As featured in Bisnow’s article – “This Company Wants To Shake Up Real Estate’s Archaic Fee Structure”
Aligning interests: Do operating partners need ‘soul in the game’ to best serve their clients?
Some crucial lessons can be learnt by the real estate industry from Nassim Taleb, a former trader and risk analyst turned essayist and modern-day economic philosopher. Best known for his book The Black Swan, in which he predicted the financial crisis, his latest book, Skin in the Game, seeks, among other things, to challenge our beliefs about risk and reward.
Having ‘skin in the game’ effectively means aligning the interests of clients and advisors. This can come through various means; however, the two most prevalent are by incurring financial risk or legal liability. It also comes through having ‘soul in the game’ which is best described as being emotionally invested in one’s craft or service of choice. An artisan producer is often the first thing that will spring to mind but the concept is also applicable to professionals of all kinds including within real estate whether they be asset managers, agents, solicitors or architects. Those who have ‘soul in the game’ and are committed to providing the best service possible should want financial ‘skin in the game’ in order to share in the upside performance delivered.
The ultimate form of ‘skin in the game’ in the UK real estate industry comes in the form of fixed charge receivership (FCR). From the moment a FCR appointment is taken on, the Receiver instantly takes on personal legal and financial liability. They are unable to hide behind the protection of an employer, a highly valuable benefit afforded to most individuals. However, expecting individuals to take on the same personal risks as FCRs is impractical.
It could be argued that professional ethics mean ‘skin in the game’ is not necessary as is the case with majority of advisors but whilst we all likely judge ourselves to live by a high ethical code, having a sound moral compass unfortunately does not prevent unconscious bias influencing decision making or prevent human hubris getting the better of us. More importantly though ethical standards vary significantly from person to person and the ultimate goal of the majority of advisors is to complete the services for a fee resulting in an element of misalignment with the investor.
With this in mind how do we ensure property advisors are motivated to give the best advice and work hardest for the best result for their client?
The solution is simple: advisors should share not just in rewards but also in risks. This can be achieved through performance linked incentives or to a greater extent by coinvesting and taking on some of risk of losing equity; what is called true ‘skin in the game’.
Performance incentives by themselves do not always work as there is no incentive for advisers to fully analyse and consider predictable potential downside risks scenarios. Should fees reduce if the advice turns out to be defective? Should there be a retention of the fees until advice has been proven correct?
Incentive structures based on various non-performance linked metrics such as value of assets under management can lead to suboptimal investment decisions being taken relative to the risk/return profile of the client. Are year-end targets for fund managers actually beneficial to the investors? Are fees based on annual performance metrics where no long-run average is considered a fair way to recompense management structures? If amount of assets under management is a key industry metric for success does this compromise the decision to sell an asset when it is deemed to be ex growth?
For letting and investment agents arguably reputation is their ‘soul in the game’, ensuring they perform consistently well over time to generate further work. I’d argue this alone is not enough as shown by continual indiscretions around what is known as double dipping and not declaring conflicts of interest. An important driver of this is the industry’s archaic fee structures and slow adaptation to a changing market place.
For example APAM has started challenging the property industry’s regime of leasing fees structures. Standard market practice is a flat fee based on headline annual gross rent however, this fee regime was introduced decades ago in an environment of 20+ year leases being the norm. The market has since transformed itself in response to tenant demand and leases have shortened to sub 7 years and are trending downwards as increasing flexibility is being demanded by tenants in most asset classes.
This structure is no longer fit for purpose as fees are not proportionate to total guaranteed income received by the landlord. What APAM proposes is a move towards a fee calculated from total rent guaranteed over the term of the lease. This proportionately rewards those that can secure longer lease terms and better incentives for landlords; in particular longer lease terms which generally are investment value accretive.
Properties with multi-service single consultancy representation, often as a result of cross-selling, is an example of where having ‘no skin in the game’ can lead to significant downsides to the investor. Regardless of performance the consultancy profits at multiple levels so there is little incentive to provide the best external service provider. The client, especially if it takes a ‘hands-off’ approach, is often unaware that a substandard service might be being provided. The opportunity cost of this is worse performance and potentially a loss of equity.
The role of an asset manager has changed dramatically due to fast evolving pace of international capital flows post financial crisis. Modern asset managers need more tools than simply managing the landlord and tenant relationship. It needs to appoint best in class advisors fit for purpose, in capability and breadth and once appointed drive the service provider to deliver the optimum result. The best advisors, whether they be agents, asset managers or property managers, understand that simple problems are often more complicated than they first appear. Those with ‘skin in the game’ acknowledge this and the limits of reliability of knowledge. In other words, they are better at filtering the good information from the bad. This filtering allows the most informed strategy to be pursued and risks managed as best as possible. This, in turn, will afford the highest chance of maximising returns. Simply, the asset manager thinks like an investor and has full alignment in delivering performance.
At APAM, as asset and investment managers, we take the view that we must be fully aligned with the interests of our clients and investment partners. This can be achieved by not focusing on amount of assets under management and transaction based fees but using incentivised performance fee structures that are only received at exit once returns have been crystallised or in the event of long term investments paid out once initial business plans are successfully completed. We can co-invest equity on a parri passu basis where required. Our true ‘skin in the game’ is the financial risk of underperformance. If our clients were to lose out financially, so would we and, as such, there is a higher level of trust and a deep understanding that everything will be done to maximise returns.
Having ‘skin in the game’ is necessary for fairness, commercial efficiency, and risk management. With partnership and collaboration between companies a growing theme in the property industry, ensuring partners’ interests are aligned is more vital than ever. Investors need to question and challenge the industry’s archaic and misaligned fee structures and partner with those who have ‘soul in the game’ as they will be comfortable to share in the risks as well as the rewards. The relationship will likely flourish and so will the performance of the asset, making money for clients and as importantly stopping them from losing money must become central to the property industry’s ethics.
As markets develop to be ever more complex and challenging Taleb’s showcasing that advice becomes immaterial unless one has ‘skin in the game’ becomes increasingly true. His prophecies will be increasingly accurate with time and we should all seek to find our own ‘soul in the game’.