It has been nearly three years since I wrote about “accredited investors” and the investments available only to them. Robert Kiyosaki, in his popular, although widely criticized Rich Dad, Poor Dad, was quick to point out that “the rich” are allowed to invest in different stuff than the rest of us. I've been dabbling a bit in these “special investments” during the last few years and thought it was time to write about them again.
If you're not aware of what I'm talking about, these investments are only available to “rich folks.” Basically, that means you've had an income of over $200K a year for the last couple of years or you have more than a million in investable assets. The theory is that you're either smart enough to not need government approval of your investments or that you have enough money that you can afford to lose a big chunk of it. In fact, most of these investments require you to sign a statement affirming both of those facts. There are 10 facts that you ought to know prior to purchasing one of these.
# 1 These Investments Are Completely Optional
There is no reason you HAVE to invest in these sorts of things just because you can. Plenty of high-income professionals have retired just fine buying only investments that can be bought and sold every day and whose price is listed in the WSJ every day. If the thought of having to analyze these suckers stresses you out, hit the “back button” on your browser right now and life will go on just fine.
# 2 You Should Ignore Any “Prestige” Factor
Please don't buy into these investments just to feel smart and rich because they are offered to you. If you really need to purchase a status symbol, just get yourself a Tesla or perhaps Dave Ramsey's “Status Symbol of Choice”– a paid-off mortgage.
# 3 Remember the Point
The point of buying into these special investments is to get high returns and low correlation with the rest of your portfolio, preferably both. If you are not getting these, what's the point? Go buy some stock and bond index funds. For example, I have been offered the opportunity to invest in some unique investments where the expected return was 5%. My usual response is that it is very hard for me to get excited about 5% (and you can see why I get even less excited about 3-4% returns available with a life-long commitment to a whole life policy.) It wasn't that many years ago when I could get 5% in a Money Market Fund at Vanguard. If you want me to go to the effort to do due diligence, much less take on all the unique risks of an investment offered only to accredited investors, you'd better be paying me more than 5% for it.
Now, these higher returns are my main attraction to these investments. It doesn't take a math genius to see that compounding your money at 12% instead of 8% makes a monstrous difference in eventual outcomes. ($50K per year invested for 30 years grows to $13.5M instead of $6M.) When you start considering that future stock and bond market returns may be far lower than 8%, these higher returns become even more attractive. If nothing else, taking on some of these other risks sure makes your Total Stock Market Index Fund look pretty tame, since it takes a once in a generation bear market just to lose 50% of your investment, and even that is PROBABLY temporary.
Low correlation to the rest of my portfolio is also very attractive to me. You can get that with Peer to Peer Loans or Syndicated Real Estate. One of the investments whose low correlation really excites me is Life Settlements. I mean, how long people live has pretty much zero correlation to the performance of stocks, bonds, cash, gold, and real estate. (Although my wife put the veto on that one, which is fine – there are no called strikes in investing.)
At any rate, if you're not getting high returns and/or low correlation with the rest of your portfolio, there's zero point to looking outside the public markets.
# 4 Returns May Be Higher Due to Higher Risk
There are reasons why expected returns in these investments are often higher than the expected returns in the public markets. For one thing, the level of risk is often higher. Higher return = higher risk. For instance, consider my investments in Peer to Peer Loans. While I've since exited this investment for non-return related reasons, it was pretty nice to be earning 12% while treasuries were paying less than 3%. (Yes, I know these aren't technically for accredited investors only, but you are required to have an income of at least $70K and a net worth of at least $250K to invest.) Why were my returns higher? Part of it is the hassle factor, some is the lack of liquidity (a major pain as I exited), but mostly it is simply because individuals are far less likely to pay me back than the US government, and Lending Club is far more likely to go out of business than the US government. The risk is a lot higher.
# 5 Returns May Be Higher Due to Less Liquidity
Remember that with a stock or bond index fund, you can pretty much cash out any weekday of the year. However, I have several real estate investments I can't get out of for 5-7 years. I don't mind giving up liquidity on some of my portfolio, but I expect to be paid for it.
