call us sandbaggers, but we might prefer naked sandbaggers.
Why FD Stonewater STAR Evergreen Fund?
Why Now?
We have been pondering this question for the last several months. Our gut clearly was telling us this was a great time to buy, with cap rates at levels we hadn’t seen since we started our real estate investment business in 2003. Over the past two decades, there was really only one period in which we believed strongly not to invest. That was the time just preceding the GFC when we were being offered 10-year interest-only debt at 80% leverage at spreads that made no sense going into CDOs. It became very clear, very quickly, that every single-tenant deal was a financial engineering exercise with little regard to business plans or the real estate itself. We knew that this level of financing wasn’t sustainable, and it felt like “garbage in, garbage out.” So, with conviction, we began to sell as much as possible.
After the GFC, there were other periods when we felt the market may have been overheated and we hit the pause button on acquisitions. In candid hindsight, there were still good deals to be had, but we were too conservative and too disciplined to buy. While I am comfortable admitting we may have missed out on some opportunities during those periods, we never have regretted temporarily sitting on the sidelines through times of perceived exuberance. Discipline is good and has been a key trait of our DNA for 25+ years.
For middle market managers (i.e., not money movers), market timing in an illiquid asset class is not skill-based and, more often than not, luck wins over smarts. While we strongly believe there is an opportunity “now” to acquire single-tenant real estate at “best in decades” pricing, we are not seeking short-term capital market windows to enter or exit. Rather, we play the long game – and as stewards of our investors’ capital – it is crucial for us to illustrate that financial engineering, timing, and luck have NOT been the core foundations of our past success. While they can certainly help, we do not expect them to be the stalwarts of our returns in the future. Our success is rooted in our active, disciplined, and interventionist approach to investment management, which generates value-creation opportunities for our tenants at these mission-critical facilities. Helping our tenants generate more revenue or reduce expenses through carefully crafted programs has been the foundation of our success. We are also seeking to hold most of our assets through lease expiration, which should generate stronger returns, especially for mission-critical assets.
An opportunity exists today to take advantage of asset prices and cap rates at favorable terms, even if the margins over current treasuries and borrowing rates are thin in the short term. In an asset with contractual increasing cash flow and the ability to refinance as rates moderate, those spreads should widen materially for assets purchased at today’s pricing. The key differentiator is we acquire only mission-critical assets and then actively create value at the asset level, which combined should significantly outperform cash yields, provide insulation to capital market fluctuations, and create Alpha.
Please contact us and challenge us with your questions. We welcome the dialogue and aren’t afraid to get to the naked truth. To learn more, please visit us at https://fdstonewater.com/star-fund/.
Disclaimer
Please note that the information in the document is not an offer to sell or a solicitation of an offer to purchase any securities of FD Stonewater STAR Evergreen Fund, L.P. (the “Fund”) or any affiliate, and any such offers will only be made pursuant to a private placement memorandum or similar disclosure document (“Private Placement Memorandum”) and other definitive documentation relating to any such offering. The foregoing information excludes material information that is detailed in the Private Placement Memorandum, including, but not limited to, risk factors. Prior performance is not indicative of future results. An investment in the Fund is speculative and involves a high degree of risk. Only investors who can withstand the loss of all or a substantial part of their investment should consider investing in the Fund. Additionally, an opportunity to invest in the Fund is only available to (a) “accredited investors” as defined in Rule 501(a) promulgated under the Securities Act of 1933, as amended (the “Securities Act”), or (b) non-U.S. persons that meet the requirements set forth in Regulation S promulgated under the Securities Act.
Endnotes
1: The Fund will target deals that combine to achieve 11-13% net IRRs to investors. Investor IRRs could vary based on individual investment periods; Projections contained herein are subject to numerous risks described in the PPM, and actual results may differ from projected results. Projected gross return target does not take into account Investment Management Fees, Incentive Allocation or Fund expenses). Net returns will be reduced by these amounts. Net returns do not take into account taxes payable by an investor or any taxes, such as withholding taxes, paid by the Fund or any of its subsidiaries on behalf of one or more investors. Therefore, net returns to all investors will be reduced by the amount of any such investor-level taxes.
2: Gross IRR and equity multiples for realized investments are reported net of acquisition fees, asset management fees, and entity expenses, but do not include the impact of promote. Net returns take into account promote.
3: Past performance is not indicative of future results.
4: Return impacts are estimates of the incremental return that we believe was driven by each category on each investment.
