[Editor's Note: This is a guest post by Phil Ayres, the Chief Technology Officer for REPSE, a real estate platform not dissimilar from blog sponsor Realty Mogul. This site “helps investors understand their preferences for real estate investment opportunities and match them with project sponsors and developers who have private investment opportunities corresponding to their criteria.” While I certainly consider private investments an optional part of your portfolio, there is no doubt that real estate has a long track record of solid returns, and investing in it in a syndicated manner eliminates most of the downsides of REITs and the downsides of landlording directly, although at a cost. It is often difficult to learn about private investments, so I hope to provide some insight into how to learn about them by including posts like this. In this post, Phil makes the case for private real estate deals such as those available on REPSE. We have no financial relationship at this time.]
A financially successful medical professional ranks highly as a target for wealth managers, and for good reason. You appeared on their radar by having assets that need managing more actively than the free time your profession allows. After a while though, a bunch of mutual funds and ETFs with a major brokerage does not feel like an active or exclusive way to grow your wealth. This is the point when professionals who would consider themselves experienced investors start to see the attractiveness in real estate investing. [Editor's Note: Introductory paragraphs are notoriously tough to write, but successful investing isn't about your emotions, feeling “exclusive,” or necessarily “being active.” The attraction of branching out into private real estate investments should be solid returns and diversification for the portfolio in my view.]
Rather than buying and leasing properties, there is another more hands-off approach. Investing in the equity of companies that run real estate projects carries many of the benefits of owning income generating properties, without the need to collect rents and fix toilets. This form of investment in real estate projects, often termed equity or passive investing, more closely fits the time pressures of your profession.
Is being “alternative” bad?
Passive real estate investment is pushed into the category of alternative investments by most investment advisors. If it doesn't fall into the traditional asset classes of stocks, bonds, and cash, then it is “alternative”. This may be fine when viewed through the same lens as private equity, commodities, hedge funds and financial derivatives, but alternatives can also include collectibles such as rare wines, artworks and vintage cars. [There is no doubt that most asset managers working for an AUM fee will recommend against this type of investment due to lack of familiarity and a financial conflict of interest- they make less money if you invest in something they aren't managing.-ed]
For successful professionals, who are experienced, accredited investors there are some major appeals to looking at mainstream alternatives such as investment in real estate projects. Escaping the clutches of Wall Street for every penny you own may be one. Gaining a few more back from the IRS for certain real estate tax advantages may be another. But a wealth manager tied to a major brokerage is unlikely to ever suggest moving funds they have under management to these alternative investments. So it is worthwhile understanding yourself what the motivations are for alternative investment opportunities.
Diversify within diversification
A major investment aim for alternatives like real estate is that they have a low correlation with the regular stock market. Stocks, bonds and foreign exchange can circle around mass investor sentiment, politics and central bank policies. Real estate on the other hand is tied closely to more local trends and needs.
With real estate, investors are able to more broadly spread risk through diversification. Real estate has a whole set of asset types, classes and risk profiles all of its own. For example, an investor can make multiple investments across multi-family, office and retail properties, in several geographic locations across the country, with a mix of new construction, rehab and income generating rental properties. With such a mix, real estate investments can help to smooth out much of the traditional market volatility from the stock market.
Deal by deal
A common reason for experienced investors to allocate capital to alternative investments is in the hope of earning higher returns than a mix of stocks, bonds and mutual funds. With this potential for higher return of course comes risk.
Every deal is different with alternative investments and private placements, so significant investment analysis and due diligence on individual opportunities is the only way to mitigate some of this risk. You don't get the benefit of an investment advisor's team of analysts when looking at this space. But you can take a bet that if a bank is willing to give a real estate project a commercial loan at a good rate, somebody with experience has assessed the project to have a reasonably low risk of utter failure. [Massive bank failures, bank bailouts, and real estate foreclosures in 2008 provides a good counterpoint to this argument.-ed]
Unlike more obscure alternatives that require a true passion for the asset being acquired, real estate has the advantage of being easier to assess current market value and potential to earn income. Although by no means perfect, comparable properties in the local area provide a strong guide to the worth of a property. Coupled with existing income and conservative projections for the future, potential investment returns can be examined, dissected and understood.
