[Editor's Note: Today's WCI Network post is from Passive Income, MD. If you want to add private real estate to your portfolio, consider investing alongside me with DLP Capital Partners. They have one equity and three debt funds with lowered $100k minimums (normally $250K minimum) for the White Coat Investor family. Check out our YouTube Channel for my recent interview with DLP Founder and CEO, Don Wenner to learn more about these funds.]
I had an opportunity this past weekend to speak with an old friend I hadn’t seen for years. We had a lot of catching up to do; we talked about our wives, children, parents, and careers.
He actually had no idea that I was running some online businesses—including this blog—and he was extremely curious why I’ve invested so much time and effort into getting them up and running. After all, wasn't I doing okay financially as a physician?
So I went into the state of medicine and my desire to create financial freedom from it. I told him that at the end of the day, my goal was to use as much capital from my day job as well as these side hustles to create multiple passive income streams. The streams would produce cash flow that wouldn't be directly dependent on how much time I put in. That was how I was creating true financial freedom.
My friend works in a high-paying non-medical job, and after hearing about my personal financial goals, he eagerly stated that he was hoping to accomplish the same thing.
So, we discussed what his personal investing desires and goals were. He stated the following:
- He was interested in investing in real estate but absolutely did not want to own or manage it himself.
- He was hoping for something tax-efficient.
- He wanted to diversify outside of his current stock portfolio.
- He wanted something totally passive.
- He wasn’t interested in chasing super high returns for a large amount of risk.
So we discussed various opportunities to utilize real estate investing to achieve those goals. I told him that it seemed to make sense for him to look into real estate funds. He was an accredited investor and therefore would qualify to invest in these funds.
He was intrigued and asked how I came to make that suggestion in particular. Well, I decided to share with him some of my goals, which were very much in line with his.
Cash Flow
At the end of the day, I want my money working hard for me, creating more passive income. I want it to create a revenue stream that I can live on.
Sure, appreciation (the increase in the price of an asset) is great, but that typically only matters when the asset is sold.
In actuality, I want cash flow to return to my pocket now so I have more choices in life. I can spend the cash, work less, or reinvest it to increase my returns.
I told my friend that when I evaluate real estate funds, I focus on the cash flow produced by paying special attention to something called “preferred returns”. These are the expected annual cash returns that are distributed first to investors before the company participates in any of the profits.
I look at projections for how the fund expects to produce that cash flow and how successful they've been in the past. I told him to remember above all else that if you have steady cash flow, you have flexibility and freedom.
Tax Efficiency
My friend had a very valid concern when it came to taxes. As we all know, it’s not only what you make but what you keep that’s important. He works in a high-paying job but stated that he pays “a ton in taxes”. He wanted an investment that kept more money in his pocket.
Personally, when I look at an investment, I also want to know if my returns are going to be tax-efficient in any way.
Just as if you were purchasing a rental property on your own, when a fund purchases an investment, they have the opportunity to take advantage of something known as depreciation which decreases the amount of taxes that need to be paid.
I look for funds that are mindful of tax-efficient strategies like these and that these benefits are passed along to the investor.
The bottom line is that a 6% return, if it’s tax-free, can be better than an 8-9% return with tax consequences. It’s important to look at what the strategy of the fund is and not just look at a simple number.
Taxes make a huge difference, and knowing how to take advantage of certain incentives and tax breaks can result in significantly better cash flow.
Diversification
My friend was also looking for some added portfolio diversification, and that’s actually one of the major reasons I invest specifically in real estate funds.
When it comes to stocks, we all know that diversification is important. That's why many invest in diversified index funds. It helps smooth out returns as risk is spread across many assets.
The same can be said for real estate funds. For example, a syndication investment is often focused on a single building. So when you invest in it, everything rides or dies with that one property. Don’t get me wrong—when I find a good syndication deal, I jump all over it.
However, there is some comfort knowing that investing in real estate funds gives me instant diversification, kind of like a mutual fund of syndications.
This diversification is created by owning multiple assets in multiple parts of the country since weather, economic, and political factors can be highly localized. Funds also create diversification when it comes to market timing because they make purchases over time and at different periods in the market cycle.
