Is a Vertically Integrated Operator a Must? | BestEverCRE

One selling point for many operators is their vertical integration. A vertically integrated real estate operator is one that has all components of its operations under direct ownership, specifically property management and construction management.

The biggest reason being vertically integrated is a selling point is because of the complete control over the execution of the business plan. But is this integration a positive in all cases?

Perks of Being Vertically Integrated

Alignment of Interests

As noted, the biggest reason vertical integration is important is that the sponsor can control all aspects of the deal, from sourcing, through day-to-day operations, and ultimately to disposition. I, personally, do see the value of this control. For instance, with a value-add operator using third-party property management, there can be a misalignment of interest in holding units vacant to renovate. In the short term, vacant units affect the managers’ fee, but for the long-term value of the asset, completing renovations can be imperative to maximize the property’s value.

Enhancing Cash Flow

Additionally, in-house management can be run as a loss leader, or at break-even for the sponsor, which can enhance cash flow to the investors. When using third-party management, the third party is a profit-driven enterprise. While it is not common for vertically integrated sponsors to run their management at a loss, it is an option they have because of the common ownership.

Risks of a Being Vertically Integrated

Conflicts of Interest

While I, personally, view in-house management as a positive, there are downsides, as well. The first can be conflicts of interest, most commonly on fees.

If the sponsor is running management as a profit-driven business, that profit is coming at the expense of the property and therefore from the investors in the property. To mitigate the chance of this happening, the legal documents for the investment should state what the maximum property management fee can be. From there, this fee will be reflected and can be confirmed with the financials shared with investors.

Potential Inability to Support a Full Management Team

The other time vertical integration can be a downside is with smaller operators. Property management and construction management is a fairly low-margin business. It also requires a good amount of expertise and time to handle properly. Because of this, if the sponsor does not have the scale to have a full management team, with the experienced head of the division, human resources, regional managers, accountants, etc., I would rather my sponsors hire professional groups. The fee income coming from five or six multifamily deals will typically not support a best-in-class team, which is what I seek with my personal investments.

Conclusion

A vertically integrated operator is a strong positive in my book, but I would not classify this integration as a must. At the end of the day, each investment is ultimately trying to achieve the highest return possible for the perceived risks. Vertical integration can help mitigate a lot of those risks through the additional control and alignment of interests, but it also has the potential to open up new risks that would not be present with third-party management.

About the Author:

Evan is the Investor Relations Manager for Ashcroft Capital. As such, he spends his days working with investors to better understand their investment goals and background. With over 14 years in real estate, he has seen all sides of real estate from acquisitions to capital raising on the equity and debt side, to operations, and actively invests himself. Please feel free to connect with Evan on Linkedin.