E317: Why Most Real Estate Investors Optimize the Wrong Return Metric

What if the biggest untapped source of alpha isn’t better investments… but better tax structure? In this episode, I sit down with Andrew Berman, Co-Founder and Managing Partner of Arqitel, to explore the overlooked power of tax-aware private real estate investing. After starting his career at AQR Capital Management and working closely with one of its co-founders inside a family office, Andrew saw firsthand how tax-aware strategies transformed public market investing. He realized private markets had yet to fully adopt the same discipline. We break down structural alpha, why many private real estate managers are incentivized to sell too soon, and how taxable investors can materially improve long-term wealth creation by aligning investment strategy with tax structure. In increasingly efficient markets, tax may be one of the few durable advantages left.

Speaker names marked ? are inferred from speaking time and the show’s known hosts — they are not voice-verified.

• 0:00David Weisburd?

  So you worked inside one of the two AQR co-founders, David Kavler's family office. You saw an opportunity to invest in real estate in a tax aware strategy. What was your thesis behind starting what you do today?

• 0:13Speaker 01

  Starting with Arcatell, we are a private investment firm specifically focused on maximizing after-tax returns for a taxable client base. I began my career at AQR and as you mentioned, I saw how AQR was developing what has now become their tax aware public market strategies. And as you're probably well aware, they've grown significantly over the past several years with this strategy. As they were growing and incubating those strategies in-house, there was an opportunity because AQR doesn't do anything within private markets to try and bring the same tax focused lens into private assets.

• 0:49David Weisburd?

  Tell me about the opportunity for tax aware investing in real estate.

• 0:54Speaker 01

  Real estate has gifted one of the most advantaged tax codes of any investable asset class in the United States. And I think what will be pretty eye opening is, everybody knows or has an intuition that real estate can be tax efficient, but I don't think most people understand just how much they're leaving on the table unless they approach it in a very intentional manner.

• 1:12David Weisburd?

  Break that down to brass tacks. What kind of tax savings are we talking about and does this really move the needle?

• 1:18Speaker 01

  Approaching private real estate investing in a tax focused manner can result in a two times greater after-tax net of fee return or basically true wealth creation compared to a tax agnostic strategy. Look at incentives of the managers that are actually managing these underlying private real estate investors, investments. They're incentivized to cycle through investments. That's typically how they take payment of their own performance fee. They can crystallize their promote. Well, when you do that, you crystallize the tax consequences, the depreciation, recapture some of the capital gains implications of private real estate. So I think, again, you're leaving a lot on the table if you don't approach private real estate investing in a manner where there's alignment of investment strategy with structure.

• 2:04David Weisburd?

  Some listeners might question why I talk a lot about tax and tax alpha. And I just look at the markets very much as mostly efficient markets. In the public markets, I believe in the mostly efficient market hypothesis. And the private markets, it's more efficient than a lot of people think. And tax is one of those parts of the market where you could actually sustain alpha, especially when you're talking about, you mentioned double the post-net returns on essentially what I would guess is a similar investment. So you have the same kind of high level investment in the same property. One is tax advantageous, one is not. You might get twice, twice as high a return on tax advantaged one.

• 2:47David Weisburd?

  One of the hardest things of investing is seeing what's shifting before everyone else does. For decades, only the largest hedge funds could afford extensive channel research programs to spot inflection points before earnings and to stay ahead of consensus. Meanwhile, smaller funds have been forced to cobble together ad hoc channel intelligence or rely on stale reports from sell-side shops. But channel checks are no longer a luxury. They're becoming table stakes for the industry. The challenge has always been scale, speed, and consistency. That's where AlphaSense comes in. AlphaSense is redefining channel research. Instead of static point-in-time reports, AlphaSense channel checks delivers a continuously refreshed view of demand, pricing, and competitive dynamics powered by interviews with real operators,

• 3:30David Weisburd?

  suppliers, distributors, and channel partners across the value chain. Thousands of consistent channel conversations every month deliver clean, comparable signals, helping investors spot inflection points weeks before they show up in earnings or consensus estimates. The best part, these proprietary channel checks integrate directly into AlphaSense's research platform, trusted by 75% of the world's top hedge funds, with access to over 500 million premium sources. From company filings and brokerage research to news, trade journals, and more than 240,000 expert call transcripts. That context turns raw signal into conviction. The first to see wins, the rest follow. Check it out for yourself at alphascense.com/HowIInvest.

