By Dr. James M. Dahle, WCI Founder
Those who have been in The White Coat Investor community for years know I spend a lot of time and effort trying to get people into a position where they can really get started investing. We help them crush their student loans, buy and pay for their dream houses, write a financial plan, put appropriate insurance in place, understand their retirement accounts, and mostly help them get their lifestyle under control enough that they can carve out a big chunk of their income to use to build wealth by paying off debt and investing.
You also know that my investments are relatively simple. I invest in stock, bond, and REIT index funds, real estate, and small businesses/websites that I have significant knowledge about and influence over, primarily Passive Income MD and The Physician on FIRE. You can only talk about index funds for so long (although as Rick Ferri says, “The truth about index investing must be told over and over again because lies are constantly being told about it.”) My index fund portfolio rarely sees any sort of changes, of course. And I generally leave PIMD and PoF to tell their own stories. So which of my investments does that leave me to write about? Pretty much real estate.
Over the years, I've invested across the entire spectrum of real estate investments, from owning and managing an individual property and its tenant to buying and holding a REIT index fund. This has included investments with half a dozen crowdfunding sites, some individual syndicated investments bought directly from the syndicator and private real estate funds. Over time, I've gravitated more and more toward the real estate funds.
The Case for Private Real Estate Funds
Why have I moved toward private funds? There are several reasons, really.
The first is that I want my investments to be very passive. I want to be able to ignore them for months or even years at a time and still be assured that someone is watching the shop and making sure I get good returns. And I certainly don't want to get toilet back-up calls or screen tenants myself. Maybe you do, and that's certainly a legitimate way to invest, but I don't.
The second is that I want my investments to be diversified. Diversification protects you from what you don't know. When you buy part of a syndicated property, even if you do it with hundreds of others through a crowdfunding site, you're only buying one property. When you buy a fund, you are generally buying 10-20 properties. If one or two of them stink, you'll likely still come out fine. Maybe it is my background with ridiculously diversified index funds, but I'm a big fan of not putting all my eggs in one basket.
The third is that I don't have any particular talent at evaluating and selecting real estate investments. When you look at crowdfunded investments, or even a syndicated deal offered directly by a sponsor, I can read hundreds of pages of memorandum, go walk the property, and participate in the pre-offering webinar. But I'm not going to kid myself and pretend I know better than the next guy which property is good and which isn't. Now if you want to talk about physician financial websites, I'm your guy. But real estate? Not so much. So the idea of having someone who actually does know how to do this choosing the investments is appealing.
The fourth is the argument that both private funds and big syndicators themselves make — the crowdfunding sites only get the bottom of the barrel deals (which is pretty amazing considering they're reportedly turning down 90% of what they're brought.) If these sponsors had a better way to raise funds, they would. If they had a really great deal (and especially if they could repeatedly find really great deals), they wouldn't have any trouble raising funds. Funds and direct syndicators also cite the significant additional layer of fees that come from the crowdfunding site, which of course, has to come out of your return. If you can go to one investor and get $2 Million, why are you going to mess around with a crowdfunder to get $2-5K at a time? You're not.
The fifth is that returns for many of these funds have been excellent. At a time when many smart people are talking about 4-6% real returns on equities for the next decade (and that's not even the perma-bears) seeing funds showing audited (nominal) returns of 10-25% become pretty intriguing. Yes, there are higher fees than you'll see in an index fund. Yes, there are serious liquidity issues. Yes, it'll be years before you'll know if these managers can do it again. Yes, you have to be an accredited investor. But geez, for the opportunity to double my money in 5 years instead of 10-15? I'm willing to run some of those risks with part of my portfolio.
