[Editor's Note: This guest post is from Dennis Bethel, MD, an emergency doc who runs a real estate website and a real estate business involving fractional investing in commercial real estate such as multi-family housing. He recently contacted me regarding advertising on the site and I told him that I (and many of my readers who have asked me questions about him after his initial guest post) still don't understand exactly how to go about getting into fractional real estate investing. So I asked him to submit a guest post about it. This is that post. At the time of writing, we have no financial relationship, although it's likely he'll be an advertiser on the blog shortly.]
Like most people who invest in real estate, I started in the residential space. Residential real estate consists of single family homes, duplexes, triplexes, and quads. Most of us start with residential real estate due to the relatively low cost of entry. Lenders require 25% down on a property and as a physician I was able to buy one or two properties a year.
Unfortunately, residential real estate runs on very thin margins. I was always one vacancy away from negative cash-flow. When the cash-flow was positive, it was small and inconsistent. To make matters worse, I had created a highly undesirable and uncompensated job as a landlord.
After several years of that, I had come to a crossroads. I wanted financial freedom, more time with my family, and the ability to retire early. I knew I needed to get out of residential real estate and go bigger into commercial multifamily.
However, first I needed to solve two problems:
- How could I invest in larger commercial multifamily properties on a residential budget?
- How could I invest without becoming a landlord?
Direct Fractional Investing
Setting out to solve problem number one was not easy. Saving $50,000 or $100,000 was one thing, but million dollar down payments were out of my league. Then I learned about direct fractional investing. Direct fractional investing is the process in which investors pool their money together to purchase a property. Instead of one investor trying to come up with $2.5 million down on a $10 million property, 50 investors can each invest $50,000, or 25 investors can invest $100,000, or any other combination you can think of. This is how I was able to access larger, more profitable properties on my budget.
Fractional investing isn’t new or foreign to anybody. In fact, if you’ve invested in stocks then you’re a fractional owner. I dare say that nobody reading this article could afford to purchase the Coca-Cola Company outright. However, we can all own a fraction of that company in the form of stock.
With real estate, however, you are getting a direct fractional interest in a physical asset instead of a paper asset. Nevertheless, the concept is the same. I invest in real estate because of its unique ability to provide current and future yield in the form of cash-flow, equity growth in the form of appreciation and principal pay down, and ways to shelter both the yield and the growth from taxes. Real estate is also an excellent hedge against inflation.
If you prefer, you can think of it this way. If you owned 2% of a 200 unit complex, in essence, you own four of the units. Unlike a residential four-plex, however, you can realize all of the economies of scale that come with 200 units. By spreading the income, expenses, and vacancies over 200 units, you can achieve greater cash-flow, less volatility from vacancies, and less cost per unit in both capital improvements and operating expenses.
Private Real Estate Investment Firms
One of the things I disliked most about residential real estate was property management. Becoming a landlord is often an unintended consequence of residential real estate. With such thin margins, the added expense of a property manager may not be worth it. Also, the quality of residential property managers is often lacking in comparison to professional commercial multifamily management.
My dislike of property management motivated me to use a private real estate investment firm. You will sometimes see various terms used for these firms – investment sponsor, syndicator, organizer, asset manager. Ultimately, these terms describe a company that provides access to commercial investments that are not available to the general public. Access to these firms and their investments usually come from networking, referral, and education.
The decision to use a private real estate investment firm was going to cost me some money. In general, I don’t have a problem paying for competent, quality work. After all, I don’t fix my own cars, do my own taxes, cut my own hair, bill for my professional services as a doctor, or a host of other things. However, I do demand that I get value for my money.
How To Choose a Private Real Estate Firm
I had never used a private real estate investment firm before and set out to find a high quality, competent one. Here are some things to consider when looking for a firm:
- What is the strength of the ownership group?
- What is their model and how well does it match with your financial goals?
- How are they paid?
- What are their target returns and historical performance?
