What is a J-curve and why does it matter? What are the risks? What are the rewards? How does it affect private equity real estate? Continue reading to learn more.
What is a J-Curve?
A J-curve plots a trendline that showcases losses immediately, but is then followed by dramatic gains, thus creating a line that looks like a capital “J” on a graph. Essentially, it echoes a reality in which a period of unfavorable returns is followed by a recovery period that rises higher than the starting point.
It’s a visual representation of “things will get worse before they get better.”
Why Does the J-Curve Matter?
Many economists and policymakers may use the J-curve effect for their research and decision-making priorities as a way to gauge both the short- and long-term effect of variable changes, or to new policies created.
For many companies, J-curves are vital to their growth. However, it can also be their doom if they experience too many, or too few of them, here’s why:
- Companies that have no or very limited J-curve investments may be doomed because they aren’t innovating their products or enough. How can you stay ahead in the market if you’re not updating your products to meet today’s demand?
- Companies with “failed J-curves” lose money and the potential publicity of these losses can hurt them even more.
- Companies with “too many J-curves” are innovating too much without backing their investments up with quality management processes. It can become too much to keep up with every innovation, that it ultimately sinks their business.
.A Cautionary Tale: Rolls Royce J-Curve Example
In 1971—Rolls Royce, a company known for engineering and quality—declared bankruptcy because they invested heavily in their RB-211 jet engine. This project gave them an array of unsolvable technical problems.
Basically, they tried using lightweight carbon fibers in the fan blades to reduce engine weight. However, if anything got sucked up into the fans, like a bird or hail, the 7-foot blades would shatter.
Because of this, deadlines on the project were missed and production costs skyrocketed—which is a common occurrence with J-curve investing. Essentially, at the time of bankruptcy, Rolls Royce had 40 percent of its employees working on projects that were not yet profitable. This forced them to declare bankruptcy.
However, even after their filing, within 10 years, their design would become the world’s most popular jet engine.
Now, let’s discuss J-Curves in Private Equity Real Estate investing. To learn about the differences between investing in private equity real estate vs a publicly-traded REIT, please read REITs vs. Private Equity Real Estate: What’s the Difference?
J-Curves in Private Equity Real Estate Investing
J-curves in private equity real estate is determined by the generated returns, and how fast those returns are given back to its investors. A steep curve on a graph shows that a fund created its highest returns in the shortest amount of time possible. A graph with a slowly rising curve represents the equity on a fund taking too long to realize its low gains.
The assets that typically make up private equity portfolios are usually made up of businesses that were performing poorly before being purchased.
Once a property is acquired, the fund sponsor will spend a substantial amount of money on various improvements before flipping, or managing the property themselves. Some potential agenda items of focus for investing may include:
- Scouting potential properties to invest into
- Managing demolition, construction and/or renovation projects
- Finding tenants to live in the property – including marketing
- Managing the property as issues arise
- Selling the property when the time comes – including marketing
To learn more about the costs of real estate investing, please read How Much Should You Invest in Real Estate today.
With the typical heavy costs of turning a net-negative property into a profitable asset, you’re going to see an initial decline in the fund’s investment for the first few years, before potentially blasting off in increasing returns as the investment matures.
In some cases, investors should expect little-to-no cash flow in the first few years as the fund matures. Most of the initial funds generated from the property are used to reduce the fund sponsor’s debt. In other cases, some investments pay cash distributions a month or a quarter after your initial investment.
Once the line begins trending upward, that’s when you can potentially see bigger payouts on a monthly or quarterly basis.
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