It’s always nice to know that your risk is somewhat mitigated by this diversification.
Passive
I told my friend it’s extremely important to know how to vet these funds before investing in them, because once you do, you can consider your funds locked up for quite a while. Just how long depends on the nature of the fund, so that’s certainly something to consider.
When it comes to the vetting process, you have to identify the operators of the fund, their track record, and their goals. You need to know the type of assets they’re going to pursue, which markets they're investing in, and how they're mitigating risk. This last factor is even more important now, considering we’ve been in a boom real estate cycle for quite a while and people are fearing some sort of upcoming recession.
The upfront time commitment to vetting these investments should be taken seriously, but once it’s done, the rest of the process is extremely passive.
Ultimately, real estate funds are very passive. You invest…and you wait for checks on a quarterly or semi-annual basis. That’s about it.
Returns
Returns across funds can vary greatly depending on the goals and strategy of the funds. You can find funds with returns anticipated at 25% or more, but often that comes with higher risk in this market.
For a portion of my portfolio, I chase slightly higher returns, while the majority of my portfolio is focused on steady returns. As I’ve reduced my time in medicine, I value the steady cash flow above all.
It only takes a simple calculation to figure out what my expected monthly and yearly cash flow will be.
For example, if the fund states that they expect 6% cash returns on a yearly basis, if you invest $100,000, that 6% amounts to $6,000 a year or $500 monthly. So by knowing how much passive cash flow you need, you can figure out how much you need to invest to accomplish your goals.
Also, don't forget that if the returns are for the most part tax-free, that makes a significant difference in how much passive income you need to create.
How to Find Funds to Invest In
After discussing all of this with my friend, he naturally wanted to know where he should invest. I was hesitant to give him any straight advice.
Where you invest your money and with what company can depend on your goals.
There are funds that focus more on cash flow. There are other ones that look for more upside potential, such as development and heavy value add properties. There are ones that focus in the South, others that focus on the coasts. There are funds that help you invest in other operators and funds for even more diversification.
The key is to figure out your goals, learn to do your own due diligence on passive real estate investments, then figure out which investments will help you get where you want to be.
Just know that most funds have a hold time of at least 3-5 years and often longer, so if you think you'll likely need immediate access to those funds, it’s probably not the right investment vehicle for you.
At the end of the day, my goal, and the clear new goal of my friend, is to have investments that produce steady cash that we can live off of. Investing in real estate funds is one of my favorite ways to accomplish that goal.
Do you feel ready to learn more about real estate? WCI's No Hype Real Estate Investing course is the best on the planet. Taught by Dr. Jim Dahle and more than a dozen other experts, this course is packed with more than 27 hours of content, and it gives potential investors the foundation they need to learn about all the different methods of real estate investing. If you’re interested in real estate investing, you can’t afford to miss the No Hype Real Estate Investing course.
What type of things are you looking for in your real estate investments? Comment below!
I’m very interested in real estate syndications and especially funds as well and have made several large investments into this space over the past year. In essence, I see the expected appreciation comparable with stocks but lower volatility as a good compromise with a limited or eliminated bond fund position now that the expected returns from these are so low. Am I crazy for thinking about these like a bond fund with similar (but not zero) lower volatility but projected 12-16% returns?
I did invest in the DLP housing fund among others and have found them to be pleasant to work with and have no complaints so far. It’s a good 6% preferred return structure, with 80/20 split above that to 12% and then a rather unpleasant 60/40 above 12% that I do fear could hamper a few banner years that would otherwise help balance a few years of underperformance.
One of the huge benefits of these investments comes from accelerated depreciation. I wonder if making bigger investments in individual syndications or funds that take advantage of this in the next few years before accelerated depreciation phases out of the tax code is more advantageous? Also curious for the best play on rolling over investments when they mature every 3-5 years and what the post tax implications would be of getting your 130% of capital or so at the end of the hold term and whether there would be a bigger tax hit compared to a longer term hold with stock index fund.