• 4:12Speaker 01

  That's absolutely correct. I mean, it's this concept of Structural alpha. So again, if you combine an underlying investment strategy and marry it with the right structure, you can get more than a two times after tax total return. It's greater than if you approach it in a tax agnostic manner. And I think this is, it's really critical because when you, when you approach investing as a taxable investor, it needs to fundamentally shift how you evaluate the investment options that are available to you because you're no longer looking at items from a pre-tax basis. So some strategies that can make a lot of sense from a pre-tax returns basis no longer makes sense. Once you layer in the after-tax return considerations, if you look at a traditional, you know, endowment model, they have high single-digit exposure historically to private real estate. They don't get any of the tax advantages that are afforded to it.

• 4:56Speaker 01

  So when you layer in the after-tax return profile, some of the diversification benefits and the correlation to other major investment asset classes, I would argue that taxable investors on average can tend to be under allocated to private real estate.

• 5:09David Weisburd?

  So maybe this is a good time to double click on what it means practically to invest in tax aware real estate strategy. So on a high net worth investor, that's investing a million dollars into this strategy. What do I get?

• 5:20Speaker 01

  You should be able to get via K ones pass through depreciation. And by the way, the current administration, um, recent legislation has been implemented that makes it very, very, um, let's say compelling to invest into real assets because you're able to accelerate a lot of depreciation and take bonus allocations upfront. You look at private real estate, whether it's the non-traded REITs or traditional closed end funds, they have, they have a set life cycle. Maybe they underwrite to three, five or seven year target durations. They're cycling through properties. That is how you trigger a lot of the tax consequences that are associated with, with private real estate.

• 5:56David Weisburd?

  And that's because other firms are not focused on an after-tax basis. So it might make sense for them to sell to generate DPI and to show a multiple to investors. You guys are focused on a very different part of the market where you're focused on the taxable investors and what they care about is after-tax return.

• 6:12Speaker 01

  There are a couple of factors that drive the cycling mentality that's been traditional throughout private real estate. The first is if you're serving a taxable and tax exempt client base, your mandate to maximize after-tax returns falls because you're also trying to cater to maximizing pre-tax returns, which by the way is how most managers operate. So that should fundamentally shift whether or not it makes sense to sell an asset in a particular moment in time. Again, if you don't have to underwrite what the tax consequences are, that's the first answer. The second answer is if you think about traditionally how most managers get paid, it's through promote, it's through carry. And typically, carry is crystallized and payable once the properties or underlying investments are sold. That's the liquidity event.

• 6:53Speaker 01

  And then I think the third thing is, look, people get addicted to liquidity. Our firm, by specifically focusing on a taxable client base, we remove that mandate of trying to serve both pre-tax and after-tax returns clients. So we can specifically focus on how do we maximize after-tax returns.

• 7:10David Weisburd?

  I want to go back to where we started, which you said that real estate investors, taxable investors can double their after-tax gain versus a comparable investment. Walk me through that.

• 7:22Speaker 01

  So let's take an investment that is underwritten in a tax agnostic manner to a five-year time horizon. Again, that may be consistent with what you see in a lot of private real estate funds, some direct investments. Think about what happens. So you make an investment, hopefully there's yield that's getting thrown off depending on what that investment is. You do generate some depreciation so that yield can be tax shielded as it's coming out to you. And then the asset is sold, and for the purpose of this illustration, a 1031 exchange is not utilized. So you actually have a taxable event at that moment in time. Well, through a combination of some depreciation recapture, so depreciation recapture can be broken out into several different buckets. Some is taxed at actually ordinary income tax rates, some is taxed at a more advantaged cap 25% federal rate.