Now there are real estate deals of all different sizes, from a $100K townhome to the Mall of America. There are huge REITs and funds that really can only look at the biggest deals due to their size. Consider one of the biggest REITs in the Vanguard REIT index fund, Simon Property Group, Inc. They have 5000 employees. They own 325 properties and are worth >$50 Billion. That's an average of $154M per property. Those are huge properties. They're not buying $100K townhomes. They're not even buying $10M apartment complexes. If you're just buying the REIT index fund, you're not getting access to those other areas of the market. Perhaps the fact that an individual investor can't afford those properties, and the “big boys” aren't interested in them because they simply need bigger deals, leaves space for solid returns to be made in the middle. Now the individual sponsors/syndicators are in this space, getting 100 doctor types together in order to buy a big apartment complex, but then you only get one property instead of a dozen.
The Problem for the High Income Professional
“That sounds great!” you say. “I'd love to make 15%+ and maintain some diversification. I'll just buy 3-5 of these funds to make up 20% of my portfolio.” So you take your $500K portfolio and the $50-100K you save each year for retirement and you go looking for funds. Uh oh, there's an issue you run into right away. These funds all have minimums of at least $50K, usually $100-250K, and sometimes $1M+. If you only want $100K in real estate total, and you want to spread that over a few funds, and those funds all require $200K minimums, well, you're just not going to be able to invest in these funds. Even though you're accredited and you know about them, you're just simply out of luck. To make matters worse, the $100K investors in those funds aren't really ideal for the managers. They really want the folks with $1-5M. Their fund is only $50-300M total and they'd prefer to only deal with 100 investors rather than 10,000. So they often offer better terms to those investors that bring more money, like $1M a piece. Now if you want 4 different funds and you only want 20% of your portfolio in those four funds, you're going to need a $20M portfolio. We've just priced out almost all the readers of this site.
Dealing with the ‘High Minimums' Dilemma
This is why I ended up working with the crowdfunding sites, as an investor and a media company. I could get into a syndication for $2K, $5K, $10K, maybe $20K. As a doctor with a halfway decent savings rate, I could afford to max out my retirement accounts and still meet those minimums in my taxable account and still be diversified. However, I recognized that these probably weren't the best real estate deals out there for investors. Luckily for me, I started making a lot more than the average doc and since we kept living like a doctor, that has freed up lots of capital for us to invest. That allowed us to meet the $75-100K minimums for some of these funds. Unfortunately, that is not the case for most of my readers.
This is the issue that Alan Donenfeld, CEO of CityVest, is trying to solve. His brother, an anesthesiologist, asked him what he should invest in. Alan told him to invest in these mid-range private real estate funds. But his brother came back saying he couldn't afford any of the minimums. So Alan figured out a way for his brother (and others like him) to have lower minimums. CityVest bridges the gap between these funds and accredited investors like you that will never have an estate tax problem.
Unlike most crowdfunding sites, they're not dealing with specific properties and their sponsors. They're only dealing with funds. So they go to a fund that requires a minimum of $100K and prefers $1M+ from an investor and say, “We'll bring you capital to invest.” Then they go to investors and form an “access fund” that might raise $5M to invest in the real estate fund. They let the investors into the fund for $25K, but then provide those investors with the preferred deal from the real estate fund, taking their cut out of the difference between the regular deal and the preferred deal. It's really pretty ingenious and a major service for those of us at this level of assets.
You also get the benefit of their screening of funds. There are 600+ funds like this. Alan tells me the initial screen is a prior fund with an IRR of at least 20%. That screens out 90% of funds right there. From there, he applies some additional criteria until he is satisfied that the likelihood of continued success is high.
Where The White Coat Investor, LLC Comes In
So as I've moved my own real estate portfolio from crowdfunding companies toward funds, I've tried to also reposition the WCI advertising relationships. Rather than write about companies I'm not investing with (and who can blame my readers for not wanting to invest in anything I'm not investing in) and not making any money, over the last year I've been trying to go to the funds I actually invest with and get them to buy ads from WCI or set up an affiliate marketing relationship with WCI. It really becomes a win-win-win for everyone when I can work out one of these deals. It's kind of like refinancing student loans for my readers. The reader wins with a lower interest rate, a bonus payment, and much better customer service. I win with an affiliate payment. The refinancing company wins with more business. Even the taxpayer wins by getting their money back so it can be lent out to the next med student. Unfortunately, I've had limited success so far with these real estate funds. While it would be a win-win-win (the fund gets capital, WCI makes money, my readers get a great investment), there is still the minimum investment issue. These funds just aren't interested in raising money $10K at a time.