- What avenues can I use to verify their responses?
Ownership Group Strength
First and foremost, you need to know who the company owners and executive team are prior to investing. These are the people who are responsible for developing and executing the overall mission and plan. I’m not impressed by an MBA, a big office or a fancy car. I want to know that they have experience, a proven system, and a track-record for success.
I also want to know what they’ve done over their careers and how successful they have been. I like to start with an internet search. In this day and age, social media is the great equalizer. A negative comment here and there may not mean anything, but it does create a discussion point worthy of exploration. Consistent negative comments are a red flag. It is also easy to check for Better Business Bureau and SEC complaints. Ultimately, you should interview the entire executive team. I have never done it myself, but I have heard of people doing formal background checks on these individuals as well.
It is imperative that you understand the syndicator’s model. Are they market-centric or asset-centric? Market-centric firms operate in a specific market or region and often dabble in multiple asset classes. Asset-centric operators specialize in one asset class – multifamily, office, retail, storage, etc. By going to the best markets, they can maximize occupancy and rent growth for higher returns.
Additionally, you should know what your operator does well. Are they developers that build new properties? Are they strong operators who maximize investor returns? Does their strength lie in stabilizing marginal properties, repositioning, and flipping for profit?
Making sure that their services meet your needs is an important piece. For example, if you are looking for consistent yield, then a company that focuses on growth might not be a good fit for you.
Paying The Firm
It is industry standard for private real estate investment firms to make money in three different ways:
- Organization and Operations Fee – It is usual and customary for organizers to take a one-time fee for developing the market, vetting the property manager, finding and evaluating the deal, negotiating and structuring the purchase and sale agreement, conducting due diligence, and securing lending. This fee, also known as an acquisition fee, can vary depending on the size and complexity of the deal. I’ve seen it quoted as low as 1% to as high as 5% of the purchase price.
- Asset Management Fee – Investment sponsors will take an asset management fee. This fee can vary in how it is applied. Some firms charge 1% of asset value annually for ongoing management. I have seen other structures where the organizer takes 2% of gross income annually. Either way, this fee is for managing the property and partnership, creating and implementing the capital improvement plan, maintaining reporting and distributions to the partners, and planning for and implementing liquidity events.
- Carried Interest / Equity Participation – Private real estate investment firms will take anywhere from 15% – 20% of the cash flow and equity on any given deal. I have seen sponsors who take as much as 33%. The reasoning behind this fee is that the investors bring the capital and the sponsor brings the experience and expertise to create a profitable investment. As such, both the investors and the sponsor should share in the profits.
[Editor's Note: These fees can really add up. Consider a $5 Million property that you own with 99 other investors ($50K each). Upon buying the property, you could be paying the firm $2500 in acquisition fees, an annual fee of $500 a year (if based on 1% of asset value) or $182 a year for a 10-cap property (if based on 2% of gross income.) The most significant fee may be the cash flow and equity sharing. If your cash on cash return is 8% ($4000), 20% of that is 1.6% a year, or $800 a year. If you're also paying 20% of both equity increases and amortization, that could be as much as another 1% or $500 a year. Adding all those up means your expenses that first year could be as much as $4300, or 8.6% of your total investment! The ongoing fees could still be as much as 3.6% per year. It may still be worth it, but keep in mind that these fees will have a significant impact on your investment return. It certainly would NOT be worth paying these kinds of fees for a mutual or hedge fund type investment. It might be worth it in the more illiquid and inefficient real estate market, but just like a bill from the ER, I'd much rather be on the receiving end of those kinds of fees than on the paying end! Keep in mind that your expected after-expense, after-tax return needs to be quite a bit higher than a typical mutual fund portfolio (or even just the Vanguard REIT Index Fund) to justify the effort and risk involved in real estate investing.]
