Dennis Bethel MD
[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.
The Model
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.
Verifying Information
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.
Summary
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!
Featured Real Estate Partners
What are the average returns you’ve recieved? What are your returns in a best year and a worst year? What kind of rights do you have to pull your money out on an investment? Would the firm just give you annual accountings at tax time? When do they typically distribute cash? What are minimum and average investments? Do you get to take the depreciation on your taxes? Do they structure it as a limited partnership, llc or some other way? Have you any experience with using a self directed IRA for this type of investing?
Great questions, I’d be interested to see the reponses as well. Great topic WCI.
I asked a lot of those questions in a recent conversation with Dennis. I’ll let him answer them here or stick them in the post that will likely come out of that interview if he elects to advertise with me.
1. The worst year I have had with direct fractional ownership is an overall return of 14.5% net of fees. This is an important point to clarify – the targeted cash flow and overall returns that I discuss in this article is after fees (net of fees). Not all private real estate investment companies are the same, so make sure you understand their fee structure before investing. You need to know if their targeted returns and historical returns are before or after fees.
2. Liquidity can be an issue with real estate. Having said that, it is incredibly rare for someone to want out of quality deals. In my experience, the handful of times that this has happened has usually been due to an unexpected death. In these cases, that ownership fraction had been offered to the other investors in the LLC at fair market value. To date, everyone who has wanted out has been bought out by others in their partnership.
3. Typically, it is one property in one LLC making reporting very transparent. The partners get a K-1 at tax time and quarterly reporting with quarterly distributions. These reports include a property manager’s report, an asset manager’s report, and the profit and loss statements showing the financials for that quarter.
4. Minimum investments are $50,000, but I have seen as high as $100,000 with some companies. If you have an interest in real estate investing, then an important step in determining if this is right for you is to gain access to the company’s deal flow. Every company will have their own process, but becoming an approved investor should be free of charge and without obligation. Potential investors will receive emails as offerings become available. Some companies even have webinars to discuss the highlights.
5. Absolutely, you take your fraction of the depreciation as well as the cash flow, appreciation, and principal pay down.
6. I have always invested with after tax dollars, but many people do invest using self-directed IRAs.
I have a number of questions for Dennis.
1) I want to really understand this: your WORST year was a +14.5% gain with fees included in that figure (ex. took home $7,250 minus taxes on a $50k initial investment)?
2) How many years have you been a direct fractional owner?
3) Were you a direct fractional owner during the recent housing crash, and how does a time period like that effect annual average cash flow?
Finally, a question for WCI. Your typical Boglehead portfolio author suggests 5-15% invested in real estate (usually some sort of REIT Index fund). For simplicity of math, would you advise staying away from a venture like this until you have accumulated a portfolio of at least $500k ($50k minimum invested / $500k portfolio = 10% invested)?
I have been investing fractionally for eight years. My worst year is 14.5% overall return. Overall return means from all sources. It is the combination of cash-flow, principal pay down and appreciation.
I could imagine a scenario in which the only benefit an investor received that year was from principal pay down. With these bigger properties, the principal gets paid down $50,000 to $100,000 a year. That benefit alone would give the investor somewhere in the 1.5% – 3% return range annually. If your property is not appreciating or spinning off cash-flow, you’ve probably made a mistake in one of four very critical areas. 1. Market selection including submarket selection (http://nreionline.com/finance-amp-investment/five-characteristics-define-nations-top-multifamily-markets). 2. Poor property management selection. 3. Poor asset management selection. 4. Inadequate cash reserves.
If you are holding a quality property in a quality market for the long term, the principal pay down is consistent, your asset manager should be creating forced appreciation through net operating income (NOI) increases and you should be seeing cash flow.
It is important to realize that this does NOT act like a REIT and as such “down” years aren’t market correlated 50% losses. In fact, during the recession, returns were enhanced as people lost their homes and moved into apartments causing increased occupancy rates in most markets.
I would add two comments: Past results are no indication of future results.. Real estate has been experiencing contracting CAP rates for the past few years so these companies have had some nice exits. That being said, a well run private Commercial Real Estate (CRE) investment with low leverage should have high single digit cash on cash returns and protect against inflation. I’m all in favor of this, but know lack of liquidity is a potential problem. On the bright side, if we get in an economic slump you may be able to buy others shares at a discount.
