Alternative Access July 2019

LOOKING BACK AND LOOKING FORWARD, PART 1 Reflecting on the Real Estate Crisis of 2009 and What to Expect Next

Ten years ago, in the wake of the financial crisis, Investors’ Business Daily (IBD) sat down with me to discuss the long-term implications of the crisis together with observations from behavioral finance. In this two-part series, we revisit what I said at the time and update you on my views on current opportunities within institutional real estate and how the current cycle might unfold. When you look back at what you were thinking in early 2009, you were pretty bullish on real estate and emphasized that the recovery would be the kind only seen “once or twice” in a career. That was a good call, but what did you get wrong? At that time, mostly everything that we were looking at to isolate the bottom, sentiment especially, turned out to be accurate. At cycle extremes, sentiment works as a contrary indicator; negative is positive and vice versa. The herd is always bearish at the low and bullish at the high. In between the extremes, sentiment turns from contrarian to confirming, so,

once a new trend starts, sentiment isn’t that helpful because it tells you what you already know. The confusion for many in early 2009 was the disconnect between broadly positive fundamentals and extraordinary negative sentiment. So, what we really got right was being comfortable with all the negativity. Looking back, I was overly cautious on interest rates. What I missed was a profound secular shift in the cost of money, driven by durable and deflationary technological change that kept rates “lower for longer” than I or almost anyone else predicted. Back in 2009, my primary focus was multifamily simply due to the inevitable give-back in the homeownership rate after the financial crisis. Single-family lenders tapped a demographic that had always rented and could not afford ownership and gave them all mortgages. That was an easy call because they had to live somewhere. I did not see multifamily becoming the darling of the investment community. But sometimes you hop on the train and it takes you further than you ever thought possible. Ten years ago, I ranked retail last among all property types. In hindsight that was a good decision, but it is only now becoming broadly investable, as long as you have the right operating partner. Your thinking about behavioral finance is different than most. Where are we today from that perspective? Behavioral finance is best viewed through the lens of emotions and not rationality. All things being equal, I would rather be rational and make money, but let’s face it: Irrational ideas make money all the time. I’m interested in the

emotional extreme of fear. Today, for some real estate sectors and geographies, we are at the emotional extreme of complacency. For others, we may have much further to run than some expect. All the hand-wringing about being at the “top of the cycle” is possibly misplaced. Then is this the top of the cycle? What should investors do now? Stock and bond markets continue to post strong results. Should RE investors be worried? Every cycle is a bit different; that’s why history rhymes rather than repeats. U.S. real estate values cycle around a long-term upward sloping trendline that’s getting steeper because long-term replacement cost is increasing faster than inflation. There are four primary factors that anchor the long-term return of illiquid real estate and infrastructure, broadly what I call DISH assets: 1) dollar-denominated, 2) income generating, 3) supply-constrained, and 4) hard. The U.S. dollar is still king and provides stability. Income is in short supply, and the risk aversion and shorter duration demanded by most bond investors in their liquid fixed income portfolios limit real return. Supply constraints are key, especially since replacement cost inflation for construction is a high and rising hurdle for new supply. By hard, I mean anything that is not a paper asset; it must be difficult to replace and have intrinsic value. So, even if the business cycle is peaking, a much longer-term cycle for DISH assets is only beginning. Broadly speaking, illiquid DISH assets will outperform liquid paper assets for the next 10–20 years. Okay, but what individual property types and institutional execution strategies are best? Do you still like multifamily? I can’t tell you that stabilized core apartments in gateway markets bought at a four cap are a great investment. I can tell you that middle- market opportunistic and value-add apartments in secondary growth markets are a much better bet simply because you can get rents higher faster. Long-term structural, demographic, and social change — including younger people delaying marriage and starting smaller families; the lack of savings for down payments for houses; and a broader acceptance of rental housing by older

emotional continuum that defines market extremes. The bookends are fear and complacency. Greed is ever present. Ten years ago, we were at the

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adults — is driving a new kind of demand. And not just multifamily; I still like a number of sectors. Decades of data tell us that investing over the cycle in virtually any sound real asset strategy works better than other alternatives, as long as the asset is prudently levered.

A CASE STUDY OF A 10X RETURN ON 1 SINGLE INVESTMENT

As you know, over the past two years, we’ve been using our skills to raise capital to co-invest alongside the same families that have invested with us.

What is the reason for this long-term outperformance?