• 8:07Speaker 01

  But between the depreciation recapture and the long-term capital gains, and I'm being generous here, assuming that the investment is held for several years, so you're not falling into a short-term capital gain scenario, you're paying tax drag at that point. And that blended rate can be, depending on your... State of residency, if you're a New York City resident, as you are, you know, that effective tax rate can be, you know, well north of 35% combined state, federal, and potentially city. Compare that to a strategy where you remain invested. So you continue to get yield off of the underlying investment. Maybe there's some refinancing scenarios that allow you to very tax efficiently continue to get your capital out from the underlying investment. And you stay invested and continue to compound. Well, in addition to deferring the depreciation recapture and the capital gains event, the

• 8:52Speaker 01

  long-term capital gains event that I just referenced, what you're also able to do is if you've generated depreciation from that investment and you've banked these passive activity losses, this tax asset on your books, you can actually free up and utilize that tax asset if you pair it with other passive income generators. And then what you can do is you can actually, again, increase the after-tax return across that second investment whereby it significantly increases the value of the first investment you made.

• 9:18David Weisburd?

  And do you also look for 1031 exchanges within your strategy? Or do you just rely on holding for a long time?

• 9:24Speaker 01

  So the 1031 exchange is a gift from the IRS. It's an incredible tool to be able to rebalance or trade out of an asset and continue to defer the tax liabilities. So to continue to defer depreciation recapture, continue to defer the capital gains of that at that moment. Our strategy specifically, we're not reliant on the 1031 exchange. We're actually underwriting to 15-year hold periods. You know, at that moment, once some of the tax benefits do start to diminish, as you think about working your way through a depreciation schedule, we have the ability to utilize a 1031 exchange to tax efficiently rebalance our portfolio. But the strategy itself is not predicated on the use of it. I think that's one thing, like, I want to highlight this. Again, it's a gift. It would be wrong of me to try and say it's not a gift from the IRS.

• 10:08Speaker 01

  But we find it's too, it's overused. It's too prevalent. And if it's used incorrectly, by the way, so you have managers that are cycling out of assets and are justifying their tax efficiency through the use of the 1031 exchange, I would still then ask, okay, how much are you paying away to frictional costs, even separate from taxes? You know, there's a lot of data that suggests that if you're a 1031 buyer, because of the time pressures that are implemented on you, you tend to overpay for the replacement property. Not to mention, by the way, some of the fees that a lot of 1031 exchange facilitators will charge to the underlying client to execute a 1031 exchange.

• 10:40David Weisburd?

  You obviously built this with a billion dollar family office in mind, David Godler. Other family offices, when they come to you, what problems are they looking to solve?

• 10:50Speaker 01

  There's two different kinds. So you have a family office that's upscale and has the in-house, you know, capabilities to go and implement direct real asset or private investing themselves. So I would say off the bat, if you're upscale to bring a team in-house, you go in and you can build a diversified portfolio where you're the only investor, you control buy and sell decisions yourself. That's the optimal way to invest, right? And you can actually layer in tax considerations from other parts of your portfolio to inform when it may make sense to actually trigger sales of those, those, those underlying investments. What we have found is that a significant percentage of family offices, whether it's because they're not of scale to actually bring that team in-house, or candidly, some that just don't want to take on the operational complexity of executing deals directly and then managing those investments, you know, an outsourced solution can be very compelling.

• 11:34Speaker 01

  And by the way, that's really what Arcatell was founded for. It's how do we become an outsourced solution for, you know, ultra-high net worth taxable investors?

• 11:43David Weisburd?

  Do you find that you have to sell the post, the, the net of tax strategy with every new client?

