I've been investing in private real estate for years. That doesn't necessarily mean much since most of these investments are so illiquid and long-term that it takes years to really know how you are doing, but after a couple dozen unique investments (including funds with dozens of investments themselves), I've learned a few things about it that are worth sharing. However, the most important thing about private real estate investing, like most investing, is that it is far more about the investor than it is the investment.
There is a massive amount of effort put into selecting investments in this inefficient market. Investors pour over track records, waterfall structures, and private placement memorandums (PPMs) trying to find the jewels in the rough. Then they form private groups to discuss these issues with other interested investors away from the sponsors. When an investment does great, they pat themselves on the back at what a fine job they did with their due diligence. When an investment does poorly, they chalk it up to a learning experience and resolve to spend a bigger chunk of their life reading PPMs.
The parallels to individual stock pickers are obvious, the only difference being that there is no great index fund for this inefficient market and even if there were, you would lose out on significant tax benefits as no depreciation gets passed through due to the REIT structure publicly traded real estate generally uses.
I think a lot of this effort may be misguided. I think it is probably a lot more beneficial to match the investment to the investor than it is to try to find the very best investment a priori. Besides, the likelihood that the very best investment is available when you have money available to invest is low anyway.
Private Real Estate Investors Should Be Wealthy (Already)
Options for the “Little Guy”
The first point I want to raise is simply that this isn't really a game for the “little guy.” I had a middle-class earner walk up to me after a conference talk I gave and ask how he could get started in real estate. He had saved up $10K to do it. There are very few options to be a real estate investor with only $10K to invest, and only two of them are any good.
REIT Index Funds
The first is to just plop it into the Vanguard REIT Index Fund. This isn't a bad option. It was the only real estate exposure I had for years and that was probably a good thing.
Direct Real Estate Investing
The second is to become an active, direct real estate investor, at least as a side gig, and maybe as a full-time job. This was actually something this young man wanted to do. In order to make sure his first investment had positive cash flow, he would likely need to recruit an investor, find an incredible value to buy or convince the seller to offer him some unique financing terms. Another option might be to “house-hack” his first investment, such as living in one side of a duplex while renting out the other side.
But there aren't any other good options. On a middle-class income, he wasn't an accredited investor, so that rules out almost all private real estate syndications and funds. Some crowdfunding sites don't have those restrictions, but each investment usually has at least a $5K minimum, which means he is only going to have at most two total investments.
There's just not enough diversification there in my view. There are some private REITS you can get into with $10K, but after the fees, I'm not yet convinced these are a better option than just buying some nice liquid Vanguard REIT index fund shares, although to be fair the private REITs (and I'm not talking about the terrible broker-sold ones) do invest in much smaller properties that likely perform differently than the huge ones bought by public REITs.
Options for the Accredited Investor
Even if you are an accredited investor, perhaps a physician making $250K a year and saving $50K of it, you're probably not in an awesome position to be buying private real estate. Despite a top 2-3% income, you're going to have a hard time meeting the minimum investment amounts ($25-250K) while maintaining diversification.
Let's say you're a few years out of residency, have a $200K portfolio already, and save $50K a year. Even if you decide to put 30% of your portfolio into real estate, that's still only $60K plus $15K a year. So you're going to put your entire real estate allocation into just 2 or 3 syndications or funds? Really? A crowdfunding site may be an option for these folks, at least until their portfolio gets larger.
But in reality, it takes a fair amount of income, a decent savings rate, and a 7 figure portfolio for any of this to make sense. I would recommend you meet not just one “accredited investor” criteria ($200K+ in income or $1M in investable assets) but both. And maybe double those numbers as they haven't been increased in decades. So now you've got a $400K income, you're saving $100K a year, and you have a $2M portfolio. Now if you want 20% of your portfolio in real estate we're talking about $400K plus another $20K a year. It's now reasonable for you to at least consider whether you want part of your portfolio in these investments.
The wealthy also generally pay more in taxes, so the tax breaks in real estate matter more to them. They benefit more from having their rental income covered by depreciation. They are also more likely to have a self-directed IRA or 401(k) for tax-inefficient investments like debt funds.
One reason why only accredited investors are allowed to invest in these things is that they are risky and get much less scrutiny from the SEC and other government entities. An accredited investor is not only supposed to be savvy enough to tell a good investment from a bad one, but also can tolerate a big or even total loss much better. Make sure that is true for you. The wealthier you are, the less it hurts to see $25K you used to own disappear. If a $25K loss is a rounding error in your financial life, you're probably wealthy enough to be thinking about these investments.