Nobody can guess where a real estate market might go in the future, but local market forces can be easier to divine than the global sentiment that drags Wall Street along for the ride. With research, speculation and no small amount of luck, returns can be greater than you might achieve with even a risky ETF suggested by an investment advisor.
Passive, but not ignorant
Investment in real estate projects is only passive from the point of view that an investor owns a share of a company, rather than directly owning the real property and participating in management and construction responsibilities. The passive part is about providing experienced project sponsors the capital required, so they can get on and do the jobs they do best, whether that is working with a general contractor, collecting rents or fixing bathrooms.
A good developer will keep investors apprised of the progress of the project, milestones and financials. This helps you remain attached to the investment over the years. Sometimes, the investors in a project may be asked to make decisions about changing management structure, taking on more debt, or exiting the investment early. On top of the initial research effort into an investment opportunity, this interaction provides investors a feeling of ownership that just doesn't come from owning a few millionths of a Google or an Apple.
Less regulation, more lawyers
Alternative investments offered privately to high net worth accredited investors gain some efficiency from having a lower regulatory burden than public companies. And with this lighter regulation comes some risk for investors too. Essentially, any real estate project needs to explicitly offer transparency in terms of feedback, financial reports and updates given to investors where the regulators do not necessarily demand them.
Without the comfort of an investment advisor's analysts, investors need to look out for themselves when examining any deal. A private real estate investment offering is really just a glorified legal agreement wrapped up with certain securities regulators' requirements. Like any serious contract, getting a lawyer involved is essential.
Private investments like these rely not just on legal and financial analysis, but on trust in the sponsor of a real estate project and the ethics that they display. These must play a role where regulators and independent auditors do not. Getting to know who you are investing in becomes an important part of your due diligence.
Is it for you?
Are you comfortable committing time to research projects, and risking some capital to an alternative investment that your investment advisor may not be able to discuss? Are you able to have money tied into a project for years? Do you like the idea of taking a risk for the potential of a greater reward than you might get from your regular investments? Answering negatively to any of these questions may well rule you out.
A serious understanding of the types of real estate projects and how to participate in them can help if you are interested in this type of alternative investment. Learn more about investing in real estate here.
WCI’s No Hype Real Estate Investing is the best real estate course on the planet and the best way to get started in this exciting (and profitable) asset class. 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!
Do you already own investment real estate properties? Have you invested in private real estate projects? How do they compare? What would persuade you to add real estate equity investments to your portfolio? Comment below!
As the author of this post I have to thank the editor for his thoughtful notes and comments on this article. One of the essential things he highlights that we should all be constantly aware of is the importance of separating emotion from logic and analysis when investing.
Of course, we’ve all seen the studies how ego trumps rationality in making investment decisions. Look at real estate investment from the point of view “solid returns and diversification” over “love to say I own a skyscraper in Manhattan or a hotel in Vegas” for an extreme example of this. Bragging rights don’t last into retirement.
Let’s assume that we’ve all learned a lesson from 2008. Wall Street, banks, mortgages on rental properties and your mattress are all risky places to keep your cash. Emotion still drives an individual’s risk tolerance. And any investor must be comfortable with what their risk tolerance allows and whether a class of investments is right for them. We can’t avoid it, so it a great idea to recognize our human-ness and check our motives for any major investment decision.
For those who are interested in private real estate investments, you might want to see a couple of reports. The first is from JP Morgan. They argue that perhaps real estate is not an alternative investment anymore.
https://am.jpmorgan.com/blobcontent/131/169/1383169203231_11_559.pdf
http://nesteggrx.com/evidence-based-investing
The second is a deeper dive into the subject of commercial multifamily real estate investing.