Partnering Up with CityVest
So Alan Donenfeld and I put our heads together a while ago to try to come up with a win-win-win-win deal. Unfortunately, the call came while I was out mountain biking on a snowy trail at dusk in late November in the Wasatch mountains. While we worked out the deal, my toes were trying to fall off. But once I got home in a hot shower (and they quit hurting,) I was glad I had spent the time to do it.
Let's look at a specific deal to understand how we all get to win.
PathFinder Access Fund
First, just a reminder that like most of these types of investments, this is only available to accredited investors. That means the investment has a lot less oversight and regulation than a mutual fund. The idea behind accreditation is that you have so much money or make so much money that you can afford to lose your entire investment without ruining your retirement. The assumption, which obviously may not be true, is that because you're rich you must be smart enough to evaluate this investment yourself. Most of my readers either already (or soon will) qualify as accredited investors by having either $1M+ in investable assets or $200K+ in annual income. Okay, let's get into the deal.
How Pathfinder Wins
Pathfinder is a private fund manager. Every year or two they start a new fund, gather money from investors, buy up a dozen properties, manage them for 5 years or so, collect their fees, send some distributions to the investors, and then sell the properties and close the funds, take their fees, and return the capital (hopefully with significant gains) back to the investors. They're now raising money for their 7th fund. Their track record for the prior funds looks like this:
Yes, they've only gone full cycle with a fund once, and it was a pretty small fund. But they've been doing pretty well with three other funds. This isn't their first time doing this. You can actually break it down by the actual investments in the funds (and CityVest does that for you on their site.)
Clearly, this isn't their first rodeo. The Pathfinder guys know how to run a fund. They also know how to choose properties that make money. Of the 72 properties they've gone full circle with, they've only lost money on two and the weighted internal rate of return is 20% per year. I asked Alan about those two losses to see if he had specifics. He did not, but noted that the way that a 100% loss occurs (see NCC Student Housing) is when something materially changes with a leveraged investment. It isn't that the property value goes to zero, but that equity is wiped out by something like a large unexpected capital expense or inability to raise rents as expected. He feels that only losing money on 2 out of 72 investments is a pretty awesome record.
Here are the original terms:
So how does Pathfinder win? Well, they're obviously continuing to raise money for their real estate funds. If you invest, they get more money to invest and charge fees on. In Pathfinder VII, they charge 1.5% per year and after an 8% preferred return to investors, they get 20% of what it makes above and beyond that. (They actually get a little more than that thanks to the catch-up provision you see above.) Their problem is they need more money. Working with CityVest brings them more money and solves their problem.
How CityVest Wins
CityVest is forming their own fund (an LLC) that then invests in Pathfinder 7. They charge the fund a $50K annual administrative fee (yes, I know it says $75K above, the site should be updated by the time this runs and will likely be reduced to $25K) and a one-time $75K organization expense fee (which may also be reduced). Then they charge an annual 0.75% fee (which has been waived for this investment.) The goal is to raise $10M for this access fund, and if they manage to do that, the $75K would be a one-time 0.75% fee and the $50K + 0.75% would be an annual 1.25% fee. It sounds like the raise will be significantly less than that, however.
Yes, there is an additional layer of fees there you would pay for going through CityVest, but as you will see below, those fees are significantly offset and in fact, since the tech and organization fees are flat, they are reduced proportionately the more people/dollars get into the fund.
CityVest's problem is that they don't have 280,000 accredited and soon to be accredited investors coming to their website every month. Working with The White Coat Investor solves their problem.
How The White Coat Investor Wins
Just like CityVest, I don't work for free either. I get paid a commission by CityVest for each investor that invests with them. This is a typical affiliate deal and the way that many bloggers (including me) make money. I get paid for making the connection between the people with money (you) and the people that need money (CityVest/Pathfinder).