As long as you follow the rules, understand the process, and use negotiation skills, venture is a tremendous wealth creator — if you can structure the risk away from you, that is. Here’s what I mean.

The reason for this lives in the fact that real assets are expensive to replace, and that cost just keeps compounding faster than core inflation. Construction costs are rising 2–3x the rate of CPI. Remember that when we look at how diverse institutional portfolios are constructed, most have a massive bet against inflation due to their exposure to equities and fixed rate debt. I think of this as investors selling inflation short. This isn’t a problem until it is recognized as such. We’ve become conditioned to a cost environment that isn’t sustainable long term. The reality is we have two competing forces: inflation and deflation. These average out to a small positive number for headline inflation. We have inflation in things we need: food, medicine, skilled labor, education, and construction materials. Then we have deflation in stuff we want: phones, TVs, cars, and anything that involves technology. And it is widely recognized that due to all the various hedonic adjustments that the government makes to the CPI, the deflationary forces are overstated and the inflationary ones are understated. I don’t know anyone who has looked at the cost pressures that college endowments and pension plans face and believes they experience anything close to 2% inflation, which is where the CPI is today. Every property type should be viewed in the context of replacement cost inflation in order to understand a key driver of long-term return. The conversation is over! Stay tuned for our August edition — I have a few more insights to share with you!

Wealthy family offices allocate about 10–15% of their wealth to venture capital and private equity, with the balance in cash and commercial real estate.

If you recall, this was an SPV that we did with several investors prior to the launch of Dandrew Partners Encore Ventures.

When we made our investment, Immunicom, headed by Amir Jafri, was worth $5.5 million.

Love it. Because mice go where elephants can’t. Here’s why:

Today, it’s valued at $37 million, as evidenced by subsequent rounds by more sophisticated institutional investors invested in — at a very justifiably higher price.

This is the result of real, tangible value being added by David Schlotterbeck, former vice-chairman of Cardinal Health, who also invested in the company and joined the board of directors as chairman of the board. He has been chairman and CEO of numerous Fortune 50 publicly traded health care technology companies. Over the last 10 years of his career, David has generated over $11 billion in shareholder returns.

Real PeopleWith Serially Successful Exits. No “Shark Tank” B.S.

Amir is gearing up for a sale or an IPO in 2020 , and it’s not inconceivable to have an exit of $500 million or more — from just one of the revenue lines from licensing.

At this point, a lot of the risk has been taken out. And risk is one of the several drivers of how a higher valuation works.

So, with less risk comes less reward for those who invest in the subsequent rounds.

I firmly believe that this is going to be a good, clean exit. The management team is best in class, and the FDA is cooperating nicely.

Right now, we’re trying to get in at the same terms before this current Immunicom round closes.

I’m pretty sure that, the way it looks now, Amir may let me come in with terms similar, but perhaps not equal, to the Series Awe did.

Value has been created, and having an institution follow alongside is going to make things look that much more appealing (credible) to the investment banks to underwrite it and sell it to sticky investors such as mutual funds.

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Always Have a Plan B.

That stacks the risk in your favor and shows more conviction in this than just putting money into it. (And I highly recommend you do something like that for your SPVs or funds, as it is out of the ordinary.)

As you know, I’m cynical at best and paranoid at worst. The Hong Kong Stock Exchange has recently relaxed its rules regarding proven biotechnology entities that can list there without having any revenues.

Tranche 3 may not be available for many investors due to ERISA guidelines regarding pension funds we will be taking in. Because of that, my hands are tied.

That is money to my ears.

Here are the terms again for your convenience.

Investors in both Tranche 1 and Tranche 2 will participate in Immunicom. Those investors who joined us in the Immunicom SPV a year ago are in for a nice treat.

Investment Terms

As of the publication of this newsletter, we will have closed Tranche 2. Tranche 3 will be a very special tranche for a very special class of investor.

Mini Investment $50,000

Self-Directed IRA Eligible? Yes

We kept Tranche 2 open to new and current investors until May 31. This may be pushed back, but I doubt it.

Duration 5 years

Target Return 8x–12x

Super Generous Terms

Return to Investors 2X to investors, then 50/50 afterward

For reference, Tranche 2 investors got generous

Reporting Semiannually

terms of 2x then 50/50, meaning you needed to double your money first before we made anything.

Tranche 2 Closing Date

Friday, July 12, 2019

Look for more updates very soon or contact Nate Schwartz at nate@dandrewpartners.com.

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