The bottom line is that the more you have, the easier it is to invest well in private real estate, the greater than benefits, and the less significant the downsides.
Is Private Real Estate a Fit for You?
Diversification Matters
This key principle of investing certainly still applies. It's simply a math equation. If one borrower defaults, one apartment complex underperforms, or one strip mall has too many vacancies, it should not have a significant effect on your financial life and portfolio performance. This affects not only return, but liquidity. For instance, I had one real estate debt investment, a one year loan to a house flipper, where I didn't get my principal back for almost three years. It was still paying interest exactly as contracted, but I expected to get that principal back years earlier. You need to own enough of these that something like that doesn't cost you any sleep, much less affect your finances.
If You Want Control, Go Direct
Some real estate investors hate not being in control. They might even avoid investing in stocks at all because it makes them feel out of control of their investments. These guys are going to like most syndications and private funds even less than they like stocks. At least if you don't want a stock you can get rid of it within 24 hours. You're stuck in syndications and funds for years, sometimes as long as a decade. If you want that kind of control over your investments, you need to buy and manage them yourself. It's not a bad option. Lots of people have done very well investing directly into real estate. But it has to be a fit for you.
If You Want Liquid, Go REIT
Other folks want or need to have their assets be very liquid. I personally believe that there is an illiquidity premium. If you are willing to tie your money up for years without liquidity, you should be paid for it. Investments that require illiquidity should have a higher overall return. But if liquidity is something that is very important to you, private real estate syndications and funds are not a great way for you to invest. Even if the long term returns and tax advantages are great, it won't be worth it to you. Stick with index funds. It's not like they don't work. Lots of people retire just fine on nothing but index funds.
You Need to Be Patient and Somewhat Disinterested
Since these investments tie up your money for long periods of time, they are best for people who are both patient and a little bit disinterested in their investments. All my private real estate investments send me a quarterly update. I usually glance through it, but let's be honest, there's no real point to doing so. I can't do a thing about it. Once you make the investment, you're stuck for years. The main reason I look at them is to decide if I want to invest more money with that sponsor.
You Need to Be Less Fee Sensitive
I don't want to say “fee-insensitive”, because fees always matter. Every dollar you pay in fees is a dollar out of your return. But lots of experienced index fund investors get sticker shock when they first see the fee and waterfall structures of a real estate syndication or fund. They were used to bragging about their average expense ratio (ER) being under 10 basis points.
What they may not realize is that you cannot compare these fees directly to the ER on a mutual fund. A stock mutual fund ER doesn't include any of the operating expenses of the companies whose stocks are in the fund. A big chunk of the fees in real estate investments are simply the operating costs. They're acquisition fees and management fees and legal fees, etc.
The Exxon-Mobile CEO salary isn't included in your mutual fund expense ratio, but guess where the private real estate fund manager salary can be found? That's right, in the waterfall (i.e. the listing of fees and how returns are distributed to the various partners in the project). Financial advisors and mutual fund managers are also generally not paid incentivizing fees. (You can thank the Investment Company Act of 1940.) They're generally in the business of gathering assets and charging an AUM fee on them. But most real estate syndicators are incentivized to provide good returns. This shows up in the “preferred return” (i.e. the manager doesn't get anything until the investor first makes 6-10%) and in the “promote”, i.e an 80/20 or similar split of returns above and beyond the preferred return between the investors and the manager.) One of the most basic rules of economics is that people respond to incentives and do what they are incentivized to do. If someone is paid to gather assets, they will gather assets. If they are paid to generate as high of returns as possible, they generate as high of returns as possible.
But if knowing and seeing these sponsors and fund managers charging these high fees bothers you (even if your after-fee return is excellent) these investments may not be for you. There is a lot of variation in these fee structures, but they're all pretty similar and none of them are single-digit basis points. Again the investor matters more than the investment.
You Can't Be Afraid of Complexity
After you've read dozens of PPMs, you get a sense of what you're looking for, but that doesn't change the fact that the PPM (and the investment) is much more complicated than a typical mutual fund prospectus. If investing isn't at least an enjoyable hobby for you, you don't have any business in these investments, no matter how much you make or have.
