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By Dr. James M. Dahle, WCI Founder
A lot of people don't think of me as a “real estate investor,” which I find surprising given that I own enough investments in real estate to live off of for the rest of my life. I've owned everything from an individual rental property to a publicly-traded REIT index fund. I've even been the chairman of the board of a real estate syndication. I may not be the most knowledgeable real estate investor on the planet, but I certainly know enough to be considered a successful real estate investor.
Despite my experience in real estate, I started my investing career as a mutual fund investor, and I still prefer a mutual fund-like experience with my investments. I love the
- Access to investments,
- Low costs,
- Professional management, and
- Pooled costs.
I particularly love the passivity of an index fund. I find it ironic that those who most claim to love passive income tend to have the most complex portfolios. The more complex the portfolio, the more hassle you will have
- Managing the portfolio,
- Dealing with the taxes for the portfolio, and
- Passing on the portfolio after your death.
So, when I consider private real estate investments, the more it acts like a mutual fund, the more I tend to like it. Now don't get me wrong, as I wrote in The Case for Private Real Estate, I love the high returns, depreciation-sheltered income, illiquidity premium, and low correlation with the stock market that private real estate can provide. I just want to get it in a vehicle that operates as much like a mutual fund as possible.
More information here:
5 Aspects of My Ideal Private Real Estate Fund
Ideally, my real estate investments have certain characteristics. Now, few (none?) of them have ALL of these, but the more of them that the investment has, the more I like it.
#1 Smart Investments
While the vehicle and its management matter a lot to me, the first thing you should consider before investing is the type of underlying investments, or asset class. If the underlying investment is no good, nothing else really matters. If I don't want more of a particular asset class in my portfolio, I'm not going to look at a fund that invests in that asset class. It seems common-sensical, but you would be surprised how many investors are willing to look at anything put in front of them no matter what their investing plan calls for. If you fail to plan, you plan to fail. Get a written investing plan and follow it. That is just as important with real estate as with stocks, bonds, or any other asset class.
The main point of investing in a fund—instead of syndications or even owning a few individual properties in your hometown yourself—is diversification. Individual properties can have terrible returns, and any given syndication can be a total loss. At least as a member of an LLC or limited partnership, your loss is limited to your entire investment, unlike when you own individual properties yourself. However, when a fund owns 10, 20, or more different properties, that diversification protects you from what you don't know and what you cannot control going in to the investment. When I'm looking at a real estate fund, I like to see it own at least 10 different properties. It's even better if all of those properties are not in the same geographic locale, although that can be somewhat mitigated by using multiple funds.
More information here:
#3 Experienced Management
While understanding and choosing the underlying asset class is critical, the management team matters far more than the individual investments. A good manager can make lemonade out of lemons, but a bad manager can easily ruin what should have been a decent investment. There are a lot of people in the real estate syndication and fund space, and the range of experience is extremely broad. Just like you would not fly on an experimental airliner with an inexperienced pilot, you should not volunteer to go for an investment ride with a brand new management team. I also consider the presence of a competent tax prep team a critical aspect of the investment. It is a real pain to receive late or even revised K-1s. The more layers of tax preparation an investment requires, the later you are going to get your K-1.
While I want to see the investment team incentivized to ensure good performance, I also want to see a reasonable waterfall structure. Fees matter with every investment. Every dollar you pay in fees is a dollar that comes out of your return. That's just the way the math works. An experienced manager knows that keeping fees reasonable ensures more rapid growth, and they end up better off in the long run because they make it up on volume.
While I like being paid an illiquidity premium, I want to have as much liquidity as possible while earning it. Liquidity, like diversification, can provide you protection when an investment turns out to be different than you thought it would be. It also provides you protection from significant changes in your financial life that merit a change in investments. Some funds lock you up for a decade, while others might allow you to exit after just a few months. There is real value there. In addition, I like to see a fund that allows you to put all of your money in at once, puts it to work right away, and then gives you back all of your money at once. When I first started with private real estate investments, I underestimated the value of these three features. I discovered that some investments do not do these things. I have had real estate investments that
- Took 28 months to call all of the capital
- Did not put my money to work for two months after I sent it in (without providing even a cash-like return on my money in the meantime)
- Returned money in dribs and drabs over years. The worst one started returning money to me in 2019 and is still doing so. My investment of a mere $20,000 has been returned to me in 80 different payments (so far), the smallest one being just $8. What a record-keeping nightmare it has been.
More information here:
A well-run fund is efficient—not just with its own resources but also with my time and money. The longer I invest, the more I value an “evergreen” fund. Some funds call your capital over a year or two. You provide the capital when they want it, not when it is convenient for you to invest. They return your capital (along with a tax bill) over a few years when they want to do so, not when it is convenient for you. With an evergreen fund, you can invest when it works for you. You put all your money in at once, and you get it all back at once.
A convenient fund offers me the option to reinvest the income from the fund automatically back into the fund. Most accumulating real estate investors don't need all of the income from their investments and often do not need any of it. Since they are investing more every month, mandatory cash flows just cause cash drag. Since an evergreen fund is set up to receive cash at any time, it has no trouble putting its own income to work.
Evergreen funds can also often provide low minimums. This gives you the option to try before you buy. Experienced syndicators and fund managers know that investors are likely to invest more over time with someone you trust, so they let you get in with relatively small amounts. If they can handle a few thousand dollars of income being reinvested, they can handle minimums of $25,000-$100,000. Sure, it's more work for them to deal with more cash flows and more investors, but that's their job.
Likewise, I want as little tax hassle and as much tax benefit as possible. With a debt fund, I want to see that the fund has adopted REIT status. Debt fund income is inherently extremely tax-inefficient, and there is no downside to a debt fund being a REIT, where the investor at least gets the 199A deduction for that income. With an equity fund, I am more ambivalent about REIT status. While it is nice to have the depreciation passed directly on to you via a K-1, REIT status can pass that on to you with distributions classified as return of capital rather than income. The taxable income you do get benefits from the 199A deduction, and perhaps most importantly, you do not have to file multiple state tax returns with a REIT.
Some might argue that an evergreen, liquid fund cannot provide the same illiquidity premium or that it gives lower returns than a less liquid fund. That may be true, but too many fund managers do not consider the individual investor's overall, after-tax return. At the end of the day, that's the only one that should matter. If their money is sitting in cash, whether at home or in the fund, they are not getting as high of returns as they should be. Funds should actively consider the tax situation their clients are facing and do what they can to minimize those tax bills.
Mutual funds were invented for a reason, and investors have reaped the benefits for decades. As private real estate funds adopt these features as much as possible without killing the goose that lays the golden eggs, both the funds and the investors will benefit.
Don't forget to sign up for the free White Coat Investor Real Estate Newsletter that will alert you to opportunities to invest in private real estate syndications and funds, including most of those I invest in.
What do you think? What characteristics do you like to see in your private real estate funds? How much return would you be willing to give up to get a more liquid, hassle-free, evergreen fund? Comment below!