Dennis, that first link is a good one. The big firms’ analysts write a good yarn, but the portfolio I trust to my investment advisor hasn’t caught up with this story yet. Saying that though, I’ve personally stayed away from fee-heavy REITs and real estate private equity funds.
Thank you Phil. The paper makes a strong arguement for direct ownership in real estate as a portion of people’s portfolio. It can provide better yield than bonds while still providing equity growth like stocks (at a lower risk-profile). Also at $6.5 trillion, the real estate market in this country represents a large investable universe.
Personally, I think public REITs can also be a good investment for certain individuals and I don’t have a problem with them. I agree that for those who like REIT investing, low fee options are the way to go.
What a lot of people don’t understand about REITs, however, is that they are paper assets like stock. They are highly correlated to the stock market, unlike direct ownership of real estate, and they are also highly volatile. Therefore, those individuals who are looking to add diversification to their portfolio, or decrease their volatility, or enhance their tax-benefits are not getting that with REITs.
For example, page 15 of the second link shows the twenty worst quarters for a 60% stock / 40% bond portfolio between 1978 to 2012. Of those twenty quarters, when paper assets were down significantly, direct real estate was up 17 of the 20. Now that is real diversification.
What do you think about vanguard REIT? And should it only be held in tax deferred vehicle like Roth IRA?
I like it. I own it. I hold it in a Roth IRA. I would do all I could to avoid holding it in a taxable account. Lots better things to put there.
Scott, this wiki cleared it all up for me, the info-graphic about 1/3 of way down is explained in detail.
http://www.bogleheads.org/wiki/Principles_of_tax-efficient_fund_placement
I am disappointed by this article, it fits into the category of sales pitch: we can do these amazing things if you go with us.
I think readers of the blog have a second level knowledge than the superficial overview provided.
A post similar to the insurance sales peoples’ DI posts should be written. Let us know what happens when we sign the contract with a firm such as Phil’s: what type of lawyer is needed (Real estate?), where does initial and additional funding get allocated, what type of communication occurs between company and individual, how does individual select the direction of funds.
How long does individual money get tied up, can it be re-allocated, etc, how are returns (or losses) realized
Then in the future we could get a post on the tax benefits and risks.
I did not learn anything from this post except “you can invest in a real estate management company and get some diversification”
Thank you for the valuable feedback. Obviously financial professionals have a dual purpose in submitting posts like this. I don’t pay them for them. They usually have some desire to educate but also hope to pick up investors and/or clients. It’s no different with the insurance agents who submit posts. It’s my job to make sure it is very heavy on the education, and very light on the sales pitches. But it’s a tough line to walk sometimes. I have some similar stuff coming up (not on real estate) and hopefully will do a better job screening and editing selected guest posts. Believe it or not, I turn down 9 out of 10 of these.
I don’t fault you or Phil. If a technical post on the tax code as it relates to real estate investment through an LLC for a retired person showed up, I’d probably flat out skip it.
The 5-post series in the past on real estate investing was, for me, a bit too much.
I would look forward to future and occasional highlights, tutorials, or walk-throughs for companies such as this, even if it is by company reps. Johnathan from MyMoneyBlog and the FinanceBuff are great at this, showing the reader how the process plays (like Lending Tree for instance)
My hesitancy toward contacting a company out-right for future education stems from the past experience we all have when we learned about life insurance. The majority of us learned about life insurance from the salesman, and we had the hammer-nail education. It took extra research and internet discussion to realize that whole life has downfalls never discussed with us.
So, more education on the topic would be great, and having it in the open for other real estate professionals and physician interaction benefits those who are learning for the first time.
Nate, I’m sorry to hear that the article came across as a sales pitch. As you can see from the editor’s comments regarding this website’s sponsors, investment in real estate as a passive investment is a popular area at the moment. From investors I have spoken to, not many are that familiar with investing in equity for this class of assets, so I started at that level.
As you have stated, there are many differences in taking this approach to investment when compared to direct acquisition and management of real estate. I would love the opportunity to fill in the specific gaps you have mentioned in a future article (although would caution the thoughts may be specific to what we do, so the editor may instantly tell me “no”, as this is an area where regulations are particularly tricky and everything is customized to fit).
