A quick perusal of the Real Estate Investing page on the WCI Forum reveals a lot of skepticism toward private real estate syndications and private real estate funds. By private real estate syndications, I am referring to opportunities for investors to pool their money with other “limited partners” to buy commercial real estate and pay a fee to the “general partner” (aka “sponsor”) to manage the deal (private real estate funds, meanwhile, simply aggregate multiple syndications into a single fund).
To be fair, there are plenty of great reasons to avoid private real estate syndications. They are generally illiquid, so you should not invest with money you may need in the near future. They often come with more complicated tax treatment and the sometimes dreaded K-1 tax forms, which can come late and require an extension beyond the April 15 tax deadline (and make you file taxes in multiple states). They also require investors to be more prudent and do more research to avoid scammers and incompetent sponsors.
For these and other reasons, it can make sense for an investor to have a private real estate allocation of precisely 0%. But some of the arguments made against private real estate syndications are less informed. I want to highlight some of these arguments and explain their shortcomings.
#1 ‘If It's Such a Great Deal, Why Are They Looking for Money and Advertising Aggressively to Doctors?'
A lot of us who invest in stocks solely through passive index funds, whether we know it or not, have the efficient market hypothesis deeply ingrained within us. We have come to believe that it is really difficult to pick the right stocks and avoid the bad ones, so rather than spend our own time or pay someone else to research these companies, we are better off keeping our costs down and just buying a tiny sliver of all companies through passive index funds. This makes a lot of sense in the stock market, where the research shows very few active managers beat the market consistently.
Real estate, however, is much more local and decentralized. Especially for properties that are too small to attract institutional interest, it is much more reasonable to believe inefficiencies can exist where a property can be purchased at a bargain compared to its potential value.
The people who are skilled at identifying these opportunities and carrying out the operations necessary to deliver a strong profit are not always the same people who have the money to finance them. Thus, a natural partnership is born. Good general partners make a career out of becoming an expert in a niche within commercial real estate and delivering strong operational and financial results. Good limited partners (investors) conduct due diligence on these general partners and associated opportunities and deploy capital to the most promising ones.
There is nothing inherently wrong or flawed with the idea that these two groups of people would seek each other out for mutually beneficial partnerships.
More information here:
How to Start Investing in Real Estate
I Want to Invest in Real Estate, But I Also Want to Be Totally Lazy About It: What Are My Options?
#2 ‘These Syndications Seem to Be Mostly Scams or Run by Incompetent People'
Scammers are out there. So are sponsors without the skills or experience needed to succeed. If you are not willing to invest some time into vetting the people and opportunities, private real estate investing is likely not for you. But to assume that these scammers and incompetent people exist in proportion to the posts you see is to fall prey to voluntary response bias. Investors who have had an investment go south are much more likely to post and speak about it than investors whose deal has gone according to plan. Negativity is overrepresented.
I love that Dr. Jim Dahle started a sub-thread on the Forum titled, “My Private Real Estate Credit/Debt Fund Paid Out as Expected This Month.” The title made me chuckle a bit at first, as it can seem silly to have a “nothing burger” sub-thread. But the fact that it seemed out of place among other negative threads was precisely the point: too rarely do we hear about the majority of deals—which are pedestrian and doing just fine, even if not producing a 30%+ IRR.
Furthermore, aside from the necessary vetting limited partners must do on their own, they can also join specific online communities that discuss general partners broadly and investment opportunities specifically. They are often free or low-cost. This serves as an added defense against scammers and bad sponsors. In these communities, limited partners can benefit from a greater awareness of possible sponsors and opportunities, others’ past experiences with specific sponsors, and unique insights others have on current opportunities.
#3 ‘Simplicity Always Beats Complexity'
By definition, simplicity is easier than complexity. Simplicity also sometimes beats complexity in terms of financial return to the investor. But it does not always. And there is no logical reason why it must. I very much identify with the Boglehead mindset when it comes to the stock portion of my portfolio. I invest in just a few broad-based index funds, enjoy very low fees, and get exposure to thousands of companies. I have found, however, that some of its most ardent adherents have a difficult time with the idea that they could be sacrificing even a small amount of risk-adjusted return when their entire portfolio consists of just three passive index funds.
Some want to believe that they are having their cake and eating it, too, enjoying simplicity and maximizing the returns of their portfolio at the same time. What we know from portfolio theory, however, is that when we add an asset class like private real estate, which has a low historical correlation to the US stock market, to a portfolio of US stocks (and bonds), we enhance the portfolio’s expected risk-adjusted return.
Perhaps the juice from private real estate is not worth the squeeze for some investors. It is a completely reasonable position to take. After all, there is no law that requires investors to prioritize maximizing risk-adjusted returns over their time and perhaps even their sanity. Most doctors and high-earners who are disciplined can afford to give up a small amount of expected return and still achieve everything they want financially. I just think it is more intellectually honest to admit this potential tradeoff between maximizing returns and simplicity.
#4 ‘Real Estate Hasn’t Gone Up That Much When the Stock Market Has Had a Downturn'
In the WCI Forum, Jim once shared that his stock portfolio went down 16% in 2022 while his real estate portfolio was up 9%. One comment suggested that the 9% real estate return was not that significant, despite it being 25% higher than what his stocks returned that year. This type of sentiment greatly underappreciates the power of diversification and what it means toward limiting the volatility of a portfolio.
For simplicity, let’s suppose that an investor had the choice in 2022 of having a 100% stock portfolio or a 70% stock/30% private real estate portfolio. The former would obviously have experienced a 16% decline in portfolio value. The latter would have experienced almost half the decline at just 8.5%.
To add value to a portfolio, an asset class doesn't need to perform incredibly well when other investments in the portfolio are experiencing a decline (although it sure is nice). In fact, even if this newly added asset class goes down in value by a more modest amount, it can be helpful.
More information here:
Real Estate Syndications — Who Are They Right For?
A Tale of 2 Sponsors: How My Real Estate Investments Have Had Vastly Different Results
#5 ‘Even If I Want Real Estate Exposure, I Can Get the Same Thing from Public REITs as I Can from Private Funds'
Public REITs certainly provide exposure to the real estate market. But these REITs need to deploy large amounts of capital, and, for the sake of efficiency, focus on large commercial real estate assets. These assets attract the interest of other large and sophisticated buyers, so the potential of finding a bargain is less likely. Why can’t they focus on smaller, less visible opportunities? Imagine being a large public REIT and needing to deploy $1 billion a year of investor capital. Trying to do it piecemeal through a bunch of $5 million-$20 million assets would require so much due diligence and monitoring as to be impracticable.
Public REITs do have the advantage over private real estate of being traded daily and, thus, offering much greater liquidity than their private real estate fund counterparts. That liquidity comes with costs of usually lower expected returns and higher correlation to the stock market. Depending on a specific investor’s goals and circumstances, one or the other may fit better in their portfolio, but they are certainly not perfect substitutes for one another.
The Bottom Line
Private real estate syndications and funds are not for everyone. They have distinct advantages and disadvantages that may appeal more to some investors than others. But to universally decry them as scams or bad investments for anyone to consider is overreach. The more humble approach is to recognize that many different portfolio constructions can make sense depending on an investor’s risk tolerance, risk capacity, liquidity needs, and time constraints.
Have you been involved in syndications or other kinds of private real estate? What was your experience like? Is investing that way something you would continue?