# 6 Returns May Be Higher Due to Due Diligence Requirements
Whatever you may think of the work of the SEC, there is no doubt they are at least doing something. If you are not familiar with the Securities Act of 1933 and the Investment Company Act of 1940 and the protections they provide for mutual fund investors, you probably should not readily give up those protections in order purchase investments available only to accredited investors. Each of these investments is different, and doing due diligence on one of them does nothing for any others. This is one reason that syndicated real estate investors will often stick with one real estate team that they trust–it is simply too much of a hassle and too expensive to do due diligence on multiple firms. Likewise, this is one of the benefits of using some of the crowdfunding sites–they do at least some of the due diligence for you.
Driftwood Canyon, Lake Powell
# 7 Returns May Be Higher Due to Difficulty Diversifying
Diversification still matters. In fact, all of the principles of investing you have previously learned in the public markets still apply- keeping costs low, the better your purchase price the higher your returns etc. But diversification can be pretty tricky for someone on a “lowly doctor's income.” You see, many of these investments require significant minimum investments. I have found investments with minimums as low as $2000, but I have also seen them with minimums as high as $250,000. $3K at Vanguard gets me part of 10,000 different companies. But $100,000 may only get me an investment in a single company when it comes to accredited investments. You need a strategy to allow you to still avoid putting all your eggs in one basket. Dishonest and incompetent managers are far more likely to thrive in an environment with less government regulation. Guard against your own ignorance by diversifying. Part of the reason returns may be higher, of course, is that acquiring real diversification is so darn difficult.
One approach to this is that I have used in the past was to only put the minimum into these sorts of investments, whether that is $2K or $10K, and then to avoid those investments with a high minimum relative to my portfolio size. For example, I had a real estate investor approach me a while back to purchase a share in a hotel in Boise (and to hopefully advertise it to my readers.) The minimum purchase was $250K. I'm not sure how rich he thought I was at the time, but plunking a quarter of my portfolio into a single business certainly didn't meet my diversification needs.
Rick Ferri has given some rules to use when considering adding an asset class to your portfolio which I have written about before. Basically, they are as follows:
- High returns
- Low correlation with the rest of the portfolio
- Ability to adequately diversify the asset class (preferably with an index fund)
- Ability to keep costs acceptably low
Keep those in mind when looking into these special investments and if you're going to bend these rules, make sure it is for a good reason and bend them as little as possible.
# 8 Returns May Not Be Higher At All
One thing to keep in mind with investments for accredited investors is that these high returns you seek may not actually be higher at all. When people started looking at the actual performance of the average hedge fund, the classic investments for accredited investors, they found it was disappointingly low. Granted, many hedge funds were not trying to get high returns, they were simply trying to “hedge” but still, that's pretty crummy.
The situation with real estate syndicators could be analogous. Nobody is looking at what they are returning on average. It is truly the Wild West in terms of what's going on out there. Sometimes returns are spectacular, and sometimes the entire investment is lost. But we do know what kind of returns we see out of the big publicly traded real estate companies (i.e. REITS.) If their long-term returns are similar to the stock market, why would we expect smaller companies to do much better? The only reason is that we believe the market they are investing in is inefficient and that they are able to add value through their expertise and nimbleness. But remember, that for every bit of alpha added, somebody else lost alpha. Make sure your investment is with an alpha generator.
The real estate crowdfunding companies generally predict returns of 14-18% for their equity investments. It is interesting to look at their assumptions in hitting those returns, and considering how those assumptions could be wrong. An 18% expected return can become a -10% return very easily with a minor change in assumptions. To be fair, these companies sometimes beat expectations too. Sometimes they project 17% returns and get 24% returns, but I would expect that most projections are at least a little on the rosy side.
# 9 Expenses Are Usually Much Higher
One thing you can almost surely expect is that you're going to pay a lot more for these investments than you are for your index funds. These can range from 1% to as much as 2% plus 20% of profits. Every dollar you pay in fees and expenses is a dollar taken out of your return. But also keep in mind that what you're really interested in is the after-expense return. If the investment will pay you enough to pay the high fees and still give you an acceptable return for the risk taken, it may still be worthwhile to you. Just don't think that the expenses are going to be anywhere near the 5-10 basis points you'll pay for a Vanguard index fund. In fact, look at enough of these investments and you'll realize just how miraculous index funds are–you get to own thousands of companies for basically free.
# 10 These Opportunities Will Be More Common In the Future
The JumpStart Our Businesses Startup (JOBS) Act was signed into law in 2012 by President Obama. This basically made it easier to start small companies and crowdfund them. This has made real estate syndicating far easier to do (mostly lowering minimum investments), and it bleeds over into many other types of investments.