So I don’t appear to be dodging your questions, and maybe I can add some deeper value to this post, I’ll step through your points:
* contracts: you are typically signing up to acquire interests in an LLC, and as such will need a lawyer who can evaluate company Operating Agreements and Subscription Agreements
* funding allocation: this, like many aspects are dependent on the project. Every project is different, since construction of senior care facilities are hugely different projects from operating existing high rise apartment complexes, in both style, use and income.
* communication: the communication between (developer) company and investor varies depending on whether you are working with a broker dealer introducing you to private deals, an intermediary consultant, a crowdfunding platform, or some other real estate investment platform or fund. Communication before investments will vary. And transparency of project performance (regular reporting) will also vary. Its important to check the details to see what you are entitled to in this regard.
* direction of funds: again, this is down to the specific operating agreement that you sign up to when buying your ‘shares’. In many cases your capital investment will be used as the sponsor sees fit and will typically facilitate getting a better loan through the equity providing a lower LTV.
* how long is money tied up: completely dependent on the project. 12 months is typically minimum. 7 years or more is not uncommon for income generating investments (for stabilized properties with steady rental income for example). These are private investments covered by SEC regulations, so you can not assume there is an exit for any investment, and current secondary markets for these investments are not highly liquid so you may lose out badly. Often operating agreements will include right of first refusal for other investors to take over your share at current market value. They are not obligated to do so.
* reallocation, returns, losses, distributions, etc are all again controlled by the operating agreement of the company (or the fund investment vehicle that insulates your from the underlying company). Again, if you’re not familiar with these types of agreements, a lawyer who is will be essential.
I hope that my comments give you some more insight into this area. You are welcome to contact me directly if you have specific questions you would like me to address:
[email protected]
Phil, thanks for answering those points.
I hope that more posts in the future will help walk readers through some of the in’s and out’s that would be allowed per regulations and blog policy; whether specific to your company or in the general/typical sense. I am eager for an expansion of your reply in a future post.
Nate, I’m pleased my additional comments helped a little. With so much interest in this area, I hope that everybody in this industry can write objectively without too much a skew to what makes their company great! As the real estate equity investment space grows, I’m sure we’ll all learn to weed out the educational content from the rest.
Would it be remotely accurate to compare this group of investment to either venture capitalism or peer to peer lending such as Lending Club?
Mo, the answer is yes and no.
“Yes”: VCs are investing in the equity of companies just like we are discussing here, and there are real estate investment companies out there that use the term VC to describe themselves. Angel investor groups (basically groups of private investors) are another good analogy. That said, I feel that the skill-set of VCs is different – they are often looking at a company that has a track record and a product. Many real estate projects have only the developer’s experience to go by, since there is just a chunk of raw land to look at. Venture Capital has special connotations in securities regulations as well, which I’d need my lawyer to remind me about. But it does allow them certain waivers to the way they operate.
The “no” part is for Lending Club. P2P investors can lend on real estate projects (basically, provide loans to LLCs that own real estate and operate or develop it). The challenge is that since they are offering something classified as “debt” (a loan, paying interest), developers probably can’t use it to secure a better mortgage. That is a primary reason for real estate developers needing equity investors.
In reality there is very little about this class of investment that is new. Real estate developers have for years had to rely on equity investors (traditionally in joint ventures as limited partnerships) to fill the gap between the cash they have available and the 20-30% a decent loan required them to put down. What has changed is the level of organization around it, and the technology that can help to keep costs down as the number of investors rises.
While all are “private” they’re also all quite different.
What is the typical (median or average) minimum amount of capital invested? What return do most investors expect? I understand there is a wide range to both of these questions depending on the specific opportunity, but I would be interested in hearing ballpark numbers.
The minimum amount invested depends on the SEC regulations and the amount of capital to be raised. For smaller amounts to be raised (typically less than a million), you’ll see the crowdfunding sites offer a minimum of $5,000 per investor (though they are hoping for a larger amount from some investors).