Recently after giving an hour-long presentation on how to set up and manage a simple index fund portfolio, a hand was raised and the question was asked, “Is there any easier way? How can I get started and what do you mean by ‘rebalance again'?” While sponsors will often bend over backward to teach you how investing works, I really don't think that should be their role. Their job is to answer your questions, not tell you what questions to ask in the first place, much less teach you how to speak “finance.” If your Roth IRA is invested in a target retirement fund, you don't want to be in a real estate syndication.
The Ideal Private Real Estate Investor
So if it is more about the investor than the investment, how do you know if you are the ideal private real estate investor? Take a look at this list. The more it describes you, the more interested you should be in these investments.
#1 The ideal private real estate investor is wealthy.
Even for a doctor. If you're not already FI, you can see it from here. You are more worried about estate planning than student loan management. You find it insulting when you are asked to prove you are an accredited investor. You can own enough different real estate investments that you are getting the “market return.”
#2 The ideal private real estate investor is a hobbyist.
You love to talk about and read about investing, at least from time to time.
#3 The ideal private real estate investor is not afraid of illiquidity, significant fees, and complexity.
If the returns are high enough and the correlation low enough with the rest of your portfolio, you're interested and willing to wade in.
#4 The ideal private real estate investor is okay not driving the bus.
You are patient and both you and your money are in it for the long haul. You don't look at your portfolio every week to see how it is doing. You'd rather let someone else make the decisions and go along for the ride.
If this describes you, sign-up for The FREE White Coat Investor Real Estate Opportunities mailing list and I'll introduce you to a couple of these deals every month. There's no commitment and no called strikes in investing. You can also check out our real estate investing partners. I would also recommend checking out our No Hype Real Estate Investing course. It will give you the foundation you need to learn about all the different methods of real estate investing.
If this list doesn't describe you (and it should not describe the vast majority of my readers), realize that's perfectly okay and that you can be financially successful without private real estate. It might help you to remember that Katie and I became millionaires without any private real estate, financially independent with very little, and that private real estate still only makes up 15% of our portfolio. If 85% of our portfolio is fine in “boring old index funds”, then 100% of yours will be, too.
What do you think? Who do you think should and shouldn't participate in private real estate syndications and funds? Comment below!
Featured Real Estate Partners
This really is a great overview of getting into the private real estate game. I wasn’t planning on jumping in anytime soon but this definitely confirmed it for me. I need to increase my wealth first to get to a point where I can achieve the diversification necessary with these investments.
I am however, investing in direct cash flowing real estate. I’m closing on my first property and using this vehicle to accelerate my wealth building. It’s very different from above as you note. It’s definitely not passive. But offers great opportunities for cash flow, equity build up and tax benefits.
Most important part is at the end though. Index funds are just fine and will get you to your goal. No one should feel that real estate investing of any kind is 100% necessary!
The Prudent Plastic Surgeon
I pretty much agree with this. But I have used diversification even more. I love real estate but it is up to 30% or so of my portfolio. It gets easier to diversify and be more hands-off as your assets grow.
Early on I still had several types of real estate investments. And now I still do. A practicing doctor can still invest in commercial real estate, REITs,, Medical office space, Single-Family Homes, Duplexes, Funds, Syndications, Storage units, mobile homes, etc. Many have different investment cycles, taxes, cash flow, etc. I still invest in many of those areas. Having more resources allows the investor to use many management teams and geographic areas so total losses are less likely and less devastating when they do occur.
This is a great roundup. I appreciate PIMD’s gentle reminder to tread lightly- for even the vast majority of high-earners. Recently there was a Facebook thread either on White cost Investors or PoF, I forget which one- where someone asked if they should invest in syndications. And the overwhelming response was not to. People responding said they’d been there and done that and that the (1) the upfront due diligence required was hard and (2) many said they hadn’t quite received the returns promised. Of course, this is the experience of a small number of people. And many others, including PIMD and you have bucked the trend. But I wonder if it’s because you know so many of the right people. Even though I fulfill the criteria PIMD put up above, I feel like it’s a toss up whether I’ll succeed in pvt RE deals.
PFB
PIMD didn’t write this post, I did. I guess that’s what I get for telling you about his course.
Oops, my mistake! And yeah, it’s not even Saturday. I must’ve been sleepy-eyed and foggy-brained. (Maybe I’ll use this line when the 6 year old says she’s “bright-eyed and bushy-tailed” past 10:00 pm and doesn’t want to go to bed).