While the above three areas are industry standard, be aware of sponsors who front load. Front loading is when they take the bulk of their compensation up front. I prefer a sponsor who is incentivized to perform well. Make sure that their interest is aligned with your own. I like to see clauses that give the investor a preferred return or one in which the carried interest is taken on the back end after a successful liquidity event (sale of property).
Be cautious of additional fees. Some organizers will tack on extra fees like disposition fees, financing fees, developer fees, construction manager fees, organizational fees, contractor fees, leasing fees, etc. My level of tolerance for this is thin. While I believe that quality sponsors, who are good at what they do, should be paid well, I don’t like being nickel and dimed with excessive fees.
Target Returns and Historical Performance
Every sponsor will tell you what type of returns they target. Most will give you a mid to high single digit annual cash-flow or cash-on-cash return. When you factor in appreciation through Net Operating Income increases, principal pay down from the renters, and tax savings from depreciation, their overall return should be double digit. Avoid any syndicator who quotes you less than double digit overall returns. However, make sure that they can back up their claims with historical performance. While there are no guarantees in investing, I would rather invest with someone who has a proven track record for doing exactly what they say they can do.
This question comes down to transparency. How open is the private real estate investment firm to educating you and giving you access to their current investors and their third party vendors. I don’t invest in anything unless I am comfortable with it and understand it. Some syndicators feel like the proof is in the pudding. They invite you to invest and see how well they do for you. They might have quality investments, but I am slow and methodical with my investment dollars. I like to research my investments prior to making an investment.
In my mind, good syndicators should be looking to create long-term relationships. By keeping their client base happy with quality investments, they will have repeat investors. As such, they should be willing to educate you on what they do. They should have newsletters, blogs, and webinars that are timely and informative. They should be available on the phone to meet with you and answer questions. They should have no reluctance to you verifying their track record.
There are multiple ways to verify that your organizer does what they say they do. Real estate is a physical asset and real estate investing is a business. As such, these firms do not operate in a vacuum. You can go to the actual property and inspect it. You can inspect the profit and loss information and the reporting that goes along with the business side of real estate. You can also speak with current investors and the multiple third party vendors they do business with.
For example, you can speak with the broker who sold them the property, the property management firm that does the onsite operations, the insurance company, the lawyers who drew up their contracts, the lenders they use, the retirement account custodians they interact with, the CPA firm they use and multiple others. The key is how open to this is your sponsor?
Once, I asked a firm if I could speak to some of their current investors as references. That request was denied. I was told that their investor list was confidential. When I asked my current organizer for the same request, I was told that every investor they had has given them permission to be used as a reference. They asked me how many people I wanted to speak with. I started with six and ultimately spoke to another few dozen at an annual investor summit that I attended.
I have also visited all but two of their properties and walked the grounds. I have toured their model units and some vacant units as well. I spoke with their property manager, as well as the real estate broker who sold them many of their properties. I have also spoken with their real estate attorney and their loan officer. I interviewed all of their executive team and toured their offices.
In the end, my wife and I felt more than comfortable investing with them. As the years have gone by, we have been very happy that we transitioned out of residential real estate and into commercial multifamily. My passion for real estate has continued to grow. I have subsequently partnered with my private real estate investment firm on the acquisitions side of the equation. I find investment grade properties in some of the best markets in the country. I also enjoy educating people about the benefits of commercial multifamily real estate on my website at www.nesteggrx.com.
Real estate investing can be quite lucrative when done right. You don’t have to endure the pain of residential real estate or become a landlord. You also don’t have to be a multimillionaire to invest in commercial multifamily. If I can help you learn more about this excellent asset class whether in general or just connect you with a proven private real estate investment firm, please let me know.
Commercial multifamily real estate investing isn’t for everyone, but for me it was the perfect combination of the following benefits:
- Inflation resistant
- Tax advantaged income and equity growth
- Hard asset in an evergreen business
- The best risk adjusted return of any real estate asset class (highest Sharpe ratio)
What do you think? Are you doing this now? What kind of returns have you seen? Was it a good experience or a bad one? Comment below!