This isn't my first rodeo either. I've learned through sad experience that if there is no incentive to go through my links that readers will simply go directly to CityVest and cut me out of the deal. So in order to do an affiliate deal, I demand that my readers get something special by going through my links. Not only does that ensure they go through my links (good for me), but it also allows me to tell my readers that I've negotiated a special deal on their behalf (which is true) that they can't get by going directly to CityVest (good for them.) In some ways, I suppose I'm splitting what I could be paid with my readers, but it's not like that's a bad thing, right?
I win because if I can get even a tiny percentage of the 280K people who come by the site, take my email newsletters, follow me on social media, or listen to the podcast to invest $25K with Pathfinder through CityVest, then a little bit of money for each one can add up to significant revenue for the site. Some of that I can use to create jobs, some I can use to support The White Coat Investor Scholarship, some I can give away to my favorite charities, some I can spend, and the rest I can invest myself.
If I'm investing in the fund as well, I also win by bringing more people and more money into the fund, lowering my share of the fixed fees.
How You Win
#1 (Hopefully) Outstanding Investment Returns
Yes, you'll be paying Pathfinder significant fees. Yes, those fees are more than the 0.12% you would pay as an expense ratio for The Vanguard REIT Index Fund. But guess what? You keep everything after that. The fund is projecting 12-14% returns. If future performance is like past performance (and obviously there is no guarantee), that could be more like 18% per year, doubling your money in less than four years. But even if the performance is half that, that's probably going to be similar to the returns you get from the equity portion of your portfolio. That's the main win for you. However, there are some more wins.
#2 You Get a $25K Minimum Investment
Want to cut The White Coat Investor and CityVest out of the deal? Fine. Go straight to Pathfinder. You'll need $100K.
#3 Reduced Pathfinder Fees
But wait, there's more. By going through WCI and CityVest, you are no longer treated by Pathfinder as a “small fry” with a mere $100K to invest. You are treated like a big investor with $1M+. Instead of an 8% preferred return, you now get a 9% preferred return before you start splitting the return with Pathfinder. That extra return doesn't quite make up for the additional CityVest fees, but it does help reduce them.
#4 Reduced CityVest Fees
Want to cut The White Coat Investor out and go straight to CityVest? You can do that. But if you go through my link, not only do you support the mission of The White Coat Investor (nobody actually pays me to talk you into becoming financially literate and saving 20%+ of your income, I have to make money doing other things) but you also get out of the 0.75% CityVest management fee for the lifetime of the Pathfinder Access Fund. Did you get that? CityVest is giving you a lower minimum investment and a higher preferred return and the only fees being charged to you are your share of the management and organization fee.
Now, why would CityVest offer that? Well, they are still making money on the fund through the one-time organization fee and the annual management fee. They are also building their business. But mostly, they're not in it for a single fund or deal. They're hoping you're going to keep investing with them over the years. Just like I want a long-term relationship with CityVest (i.e. a long, stable revenue stream for WCI) they want a long-term relationship with you.
If you add up all the likely fees and discounts and the amount the access fund is likely to raise, I calculate that what you're paying to have the lower minimum investment will be something like 2% per year. You don't want to give that up? Go directly to Pathfinder with $100K.
Now down the road the deal for going through WCI links probably isn't going to be quite as good as this initial one (it'll be one year of waived management fees, not waived fees for the entire lifetime of the investment) but that's still pretty nice when added to the higher preferred return and the lower minimum (the main purpose for the existence of CityVest.) We'll take a look at those deals as they come up in the new year.
The “waterfall” (who makes what in various scenarios) can sometimes be a little complicated. Let's run through a few scenarios so you can see how it works out.
Scenario # 1 – The Investment Loses Money
- Pathfinder gets its fees.
- CityVest gets its fees.
- Everything else goes to the investors.