The number of crowdfunding companies has exploded since the JOBS Act passed.
So, if you're interested in adding some of these investments to your portfolio, feel free to do so. But if you choose to go that route, remember the principles of investing still apply- diversify widely, purchase different asset classes that have low correlation with each other, keep costs as low as possible, try to be tax-efficient (although it is particularly hard to put many of these investments inside retirement accounts,) do your due diligence, and don't take on too little or too much risk. Also, I would recommend adding these investments onto a core consisting of a broadly diversified, low-cost index fund portfolio. There is certainly no reason your portfolio should miss out on the benefits of publicly-traded stocks and bonds using index funds inside retirement accounts.
What do you think? Do you invest in anything that is only for accredited investors? Why or why not? Comment below!
think you are talking to a degree about hedge funds, which are not a wise investment for anyone
85% of them underperform and many go belly up as well
just imagine 2% in fees and giving up 20% of profits
do you think they can out perform
and you have no idea where your money is invested nor do you see daily the return
a fool’s investment, not me anyway, anytime
Great article and very timely. I am involved in a few of these investments, with varying degrees of risk/reward, and am on the verge of another. Don’t see much talk of this on the BH site, so thanks for the article. I think one of the things about these investments is investor access, and it took me a little while to loosen my boglehead hat when evaluating what seemed to be at first eye brow raising returns. As I have now done a few of these, I realize it is 100% true that the rich get richer. Even at my entry level of 100K, there are plenty of projects with floors waaaaay higher (5MM?) that are historically very lucrative. One can certainly argue or hand wave that these are super risky high risk high reward, true, but I have seen some real due diligence by some very smart people – we are not talking about sleazy combover dudes investing in 3rd world junk bonds. These vehicles certainly have a place in my portfolio – and for me they tend to be long hold times are completely illiquid. I keep them rotating, with cautious sums invested in each as it aint never a free lunch. It’s easy to be lulled into over-investing in these – and hogs eventually get slaughtered.
or, you may inadvertently be funding an Islamic terrorist.
Malik and Farooq funded their shoot out with a consolidation loan from Prosper.
http://www.wsj.com/articles/citigroup-funded-loan-to-syed-farook-made-through-prosper-marketplace-1449871936
Could have just as easily been a credit card. While interesting, hardly a reason to avoid that sort of investment.
I have participated as an accredited investor in two hospital syndication deals and one outpatient surgery center. The returns were ok. I dislike the K1 form. My most memorable investment along these lines was an “angel Investment.” I was invited to join a group of angels that fund start up companies. The group was comprised of people who had started several large publicly traded companies. Several doctors were also in the group. I listened to several deal presentations over the 2 year period I was active in the group. I decided to invest in a start up that would manufacture a new type of incubator specifically for neural tissue. A company had been located in China to manufacture the product. A patent had been applied for. The inventor/president had a PHD from Harvard. Lots of sophisticated people invested. Then this Harvard PHD walked into a meeting and shot 6 people. Thankfully my first and last angel investment was only $15000 and I used the loss on last years taxes.
what a story.
The most important thing to look at with syndicated real estate is track record. It’s not the only thing, but it is the most important thing. Crowdfunding (the use of a middle man to raise capital for your offerings) has the advantage of a lower cost of entry for the investor, but it is new. At most, you only have a 3 year track record to look at.
The top syndicators (the ones with a long track record of success for making their clients money) do NOT generally use crowdfunding. Why would they? Using a middleman to raise capital creates an extra expense for them. Those companies have no trouble raising capital for themselves. Many have a fervent following that parks their money in the bank waiting for their next offering.
I have no doubt that some of the syndicators that use crowdfunding will eventually develop a successful track record and get to the point in which they can stop paying a middleman. Others will not. If you are going that route, don’t just trust the middleman crowdfunder. Make sure you find out the syndicators track record (are they new?…have they had failed ventures previously under a different company name?), how long they have been in business, and why they are using a middleman to raise capital instead of raising it themselves.
Due diligence is important with any type of investment.
While all that is/may be true, it’s important to disclose that you work for and are paid by a real estate syndicator that does not use a crowdfunder.
I do partner with a syndicator, that is true. Nevertheless, I believe the above advice is sound for those interested in investing via crowdfunding. As you know, real estate has been doing well (some classes better than others). It is wise to find out how these syndicators did in bad times (2008 for example).