More awake now,
PFB
Having Invested in about 10 debt and equity holdings so far, I really appreciate that points expressed in this posting. Unless you can afford to put down the large minimums for One of the premier diversified partnerships, you have to be willing to take the additional risk and self education for syndications, and I personally am still on the steep part of the learning curve.
But if you’re willing to put in the extra time And especially willing to make mistakes,it certainly makes investing less boring And potentially empowering by interacting with sponsors/general partners
Private real estate investing is part of alternative investing. The usual reasons given for alternative investing are diversification and as a fixed income substitute. I’m not certain that those reasons apply to private real estate. The reason for that is that there is another option to private real estate, which is public real estate.
What makes private real estate different from public real estate? There is much less of a secondary market.
The absence of a secondary market means that you can’t rely on the market to provide price discovery. You, or the person/group you delegate the task to, have to be able to value real estate. I wouldn’t consider real estate valuation simple.
The absence of a secondary market means that it will be more difficult to diversify.
The absence of a secondary market results in decreased liquidity. That means it will be more difficult to buy/sell, and transaction costs will be greater. It also raises the possibility of a liquidity risk premium. In small cap/microcap stocks, there is a liquidity risk premium. I’m not aware of research on a liquidity risk premium in private real estate, although my guess would be that such research exists.
The absence of a secondary market will result in greater inefficiency, with more dispersion of returns. This will result in increased opportunities for positive alpha. But the corollary is that there will be increased opportunities for negative alpha. To a great extent, it will depend on how good your valuation skills are relative to your competitors.
There will be many real estate investments that are too small to justify a secondary market in. So private real estate can include the equivalent of nanocap stocks, which public real estate can’t. Such small real estate investments will result in increased dispersion of returns and decreased liquidity.
Another difference between private and public real estate is in the ability to use depreciation. That’s true in the USA, but not everywhere else.
Are private real estate returns better than public real estate returns? I’m not aware of any data on that. If they were, there would be many hedge funds and companies engaged in private real estate investing.
You mention a parallel to stock picking. For me, stock picking makes more sense. I can build on the the knowledge that I have already gained, rather than develop a new area of expertise. And there are rigorously tested comparatively simple ways to stock pick. I’m not aware of anything similar in private real estate investing.
You make a good point That the lack of standardization and regulation in the financials as reported to prospective investors, creates a lot of in efficiency, and potential risk. However, for most common income producing real estate, There are certain valuation norms in the same way that there are imperfect but hopeful valuation norms for stocks.
Hopeful or helpful?
Interesting read. I just got out of urology residency. My plan is to max out retirement accounts and pay off student loans within 5 yrs. Due to previous blog posts on the benefits of syndications/funds, I was thinking about investing in these with whatever was left over from my 30% savings rate. Maybe I should do some more wealth building first?
Hard to say. Depends on your goals and your financial plan.
Just a general question for you Jim Dahle.
For your asset allocation of 60% stocks, 20% bonds, 20% RE; is that the allocation for your entire portfolio (retirement and non-retirement)?
Do you differentiate between your retirement and non-retirement accounts?
If it is for your entire portfolio, is RE divided equally between retirement and non-retirement? Or do yo overweight in one or the other?
For real estate, I’m thinking about just using non-retirement funds as I’m assuming there would be a lot of red tape and paperwork to go through for the retirement accounts. Also, I’m more risk aversive with retirement funds and prefer TDF.
Entire portfolio. All accounts for the same purpose (retirement) are managed as one big asset allocation. This includes Roth IRAs, 401(k)s, and taxable account. College funds have a different AA.
Most of our real estate is in our taxable account. In fact, most of our portfolio is now in our taxable account. But that’s more of a function of our income and our wealth and the rate at which we acquired it, not some sort of asset location play.
I agree it is easier to invest in real estate in taxable. For equity real estate, at least you can use the depreciation. For debt real estate, it would be nice to have it in a retirement account if possible.
I’m surprised someone who uses Target Date Funds has any interest in real estate though. Seems odd to try to minimize complexity in one place while maximizing it elsewhere.
Thanks for the info Jim.
To expand on your comment on TDF’s and interest in real estate. I don’t think the two are exclusionary.
For the stock and bond portion of the portfolio why not pick TDF’s? They’re almost perfect. I didn’t pick them to decrease complexity, but I don’t think you can do much better than them.