Scenario # 2 – The Investment Makes 0-9% Per Year
- Pathfinder gets its fees
- Cityvest gets its fees
- Investing get all their capital back
- Everything else goes to the investors
Scenario # 3 – The Investment Makes 9-15% Per Year
- Pathfinder gets its fees
- Cityvest gets its fees
- Investors get all their capital back
- Investors get 9% per year (the preferred return)
- Investors and Pathfinder split additional return 50/50 (this is the catch-up) At 11%, investors make 10%, Pathfinder makes 1%. At 15%, investors make 12%, Pathfinder makes 3%.
Scenario # 4 – The Investment Makes > 15%
- Pathfinder gets its fees
- Cityvest gets its fees
- Investors get all their capital back
- Investors get 9% per year
- Investors and Pathfinder split next 6% 50/50
- Investors and Pathfinder split everything else 80/20
The idea behind the structure is to incentivize excellent performance. However, the usual warnings about investing expenses apply. Pathfinder makes money no matter how badly the investment does. Every bit of return that goes to the manager cannot go to the investor. The less they charge, the more of the return you get to keep. However, this sort of structure exists in pretty much all of these deals, although sometimes it is slightly better than other times. This is the price you pay to play. The game is optional, but this is the price of entry.
Now don't be stupid. $25K is less than 1% of my portfolio, but it might be a significant portion of yours. Don't invest more than 5% of your portfolio into this fund. Diversification still matters. And this investment isn't going to be liquid. Don't plan on seeing your money for a half decade or more. Think of the high investment return partly as being compensation for being willing to give up liquidity.
If you don't want to play, that's okay. You can watch from the sidelines. There will be more funds, more crowdfunding companies, and more real estate deals out there in the future. There are no called strikes in investing. If this deal (or its timing) isn't right for you, then let this pitch go right on by and maybe we'll catch you on the next one. But this pitch won't last forever, the fund is expected to close by the end of the year.
Like any structure or business, CityVest isn't perfect. Perhaps the biggest criticism leveled at CityVest is simply that if CityVest doesn't raise enough money, the flat fees can add up to a large enough percentage to really take a bite out of the returns. For example, on a $10M investment, a $75K/year flat annual fee is 0.75%. But on a $1M investment, it's 7.5%, possibly half the return. In addition, there is the issue that all the investors want to wait until they see how much is going to be in the fund before committing their dollars.
I asked Donenfeld about these two issues. CityVest is about a year old and has done three access funds so far (in addition to the three on the site now) for a total of about $5 Million. He's raised $750k for the Pathfinder fund so far (as of a week ago) and expects it to close at the end of the year with perhaps $1.5 Million. He repeatedly told me he didn't want to gouge the investors, and so with the Pathfinder Access Fund has not only waived the 0.75% annual fee for the life of the investment, but also lowered the flat fees. He expects less difficulty raising more with funds moving forward as there will be months instead of weeks to do it, so I'm excited to see what the new year will bring. I expect that with the Pathfinder Access Fund the fees will add up to around 2% a year to CityVest (plus the 1.5% + a share of profits over 9% to Pathfinder). That's a little more than I'm comfortable with (even if dramatically less than many crowdfunders), but I also have enough that I could go straight to Pathfinder with $100K and save those fees. Remember that the expense ratio (ER) on the Vanguard REIT Index Fund is not directly comparable to these fees because the business expenses of the REITs in the fund aren't included in the ER. Getting access to this type of investment at this minimum may very well be worth paying 2% in fees to you.
Donenfeld summed up the benefits of investing in Pathfinder right now as follows:
- Stellar Historical Performance
- 20% Annual IRR (after fees) – Over 6 Previous Funds and $500 million invested
- 9% Preferred Return – Targeted 12% to 14% IRR
- Low Minimum Investment of $25,000
- Investment Prior to Year End will Receive Attractive 2018 Depreciation Benefits
- New CityVest Investors Pay No Investment Management Fees for the Life of the Pathfinder Investment
What do you think? Do you invest in private real estate funds? Why or why not? What do you think of this opportunity to invest in Pathfinder? Will you be investing? Why or why not? What do you think about going through a firm like CityVest to get access at lower minimums? Comment below!
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