Right. I think it’s probably good advice too. But disclosure matters so people have the proper perspective from which to evaluate your advice.
My apologies – I’ve been around here a long time…but won’t assume everyone knows me.
I don’t even mind you giving a plug for your company, but I do want people to know where you’re coming from.
I will give a plug for Dennis….Although the real estate company he works with does not have inexpensive options, so far I have been very happy with my investment and returns.
Thanks!
It’s less important to plug anything than it is to give good advice…and for anyone thinking of investing in real estate (whether directly with the syndicator or through a crowdfunding middleman) confirming track record through due diligence is key. Don’t forget that failed syndicators can and do open up new companies with new names. So look into the company AND the managers.
On another note, there was other questions about tax benefits and about active investing versus passive investing. Another big advantage of active investing is real estate professional status on your taxes. However, the point was made that you should definitely know what you are doing before investing actively. That point is correct. The tax benefit is substantial to the person making money. However, it isn’t nearly as helpful to the person who is losing money in real estate.
Just being an active investor doesn’t give you real estate professional status.
In order to qualify as a real estate professional you must spend at least 750 hours on your real estate trades or businesses in which you are an owner.
http://www.forbes.com/sites/peterjreilly/2013/01/27/real-estate-professional-status-becoming-more-important-very-hard-to-prove/
Most docs aren’t to qualify unless they’re doing something like you are. Just buying a couple of properties directly doesn’t give it to you.
I can’t believe you just said that to me. Lol. I’m very well versed in this tax code. I didn’t say that you are automatically a real estate professional if you are an active investor. However you are automatically NOT a real estate professional if you are a passive investor. Hence the advantage of actively investing. You still have to meet those requirements. If you cannot, then passive investing starts looking a whole lot better (especially if you don’t have the expertise as well). And there are still plenty of tax advantages available to passive investors.
I agree with all that. I’m also confident you know the IRS rules on this subject. I was mostly providing them for anyone else reading who might think from your comment that just buying a property or two directly would give them professional real estate status.
there wasn’t much mentioned about tax implications in this article. I think that’s huge. Obviously, accredited investments are only for people who have maxed out their tax-advantaged space…but maybe should have made that point clear in the article.
one exception would be P2P lending sites that have IRA options
Excellent point. Certainly I don’t invest in them prior to maxing out my tax-advantaged space….which just keeps getting larger all the time. Just doing that is no small feat for many self-employed docs. Not counting 529s, I think I’m up to about $170K per year in tax-advantaged space now.
wow…that’s a LOT of tax advantaged space. as I’ve commented before, many of us employed docs are lucky to have anything above and beyond 18k (401k) + 5.5k (or 11K married) IRA’s.
If I had that much, I’m not sure I’d be saving any extra in taxable acct. I’d work less though, not spend more 😉
Exactly. I’m wondering the same thing and that’s part of the reason I’ll be dropping some shifts next summer.
Could you break that $170k down in terms of possible accounts? Not that I don’t believe you, but that’s mind-boggling (in a very good way!)
Sure.
401(k)/PSP: $53K
DBP: $30K
Backdoor Roths: $11K
HSA: $6650
Individual 401(k): $53K
Her Individual 401(k): Depends on income, but at least $20K.
Total: $173K+
And of course that doesn’t count the 529s, Roth IRAs, and UGMAs for the kids. And then people wonder why I don’t have much in the way of taxable investments. I see lots of these “accredited investor” investments that interest me, but not quite enough to pass up tax-advantaged and asset-protected space. Remember the only asset protection I get in Utah is retirement accounts. Only like $40K of home equity is protected here and I don’t have any cash value life insurance.
Why are there 2 401k plans here? I’m a 1099 and put 50k/y in my IRA but no more…when I looked into DBP is seemed like it was expensive to set up & maintain. Is it really much better than just a taxable vanguard account?
Why do I have two 401(k)s? Because I have two businesses that are unrelated. More details here:
https://www.whitecoatinvestor.com/multiple-401k-rules/
How did you create DBP? Was it offered at your work?
Yes, my partnership set it up before I got there. If you’re an independent contractor, you can get your own. There are higher fees than with a 401(k), but it might still be worth it to you.
I was unaware that you can use the back-door roth method as a tax write-off?
Not sure what you’re saying or asking. If by “write-off” you mean deduction, you’re right, there is no deduction there. But future growth is not taxed.