Thanks for the interesting article. I have been curious as to how I can diversify into real estate. For many reasons recently I see the wealth and tax benefits of this type of diversification. I have 3 main questions. 1. How much is Dennis’ cut if we use his investment firm as this further reduces gains. 2. If David is so real estate heavy has he diversified into other areas of real estate? Although I agree from what I have read, fractional commercial does seem like a good area especially for physicians, there are many other area’s and ways to continue wealth accumulation through real estate. 3. If one is purely a fractional investor do they have any ownership status and does this then make you a business owner as it would if you were doing residential real estate? This is mostly a tax-related question.
John, the private real estate investment firm that I use and partner with take the usual and customary fees. They are either at or below the industry standard for those fees and they pride themselves on being aligned with the investor’s interest. My compensation is not tied to investor returns and therefore does NOT reduce investor gains. I do dilute the syndicator’s returns as I share in their equity position depending on my involvement.
I have not had direct ownership in other asset classes. The main reason is that multifamily real estate has had the highest returns with the least variation of any other real estate asset class over the last 30 years. Shelter is a basic need, so for me, apartments are where I want to be. That is not to say that you cannot make money in the other asset classes. Plenty of people do.
Investors are limited partners in the LLC and get a K-1 at the end of the year. Real estate is very tax-advantaged and generally provides a paper loss for several years via depreciation and accelerated depreciation from a cost-segregation study.
Dennis, Thanks for taking the time in your responses and post.
WCI – clearly an area of interest for some of us as it has generated many questions and good responses. Thanks.
Yea…people seem to like real estate a lot more than diamonds! 🙂
Thanks for the more in depth explanation Dennis! Question for you. Because you are taking out such a large loan (effectively leveraging your pool of money) what kind of effects will changes in interest rates have on profitability? In the 10 million dollar example above, paying an extra 1% on your 7.5 million dollar loan would cost the owners 75k a year. I will not be in a position to get into this business for years and I wonder about investing down the line, when credit might not be so cheap.
Hello Jesse, in today’s lending environment, most private investment real estate firms are locking in low fixed rates for 7 to 10 years. In the right markets, it is not uncommon to raise net operating income 20% or more over 4 – 5 years. Longer holds will create even higher cash-flows and equity.
I cannot predict what future interest rates will do, but evaluating a property for acquisition (once you have vetted the market and submarket) comes down to basic math. The current interest rates should always be factored into the purchase price of any given property before an offer is made. Ultimately, if the property will produce the targeted returns at a certain price then that is where you stand firm. If they don’t, you walk. The fundamentals should work on day one.
There are plenty of properties in markets all over the country that do NOT make sense today even with the very low interest rates. Places like Los Angeles where people are buying at very low cap rates with negative cash-flow banking on appreciation that may or may not come. I’m sure some of these people are making money, but for me it is too risky. Personally, I believe in buying quality properties in quality markets for long-term holds.
Is the loan that is taken out for leveraging a recourse or non-recourse loan? ie: if the property tanks and all the other investors bail/bankrupt, are you stuck holding the bag with your other assets at risk of loss?
Jon, I would strongly advise against investing with full recourse loans. Nationally, properties that conform to current Fannie Mae underwriting standards have a 1% – 2% foreclosure rate. In the better markets, the rate is less than 1%. Admittedly, we are talking about a very rare type of thing. Nevertheless, I would only invest using non-recourse loans.
http://www.nesteggrx.com/the-best-real-estate-investments-utilize-non-recourse-lending-to-decrease-the-risk-of-leverage/
Dennis, thanks for your answers. Another question for you, you have listed your rate of return on your property(ies) at 14.5%+. I believe you said it was net of fees. Was this done through a private real estate investment firm and a syndicator? ie: does this include all of the typical fees you discussed above: 1.Organization and Operations Fee 2.Asset Management Fee 3.Carried Interest / Equity Participation and syndicator fees? Thanks.
Jon, in my writings both in general and my own specific historical returns, I am discussing returns after fees or net of fees. This is an important point of clarification when speaking with a private real estate investment firm (also known as a syndicator). Are they quoting you before fee returns or after fee returns? Obviously, the answer to this question makes a difference.
is it common to include principal pay down and appreciation in your calculation of annual returns? Before you said this, I assumed by annual returns you annual cash flow net of fees. What is your annual average return excluding principal pay down and appreciation?