Projects requiring more capital start to hit the restriction of the number of investors who can participate in a deal under the regs. So more significant deals often have a lower baseline. $50,000 is not unusual for private deals where a developer is placing it his / herself.
Returns vary more by the perceived risk, style of project and more. Crowdfunding sites seem to go from 11% annual returns for lower risk projects up to about 18%. Traditional private placements done directly with developers may end up near mid-twenties percentage returns, since the developers want the returns to be appealing to investors. But beware, this is not like an interest rate. A bulk of the returns can come at the end of the 2-7 year project, based on appreciation and project success. So returns may be better or worse than originally projected. And any cash flow through the project may be minimal.
Two terms to look up on Wikipedia: IRR and Cash on Cash.
I hope that helps.
I had an opportunity recently presented to me for a 6-7% return. I took a pass. So did everyone else as the offering then went away!
For those who are eligible TIAA CREF offers a real estate fund. Here is a discussion from 2007 on the Boglehead board on how it differs from the Vanguard REIT.
http://www.bogleheads.org/forum/viewtopic.php?t=251 Not a TIAA CREF rep.
WCI – What would you classify the rent received from a rental, or do you even include it in your asset allocations? I purchased my office building during the recession and it’s been a great return on investment, but I’ve never included it in my asset allocation. I use the Vanguard REIT fund for that and it’s only 5%. Is it possible that I am to heavily invested in real estate then?
I feel like this article may be one of those things fro those with more time on their hand than I have. I have a few friends that build residential communities and they are always optimistic, and they do well, but never as well as they seem to be projecting. I remember you saying in a few of your posts that because doctors make 200+ “we’ve made it!” Now it’s just slow and steady, no need for double digit returns every year.
I think I’ll stick with my 7-9% returns by doing . . . well nothing but re-balancing once a year!
I don’t use rent for the asset allocation. I would use the value or the property or at least the equity in the property.
While I suppose its possible you’re too heavy into real estate, you don’t mention how much of your portfolio is in equity in your office building. If your portfolio is $200K ($10K REIT) and you have $800K in equity in the building, then yes, I think you’re too heavy into real estate (not to mention terribly undiversified.)
I agree that these types of investments are completely optional and that a doctor who saves a reasonable percentage of his income and invests it in any reasonable manner is going to do just fine.
Definitely agree on the rent. It was one of those mistakes that you can’t take back after hitting the post button… like my spelling sometimes. I did mean the property value, not the annual income, or “dividend,” from it.
I’ll take it into account on the next re-balance. It would actually be nice to reduce some of the REIT fund I have, simply because I don’t have enough room in my tax advantaged accounts for everything.
The more I think about this, the more I’m debating with myself whether it is best to use the property value or the equity for an asset allocation. I think the equity is probably better.
Once again I agree, but in this case they are one and the same.
Of course, in a paid-off property they are the same.
As above , have been confused about real estate in asset allocation.This is for real estate not held in REITS , but actual physical ownership.
If we use equity/property price — are we not placing emphasis on appreciation? In the mean time what about the negative cash flow draining your net worth?Does one include in expenses , other expenses besides PITI(vacancy, maintenance, management etc) Also unless one is highly appreciating market like parts of California – whether appreciation adds to net worth after inflation/expenses is quite debatable.
I find the benefit of real estate is in cash flowing asset. Other perceived benefits like appreciation, tax benefits (unless real estate professional tax status) are of debatable use.
But that still leaves the question of how to assess real estate in ones portfolio.
All of that stuff obviously goes into your returns. Returns are easily calculated including cash flows, whether that cash flow is used to pay extra on the loan (increasing the equity value) or taken like a mutual fund dividend and spent on something else. If you have to put money into it (like a new roof, mortgage payments etc) that’s a negative cash flow. XIRR can handle all that.
Appreciation and tax benefits aren’t debatable. They’re very real aspects of your return.