Would you mind itemizing that space? It is making W2 employment look more and more terrible.
Personally, I think W2 employment does look terrible. Unfortunately, it’s becoming reality for more and more doctors every year. In some specialties and areas, it is your only option. In many other specialties and areas, it is your best option.
Of course, you can always have a business on the side, which is part of where all my extra tax-advantaged space comes from.
Outside of my house, my real estate investments are in these type of syndication investments. I often wonder which is better. Owning a property with property management or serially investing in these real estate sponsors. I tend to believe it is the former but am curious about others opinion. I recognize the argument of time, ie spend your time being a dr instead of a landlord. Thus, I have stayed away from buying my own real estate inestment
Hi, I can tell you that the returns are generally higher owning properties but the downside is that there is more active involvement and commitment even when you hire property managers. You still need to find the property, get great tenants and oversee it. If you like having more control (often equals to more work but with higher returns) then owning real estate is better. Some of the benefits to having more control is having the ability to influence appreciation ( renovations), buying it under valued, and filtering who your tenants are. I have friends who have done both and they prefer syndicate investments even with less returns because they place a higher priority on time over returns. Hope that helps.
First, it’s only better if you’re skilled. One benefit of going the syndicated route is you get to buy someone else’s skill (which hopefully is higher than yours.
Second, you also need to subtract out the value of your time when you calculate returns.
I think tax-wise you’re better with the property manager (because it’s easier to exchange.) But hassle-wise, I prefer the syndication. I think it really depends on how skilled you are personally at selecting properties and managers.
I have invested on several real estate platforms. I have been a little disappointed in Realty Mogul as of late with delays in closing (4 months!), investment being returned and then asked to resubmit due to the site changing escow managers, investments not performing as well as predicted (selection bias?), and apparent looser lending standards (don’t seem to require the syndicator to have as much skin in the game). Conversely, I have had a better experience with Realtyshares with regards to deal proposals, performance of my deals (again, selection bias?), and clear updates on the performance of my deals. With regard to debt platforms, I think Patch of Land is the best and am surprised that more people on Prosper and Lending club don’t switch over to these hard asset backed loans.
can you comment on how patch of land is similar or different to the other real estate crowdfunding sites you mention? You refer to it as a debt platform (like Lending Club) but I thought it was distinctly different…
Realtyshares and Realty Mogul, among others, started out by mostly being a crowdfunding syndicator for equity deals in real estate. Many of them have since added real estate debt deals to their platform of investment options–in addition to the equity deals. Patch of Land has always, as far as I know, been a real estate debt only platform, no equity investments. They seem to be the early adopters of crowdfunding for real estate debt–essentially crowdfunding for hard money lenders. Why I prefer Patch of Land, opinion here, not necessarily fact, is that their whole platform and business structure is built around offering debt deals. Their debt deals typically seem to offer a higher return and have a better debt/ratio (typically in the 60-70% range, sometimes lower–lower is better) than Realtyshares and Realty Mogul. (I have also been enticed by iFunding, but their deals seem to be fewer and far between). Also, if I remember correctly, they prefund all of their deals meaning, they immediately loan the money to the borrower when they decide that the deal is worth doing, then they replace their investment with the investor’s investment as they trickle in. The benefits of pre-funding for the investor are that they obviously believe in the investment enough to be willing to put their money in before any investor and if no investor wants to invest, they know they will be stuck with the investment so their incentive is to only accept investments that they themselves are willing to invest in. The second benefit of prefunding is that you immediately start to accrue interest when you invest, instead of having your money tied up while you are waiting for the deal to close (common problem with equity deals–see my first complaint in my initial post).
Real estate debt deals are different from other debt platforms such as Lending Club in the sense of who is borrowing the money and for what purpose. I don’t do Lending Club, but from what I understand, you are essentially loaning money to various individuals for various reasons, but in most cases, there is no underlying hard asset of value to back it up–you’re essentially relying on their honesty and credit score. In hard money lending, you are theoritically only loaning 60-70% of the total value of the asset, so if the project fails, supposedly your investment is preserved due to the value of the underlying asset (doesn’t always work that way–talk to hard money lenders during the last recession), but to me, it seems a lot safer than paying for someone’s moving expense that doesn’t have any recourse behind your loan. Why I compare them is that they are loans that pay interest that are taxed at regular income tax rates (unlike equity deals). Many people that invest in debt deals do so with IRA money so as to avoid the high tax rate. In my mind, I just lump all debt lending together as one asset class for investing even though there are various forms/risks in doing it. Does this answer your question, or is it just more confusing?