Thanks Dennis, I guess what I was wondering is in the example you gave of your returns, if that particular investment that you are referring to has all the fees you discussed applied or if you are able to avoid some of those fees due to how the deal was/is structured? (ie: maybe you don’t pay syndication fees, or maybe it was a group of investors that came together on their own, thus there is no equity participation fee, management fee, etc)
Also, in followup to one of the above comments, if you include appreciation into the return, isn’t that just an estimate? You won’t really know what kind of appreciation you have until you sell. If you wouldn’t mind, what amount of the return is due to an estimate of the annual appreciation?
Jon, all the deals that I have invested in fractionally have the same three industry standard fees. They do not tack on additional fees. Having said that, the asset management fee and the carried interest are paid out of the successful operations of the property and not from the investors themselves. I have not seen a private equity firm that didn’t include these fees. My returns have been excellent, so the fees don’t bother me. Having said that, there is no doubt that a group of individuals who went in together and purchased a property could structure the deal however they wanted. The biggest hurdle they will face is qualifying for lending since currently you need to have 2 years worth of payments in the bank and a net worth matching the value of the property. In addition, the lending companies will want at least one of the individuals to have the experience and expertise to insure for a successful outcome.
Appreciation for commercial real estate does NOT follow the comparison appraisal model like residential real estate. With the comparison appraisal model, an appraiser finds similar sized properties in close vicinity to your property that have recently sold. Then they estimate the value of your property based on sales price of those other properties. Fortunately, commercial real estate follows an income model to value your property.
The formula is: Market Value = Net Operating Income / Cap Rate
The whole business of asset management revolves around the numerator. Maximizing net operating income creates forced appreciation. It is true that real estate is an inefficient market, so your calculation of value is not iron clad like the price of a stock at any given moment. However, it is a very good apples-to-apples portrayal of how your property is doing on a yearly basis and how much it is appreciating. Ultimately, when you sell the property, you may get a bit more or a bit less, but you will be in the ballpark.
If I still haven’t answered your question or if you want to discuss it further, feel free to schedule a phone call and we can go over it in more depth. I’m always happy to answer any questions you may have.
http://www.nesteggrx.com/passive-investment-fractional-ownership/
If I didn’t include that, then I would be showing an incomplete picture. Let’s take a different example. If you had a dividend stock that paid you a 2% dividend each year, but was also down 20% that year, would you just say you made 2% for the year? Representing the yield without reflecting the loss would be misleading.
Real estate provides multisource income. You get yield in the form of cash-flow, but you also get growth in the form of equity from forced appreciation and principal pay down. The yield is tax-advantaged from depreciation and the growth (equity) can be harvested tax-free by refinancing or tax-deferred via a 1031 exchange.
Targeted cash-flows range from 5% – 9% per year on average over five years. In general, year one will be your lowest yielding year while subsequent years will have increasing income. Having said that, I have had years in which my cash-flow was as low as 3% on a property. I have had times when a quarterly distribution was missed.
The company I use has a 90% history of making their quarterly distributions. I consider this to be excellent as things do come up. Unexpected capital repairs are probably the biggest reason for missed distributions. Tax-free or tax-advantaged cash-flow is very nice, but if you are absolutely 100% counting on the cash flow to live on (like a guaranteed annuity for example) then this may not be the right investment for you.
Well it depends on what you desire. In retirement you need cash flow or some tax savings that equal cash flow. I have some investments that yield about 4% on my investment but has a potential capital loss if I sold.
Thank you for taking the time to respond. Even in a bad year it still beats most dividend stocks, especially when you consider the tax benefits.
My pleasure.
Yes, thank you very much for your detailed responses. It is something that I have been considering for quite some time.
I read this article This project really good feel free to buy. I appreciate this project
Recent L.A. Times article about rentals I thought some would enjoy reading.
http://www.latimes.com/business/realestate/la-fi-lew-20130728%2C0%2C907153.story
Investing in the commercial property with the help of an investment firm is probably on the best ways to break into commercial real estate world. If you a first time commercial property buyer, nobody can guide you better than a group of professionals who makes living by doing it.
It doesn’t mean that you shouldn’t do your research; however, it’s always better to be prepared before you talk to professional adviser. This is a great article for everyone who is in the beginning stage of the commercial real estate purchase.