I like real estate as an asset class. I think I would eventually even like to see real estate get up to 20% of our portfolio. Stocks, bonds, and real estate make for a very nice portfolio. The stocks and real estate provide the power, with high expected returns and low correlation with each other, while the bonds smooth out the ride, provide rebalancing opportunities, and occasionally, even outperform the other asset classes over the short to medium term. (You know medium term, like 1-2 decades.) However, I've spent years struggling with how best to implement the real estate portion of our portfolio.
Initially, we added Real Estate Investment Trusts (REITs) to the portfolio. Our timing was pretty terrible. Our first investment in REITs was 11/27/2006, in the Vanguard REIT Index Fund (VGSLX). The value of VGSLX peaked on 2/9/2007 before losing 3/4 of its value over the next 2 years. But we persisted, continued to pour in good money after bad, stayed the course, and in January 2015, the value of VGSLX returned to its previous value (although at the time of this writing-March 2016, it is back down below its January 2015 peak.) That sounds pretty terrible, right? But OUR dollar-weighted returns in that fund are actually pretty good- 10.3% per year as calculated by XIRR on our investment spreadsheet.
Why are our returns so much better than the apparent fund performance? Well, number one most of the return from REITs, just like an investment property, doesn't come from appreciation, but from the rents. With a mutual fund, the yield is the rents minus the expenses of the properties and the fund. With VGSLX, the unadjusted yield is currently 4.07%, about double that of a total stock market index fund. But the larger effect on our returns is due to staying the course through perhaps the worst real estate meltdown in our country's history. We bought many of our shares at an incredible discount compared to those first shares we bought. Those first ones were about $27 a piece. My records show I bought shares in January of 2009 at about $11 a piece, and since then have bought many others at prices in between those two figures. Over 10.3%. Not too shabby and very little hassle. No tax cost either as they're held in tax-protected accounts where they belong. We still hold REITs and will continue to do so in the future, although the volatility and the correlation with the stock portion of our portfolio are concerning.
Direct Property Ownership
We also had the opportunity to own investment property directly. To be fair, we didn't actually mean to do this. It was forced upon us when it came time to sell our town home in mid-2010 and we still hadn't sold it by mid 2011, so we rented it out. We learned a lot from that experience, as noted in this post. We also got a pretty fat tax break from it. I would have preferred not to have lost the money rather than to simply have shared the loss with Uncle Sam, but much of that loss was probably due to a decrease in value of our residence rather than an actual investment loss. Converting it to a rental property was just making lemonade from lemons. We learned a few things from the experience that we'll apply going forward–we don't like being landlords, we don't like being long-distance landlords, we don't like doing tax returns in multiple states, we don't like being property managers, and we're not very good at being landlords or property managers. I much prefer making money by writing and by seeing patients than by dealing with tenants. The equity we took out of that property went into stocks as part of our mortgage payoff fund.
Syndicated Real Estate
Since becoming accredited investors, we've begun looking at syndicated real estate investments for several reasons. First, the correlation with the stock market and apparent volatility (one could argue the actual volatility is different) seems to be much lower. Second, these investments are almost universally illiquid, and I believe I am getting paid for taking on that illiquidity, which we can easily afford to do. Third, it's a set it and forget it type investment. I make the investment, then I forget about it. Every month or quarter or year cash shows up in my checking account and after 5-7 years, I get the principle plus (or minus) any gains back. Fourth, the projected returns are excellent. Projected returns on debt are generally 9-10% and projected returns on equity are generally in 14-25% range.
There are a few things I don't like about syndicated real estate. One is that you usually get a K-1 every year to put into your taxes. They're not terrible (since I'm already doing two of them for my earned income and one for my wife's earned income) but they're a bigger pain than a 1099-int or 1099-div. The state income tax treatment of out-of-state syndicated partnerships also can be a pain, as noted here. Finally, the difficulty of balancing diversification and hassle is dramatically worse than investing in REITs. When I buy the Vanguard REIT Index Fund I own a piece of something like 120 REITs each of which owns hundreds of properties. When I buy into a syndicated real estate investment, there's just one property. That means it's on me to research if it is a good deal or not and if I'm wrong, I pay the price. But the more of these I buy, in a search for diversification, the smaller the amount I can put into each one, and the larger a hassle it becomes.
I thought it might be interesting to do a post on our actual investment properties and compare the expected returns to what we have actually seen. You really have two options with regards to syndicated properties- you can go through a crowdfunding website, like RealtyShares, RealtyMogul, of Fundrise (among dozens of others with a new one every month) or you can go directly to the real estate firm putting together the deal. The benefits of the crowdfunded sites are that you can look at multiple deals easily and can diversify between real estate firms, you have somebody else helping you vet the deals, and the minimums are generally lower ($2-20K.) Going directly to a real estate firm cuts out the middle man (and his fees) but the vetting is all on you and the minimums are generally higher ($50K is typical.) Mostly due to the minimums, most of our current real estate investments are with crowdfunded sites, but we continue to evaluate direct deals from real estate firms and will probably invest more in them in the future.
Our Partnership Office Building
My physician partnership now includes about 150 doctors. We have a business office in downtown Salt Lake City where our CEO and other non-provider employees work. The physicians own the building through a partnership LLC. When I became partner, I was offered the opportunity to buy 0, 1, or 2 shares. But the year I bought in they were allowing new partners to buy in at the lower original price rather than the higher current value. I'm no dummy, so I bought the maximum two shares. I then suggested they refinance the mortgage to a lower rate, which for some reason they had not yet done. Bottom line, we've owned these shares for almost 2 1/2 years and have a return of 12.01% on them.