I’d say those are fairly different asset classes- secured lending on real estate vs unsecured lending. I would expect them to perform differently in different economic circumstances, although both could certainly tank in a big recession.
No it makes perfect sense now…I perceive a spectrum of platforms with equity financed loans (RealtyShares) on one end and unsecured personal debt (Lending Club) on the other, with asset/collateral-backed debt deals in the middle (patch of land).
I also see your point that any high income investor (ie, doctor) looking at these deals will be drawn to the one with most favorable tax treatment. WCI has talked about how he transfers some of his backdoor IRA from vanguard to Lending Club…do you know if Patch of land offers a similar vehicle?
If Patch of land and other debt platforms don’t offer IRA options, why would a high income investor use it? Doing so cuts returns nearly in half for the upper tax bracket, thus wiping out the alpha advantage of the asset class
Looks like you can use an IRA at Patch of Land
https://patchofland.com/blog/building-wealth/2014/07/02/guest-post-kingdom-trust-using-your-sdira-to-invest-in-real-estate-crowdfunding/
Tom is correct in that you can invest IRA money in PofL (or into pretty much anything else for that matter), however it is kind of a pain when you need to direct the IRA custodian to invest in each and every deal you decide to do (Lending club et al, may allow you to plunk a chunk of change into an account–similar to a brokerage– so you don’t need to go back and forth between the custodian every time). The hassle factor is the biggest reason why I haven’t done any real estate debt deals with IRA funds…yet (I agree, interest income is not ideal unless it is in a tax advantaged account). For the past 10 years or so, I’ve used a self-directed IRA for various investments that allows me to invest IRA money into areas that are not readily set up for IRA investments–ie private stock placement, debt to equity conversion for startups, etc, however, these are typically long-term deals that don’t require frequent investment and interest payment transactions through the custodian. The ideal way, in my opinion, is to set up a self-directed IRA as a “check book IRA LLC”. This is when you transfer your IRA money to the IRA custodian who then “invests” the funds in an LLC that is soley dedicated to your IRA funds, but that you have control over all of the transactions. This way, you comply with all the cumbersome IRA regulation, but still can make the investments directly without going through the custodian each and every time, they are taken care of at the LLC level and then reported back to the custodian on the yearly K-1 statement. I learned about the checkbook IRA after having already set up my self directed IRA many years ago and have just been too lazy to ever get around to switching it over to a check book IRA LLC. There is the added cost of having your accountant issue a K-1 to your IRA custodian every year. Even though it is in an LLC, the same IRA rules still apply, ie no prohibited transactions, etc. FYI, I use Sunwest Trust, they have been fantastic. They also allow and help with setting up a checkbook IRA LLC. At the time they were essentially the cheapest around, but like I said, it was a while ago that I researched all the other options out there. Things may have changed. But if I ever get around to setting up the checkbook IRA, I will use it to invest in debt real estate loans.
The biggest issue I’ve had with using IRA funds to invest in stuff like this is the backdoor Roth IRA issue. I mean, that IRA has to come from somewhere. If you’re like most docs, your Roth IRA is relatively tiny and you don’t want to do huge Roth conversions. So the only way to get a huge IRA you can use for real estate investing is to rollover a 401(k) into an IRA. But if you keep a traditional IRA out there, whether self-directed or not, you can no longer do backdoor Roth IRAs.
My Roth IRA can handle my Lending Club slice, but it couldn’t handle $200K in real estate investments. It’s just not big enough, and I’ve been maxing it out for years and even done some conversions.
So my real estate ends up in taxable, where it may not be ideal tax-wise especially the debt deals that pay fully taxable interest. Maybe in a few more years.
Fortunately, my parents started me off putting my measly lawn mowing money into an IRA when I was a kid and I told my wife I wouldn’t marry her until she set up an IRA :-), we then converted them to Roths during medical school (when the new laws came into place) at essentially a 0% tax rate. Thanks to some good fortune, luck, and opportunities, our Roth’s are now worth about $600,000 so I am always looking to use my Roth IRAs to hold the high taxed investments of my portfolio. We still do the backdoor every year, but don’t have any regular IRA’s to complicate the conversion process.