• 11:49Speaker 01

  The, the answer is yes. And I mean, I'll, I'll even take a step back. As we were launching Arcatell several years ago, you know, looking at how competed, you know, the private real estate industry is, you know, most, most investable asset classes, you've even talked about, you know, alpha gets eroded. Everybody's going to say they have smart investment teams and they're, they're, they're smart and thoughtful with underwriting and risk management, you know, given how competed and commoditized the space was, you know, our North Star to really differentiate in a sea of savings was how, how are we more thoughtful about tax efficiency? How do we specifically focus on serving a taxable client base to the best of our abilities in a co-mingle structure? So, you know, for us, that has allowed us to get into business and to keep growing our business in this really commoditized and

• 12:30Speaker 01

  competed space. I think we're still in very early innings of the tax story here. I mean, you look at the incredible traction some firms like AQR have gotten as they've grown their tax aware investing business. You know, I think if you're a taxable investor, The metric that matters is what your after-tax return is. And I think that is going to continue to proliferate across the investment industry. And if you're an RIA or you're a family office or a multifamily office, you know, how do you differentiate and provide value to your clients? How do you provide, you know, alpha that won't get eroded? Structural alpha. It's really through how do you, how do you, how are you smarter about tax? How are you more thoughtful about the structure and the strategies that you're marrying?

• 13:08David Weisburd?

  You have a unique vantage point where you are helping the co-founder of AQR, who built the largest really franchise in tax aware investing. You now deal with tax aware investors all the time. What do you attribute to the rise of tax awareness and this entire trend?

• 13:23Speaker 01

  It comes back to how competed and commoditized the investment space can be. All the products and look about the sales forces that are distributing here. It's, you know, you, you, you can try and differentiate, but all sources of alpha, as you mentioned, you have typically, I shouldn't say all, but alpha can erode over time. If you think about structural alpha and trying to be smarter about maximizing some tax benefits, which are afforded by the tax code, which can change, but you're, you're, you're operating based on what the current IRS guidelines and the rules are today. That's a way where, by the way, the magnitude can be so significant that it, it becomes a much more compelling story to tell. I mean, you can talk about, again, finding a manager that has, you know, top quartile, top decile, pre-tax returns absolutely matters. I'm not trying to diminish that. But let's look at what the dispersion of the returns might be.

• 14:05Speaker 01

  The guess here, the statement would be that will dwarf the return dispersion compared to, you know, lower quartile to top quartile. When you layer in the after-tax, the after-tax component, ideally you marry both. You marry top quartile, top decile, pre-tax performance with the tax efficiency.

• 14:22David Weisburd?

  If you look at median versus top quartile and core, core plus real estate. So the bread and butter, typically about 200 basis points. There's of course a whole question on whether that's sustained, whether top quartile is sustained. There's also a question on whether you could pick those managers, whether there's some luck involved there. But even so, it's only 200 days basis point, which is why I think this whole tax aware strategy has become so big in the public markets because you have a similar phenomenon there. The spread is even lower between top, top quartile and median. And when you see this tax, structural alpha tax strategy, I think it's going to be a thing to come for many years.

• 14:57Speaker 01

  You look at what variables you can control, right? You can diligence managers, you can diligence underlying investments. They can be very shrewd investors and risk managers, but you know, a lot can happen that's outside of your control. I think tax is more within your control certainly, I would say than the pre-tax return outcome of an underlying investment. So you focus on those variables that you can at least better control.

• 15:21David Weisburd?

  Well, I think tax aware investing is here to stay. I think we're going to see a lot of really interesting applications across different asset classes. So really appreciate you jumping on the podcast. Looking forward to continue this conversation live.

• 15:30Speaker 01

  Thank you very much, David.

• 15:31David Weisburd?

  That's it for today's episode of How I Invest. If this conversation gave you new insights or ideas, do me a quick favor. Share with one person in your network who'd find it valuable or leave a short review wherever you listen. This helps more investors discover the show and keeps us bringing you these conversations week after week. Thank you for your continued support.