For me the hands off and locked up nature of these plus high projected returns is perfect. Keeps me from touching the funds and behaving irrationally.
Yes. Real estate is DEFINITELY not a bond substitute. I also would not necessarily expect lower volatility than stocks. For example, I have a syndication that came very close to being a total loss and may still finish with a substantial loss.
I agree it’s tricky to swap investments without paying capital gains when investing in syndications and funds.
Interesting argument FOR illiquidity. I’ve heard the whole life folks make it as well. Sorry, illiquidity is a downside. Might be worth it if you’re being paid for it (and if you really get 12-16% I think you are), but it’s not a benefit.
These investments are also a complete tax nightmare. You take a simple situation with stocks, bonds, cash, and maybe some side project income…and then turn it into something with complicated numerous state K-1s. No one is talking about this and the accounting fees that will result. Fees and time/hassle take away from your bottom line. In addition, this is a lot of headache and fees for little diversification if you are talking about a multimillion dollar portfolio. My real estate fund yields less than 2% a year after accounting fees, and even less with the time I have to waste come tax season. Fees matter, and time also matters. I would never do it again, maybe it would make more sense at 500k invested, but then there is a lack of diversification at that level with a single sponsor. Wish I had just purchased a vanguard REIT index…which is what I recommend to anyone who asks.
I’m talking about it. I’ll be filing in 5-10 states this year.
I agree it doesn’t make sense if you only invest a little.
Agree on the multiple states thing. I will only invest in a fund with a consolidated K1 or in my state or property in a no income tax state.
Wow thank you for that warning. That alone will keep me away from these investments.
No one discussed exactly how much of a headache and how expensive just one fund (MLG) would be. Its absurd, one of my quarterly preferred return payments goes entirely to the extra cost of filing in 7 states. After these hidden “fees,” your return is not great unless you have about 100k minimum in each one.
I agree that with small investment amounts the tax burden/hassle eliminates a great deal (all?) of the benefit of investing at all. $100K seems a reasonable number.
Unfair to say I have never discussed it though.
I’m sure you have discussed it, I just didn’t see it. My point being, these things are being peddled by everyone and discussed. But, everyone is not focusing on the gorilla in the room that would be the biggest problem after you are locked in, the yearly tax headaches and associated fees. I’m sure you discussed it, but I don’t believe I’ve seen anyone else.
I don’t think that’s the biggest problem. I think the biggest problem is manager risk. Other big problems are fees and high minimum investments. Liquidity also an issue. But tax hassles aren’t insignificant.
I agree Peter Kim, the author of this article, has a tendency to be particularly positive in how he views all things real estate and that both he and I are incentivized to be more positive than we might otherwise be as we “peddle” these things. But I still try to call it like I see it.
Nobody should be surprised by this stuff though. I consider knowing how it will affect your taxes and tax preparation an integral part of doing your due diligence on these. But I’ll admit it’s hard info to get from the company. Easier to get from previous investors in my experience.
Biggest issue with alternatives is there are so many unknown unknowns. So many ways to screw it up with taxes, yearly tax filing can be held up if just one sponsor is late, illiquid and open to sponsor fraud (such as what happened at Equity Multiple, and yes I was a part of that one). People fall prey to the idea that complicated and “sophisticated” investments are somehow better or safer compared to market risk. I have not found this to be true in my short experience, but just the opposite.
If you do alt investment, do it in your state or a state with no tax filing necessary.
Couldn’t find a great place to post this but: Do you have (or know of any) good spreadsheet templates for tracking multiple investments in private real estate funds and syndications?
Something that calculates Total Returns and Annualized Returns and compensates for the distributions, etc…
I use the Bogleheads Total Returns Spreadsheet for the rest of my portfolio, but I’m looking for something that would give Fund level results.
Thanks!
I use the same XIRR spreadsheet I use for my mutual funds. You know about XIRR right?
https://www.whitecoatinvestor.com/how-to-calculate-your-return-the-excel-xirr-function/
Yes, but I was thinking something that also included annualized returns based on the dates, etc…
I don’t have anything already set up, but what you’re asking for could be set up in Excel.