Good for you man, that’s awesome. I don’t think we have half that in Roths combined. I guess it’s still an option for us. I’ll have to spend some more time thinking about that.
One point of clarification. Debt lending with IRA money is straight forward, but real estate equity purchases are a bit more complicated if there is a loan out on the property. The government doesn’t allow you to purchase leveraged real estate with an IRA and not pay taxes on the leveraged gains. If you do buy a leveraged piece of real estate, you need to calculate out the gains from leverage vs the unleveraged gains and pay taxes on the leveraged portion. I’ve never done this, but it seems like too big of a pain and not enough of a benefit to be worth the hassle. For this reason, I don’t think real estate equity deals are ideal for IRA funds. However, as mentioned before, debt deals are great for IRA’s.
Interesting. Not sure I realized that.
Another reason that a real estate PURCHASE is not ideal for an IRA is that it is already quite tax advantaged if you apply accelerated depreciation to your ownership, which can result in paper losses for tax purposes despite positive cash flows–tax deferment, no exclusion (this has been discussed by WCI on other threads). In my opinion, real estate ownership really doesn’t fit into an IRA–despite all the self-directed hype about real estate–another poorly understand fact is you can’t even stay in the property without breaking the prohibited activity rules for IRAs. Great for real estate loans, terrible for real estate ownership.
Excellent points.
As you know better than me, there are 3 drivers to investment return and risk: asset allocation, security selection and market timing. With enough time, many can master asset allocation; few can master market timing; some might be able to master security selection.
With an “accredited investor” investment, you’re entering the realm of security selection, as I don’t know of any index fund for such investments. With publicly traded securities, you can ride the coattails of larger institutional investors, when it comes to security selection. I’m not saying such investors are perfect, but to some extent, they’re doing due diligence for you. “Accredited investor’ investments are not publicly traded; you don’t have those coattails to ride on. When it comes to selecting privately traded securities such as these, you’re on your own. If you don’t think you can pick publicly traded stocks or corporate bonds, I question whether you should be investing in privately traded securities.
About the increased return, it might happen. If you’re investing in privately traded securities, they will likely be less liquid than publicly traded securities. Less liquidity should result in a liquidity risk premium. David Swensen’s fame as an investor comes from obtaining that premium. Such a premium should result in alpha. But historically, alpha goes to the manager, and not the average investor. My guess is that the vast majority reading this blog belong to the average investor category and not the David Swensen category.
The bottom line, when it comes “accredited investor” investments, is that you have to believe in active management. If you don’t believe in active management when it comes to publicly traded securities, why would you believe in it when it comes to privately traded securities? What research I have seen, when it comes to active management, is that the results are worse for private investments than for public investments.
Excellent points. I’m curious what research you have seen that looks into the results of private investments. I have found that data very difficult to find and not to necessarily apply to the investments discussed in this post.
The other thing to keep in mind is WHY index investing works. The story is mostly one of low cost, broad diversification and efficient markets. Keeping your costs as low as possible is generally a very wise move. Broad diversification provides index-like returns, so if you broadly diversify your returns should approximate the market return for an asset class. And, of course, there is an argument that some of these asset classes aren’t efficient at all. My hometown real estate market, for instance, isn’t efficient in the sense that skill and knowledge of the market can’t bring you additional returns. The rules that apply to a very liquid publicly traded market like US stocks don’t necessarily apply to every market. How many analysts are there watching that property down the street from you compared to watching Apple?
About data regarding private investments, that comes from hedge fund research, and doesn’t necessarily apply to the investments discussed in this post.
Index investing works due to lower costs. But markets don’t have to be efficient for indexing to work. Assume a very inefficient market. 50% of investment is index, 50% is active. On a precost basis, both halves will have the same return. But after costs, the indexing half will beat the active half on average. Sharpe pointed this out years ago.
I agree that one’s hometown real estate market is likely less efficient than the Russell 1000. So there is greater opportunity to both outperform and underperform. But most people reading this blog are more likely to underperform IMO. They will be competing against people who are much more knowledgeable about the local market, and I doubt that they will win that competition; that ignores the increased costs associated with such investing.
I disagree that US stocks uniformly are very liquid. There’s no question that large cap stocks are liquid. But as the stocks get smaller, that becomes less true. At the microcap level, institutional investors often can’t invest, and you’re in the realm of individual investors.