Indianapolis Apartment Complex
Our first crowdfunded investment was through RealtyMogul, who has advertised on the site and sponsored the scholarship, back in November 2014. [Update: Since writing this piece, I've also brought them on as an affiliate advertiser. So if you sign up through this link, it helps support the site.] The minimum was a bit higher than the $10K we put in, but we got a break for our business relationship. The property was an apartment complex in Indianapolis. The plan was to fix up the units over the first year or two and increase the rents substantially, then sell after 5-7 years. They estimated a 5-7 year holding period, a 7-12% cash on cash return, and a 15-16% overall return. It's hard to tell what my shares are currently worth, since the Realty Mogul Dashboard still says they're worth $10K and as far as I know no one has appraised it since purchase, but my K-1 states there was a loss of nearly $3K in 2015. Some of that is probably money invested in the apartment upgrades and some of it is depreciation (in some ways just a paper loss) so it is hard to tell what my investment is really worth right now. Meanwhile, it has kicked out $610.45 in distributions, which is obviously less than a 7-12% cash on cash return. If you assume my investment is still $10K, as the dashboard states, then my current annualized return on this investment is 4.68%. If you assume my investment is now worth the $6,750 my K-1 says it is, then my return annualizes to -21.17%. Either way, there's nothing I can do about it for 5 more years, so I'll be hanging tight and let you know how it goes.
Salt Lake City Apartment Building
My next investment is via Fundrise in July of 2015. We put in the minimum $5K investment. It is a hole in Salt Lake City, only a block away from my partnership office building. I say hole, because that's literally what it looked like the last time I drove by it. They demolished what was on the site and are building an apartment building from the ground up. The plan is to build it up over 14 months, lease it out, rent it for a couple of years, and then “exit via refinancing.” Our shares have a preferred equity position with a 14% projected return. Construction is reportedly “on-track” and so far it has paid us $313.72, so assuming our shares are still worth $5K, that's an annualized return of 9.31%.
Our next investment is a $2,000 debt investment via RealtyShares in a single family home in Merrick, NY in July of 2015. It pays 9%, is supposed to last one year, and I am in “first-lien” position so we can foreclose if we're not paid. So far every payment has been made in full, so our annualized return is 9.16%. I kind of like these investments. They fill very quickly, return about what you can get on a peer to peer loan portfolio (9-11%), and yet are secured by a property that can be foreclosed on. It's obviously terribly tax-inefficient, but I may eventually dedicate a bit of a self-directed Roth IRA to them. For now, I'll just pay the taxes due on the $15 that shows up in my checking account each month.
My Grocery Store
Our next investment is also via RealtyShares, but it is super-local. It's a strip mall and grocery store we frequent, about a mile from the house. It's a great neighborhood, the parking lot is always full, and we personally know people trying to move their businesses into it. It is a 5 year equity investment with projected returns of 16-20%. We invested $5K in December 2015 and have only gotten one $50 payment from it so far, for an annualized return of 3.53%.
My newest investment, in April of 2016, is $30K in an LLC that owns one of the hospitals I work with. This investment actually violates one of my rules-never invest in something where all the other investors are physicians. Technically, we're investing alongside the hospital corporation. It's an “absolute lease” (better than net-net-net) where the hospital corporation pays for everything and pays us a guaranteed rent. We're locked in for five years, then can cash out if we like. The investment will yield just a little better than 7% and the rent contract says the rent goes up with CPI up to 2.5% per year. It's not an awesome deal, I expect long-term returns around 9%, but I like being on the inside when it comes to seeing how the hospital is doing and it makes our group a little harder to fire as the corporation would have to buy us all out at once since we would no longer be on staff. [Update: This investment ended up not getting off the ground. Bummer.]
Our overall returns on the non-REIT, real estate portfolio annualizes to 9.59%, which is obviously better than our stocks have done over the last year. Including REITs, our real estate investments make up about 10% of our portfolio right now and about 2/3 of that is REITs. As you can probably tell, I'm still dabbling a bit with these crowdfunded investments. Part of that is what I did with Peer to Peer Loans, where I started slow, but part of it is simply that we have so much tax-protected space available to us–I'm not going to pass up a 401(k) contribution in order to buy some property. I view the 401(k) invested in index funds as the serious money and the crowdfunded real estate as the fun/speculative money. So we're limited to the money going into our taxable account every year, which is much smaller than what goes into tax-protected. Plus, we're prioritizing our mortgage payoff fund lately, so that limits how much we have available to invest in syndicated real estate. It is fun to be able to easily drive by four of the six properties though. Next time you're in town swing by and I'll show you the empire!
So what will our real estate empire look like in the future? Well, it partially depends on how these syndicated investments turn out, but as I mentioned earlier, I'd like to eventually move from 10% to 20% of the portfolio in real estate. It is possible we'll do some direct property ownership again in the future, especially as a way to get our kids involved. But the property would be nearby and it would be purchased as an investment from the beginning. More likely, if the syndicated investments go well, and especially if more 1031 exchange eligible syndicated investments become available (RealtyMogul is starting to advertise more and more of these) we'll stick mostly with that route. Perhaps eventually it will look like this:
- 5% REITs
- 5% Real-estate related debt investments
- 5% Residential syndicated
- 5% Commercial syndicated
But we'll see. We're in no rush.
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What do you think? Do you invest in real estate? How do you do it-REITs, direct, syndicated, or something else? What returns have you seen? What percent of your portfolio do you have in real estate? How did you decide that? Comment below!