One of the most significant downsides of private real estate deals (and other “alternative” investments) such as private funds and syndications is their illiquidity. While one of the goals in investing in these types of investments is to get paid for taking on that illiquidity, it makes it tough when things aren't going well. In fact, a large percentage of these deals, even those with a solid return afterward, will have a hiccup or two along the way that you will have to ride out. Let me give you a few examples I have encountered with my own personal investments.
Lending Club and Prosper
This one isn't real estate, but I thought it was worth including because it is an illiquid investment, the main subject of this post. I started investing in peer to peer loans in 2012. While yields were insanely high (15-30%), defaults were also substantial so I generally had solid 8-13% returns. I later decided I didn't like the platform risk nor the unsecured nature of the loans (especially when I could get loans with similar returns with real estate collateral in first lien position.) So I decided to get out.
Well, the problem was I had a portfolio of 3-5 year loans (technically notes). Lending Club had a mechanism to sell notes on a secondary market, but it turned out to be a fairly thinly traded market. It took me 2 1/2 years to liquidate, despite taking small losses on many of the notes. About the same time, Prosper decided they weren't going to let you sell loans at all. I've still got $22 invested there and will for yet another 15 months. My overall returns were fine, but the opportunity cost and hassle of gradually liquidating and reinvesting an investment is annoying to deal with.
AlphaFlow Decides It Doesn't Like Individual Investors
Something similar happened recently with a company called AlphaFlow. One of the big hassles of investing in real estate debt (usually loaning money to house flippers) via the crowdfunding sites is the need to vet the deals, manage all the cash flow, and diversify the investment. Along comes Alpha Flow, technically an RIA charging 1%, that takes a lump sum from you and spreads it across dozens of loans, reinvesting the earnings as you go. I invested $20K as part of my real estate debt allocation and have been enjoying 7.5% returns after fees.
Well, AlphaFlow has decided it wasn't actually profitable to serve individual investors like me so now they're focusing purely on institutional investors. Basically, they're not reinvesting any of the cash coming out of the notes as they pay their yields and mature. Unfortunately, I've got notes as long as 11 months still in there, so I'll be getting cash in drips and drabs over the next 11 months to reinvest elsewhere. Not the end of the world, but definitely not my favorite way to end an investment. At least it won't take 2 1/2 years this time.
Broadmark Decides to Go Public
Another investment I really liked was a private real estate debt fund run by Broadmark, which lends money to developers in Utah and Colorado. When the 199A deduction came out, they changed their structure from a fund to a REIT. That's probably a good thing for those of us who were investing in a taxable account as 20% of the income was no longer taxable due to the 199A deduction. However, they then decided they wanted to go public. As I write this it is unclear if the proxy vote will clear the path for that or not (I suspect it will) and it is certainly unclear if the market will judge the company to ultimately be worth more or less than its Initial Public Offer (IPO) price.
[Update prior to publication: The vote passed. The company did go public and it is up a little bit since then. Interestingly, because I voted against the merger I was given the right (due to WA state law) to sell the stock at the original price until December 20th, essentially a free put. Now I've got to decide whether to sell now for a short term gain or wait a year. Given my abundance of capital losses from tax loss harvesting, I think I'm inclined to sell sooner rather than later and diversify.]
My Fund That Flip Loan
Before I gradually transitioned from individual deals to funds, I had a few small loans I made on the crowdfunded sites like RealtyShares, PeerStreet, and Fund that Flip. To be fair, unlike some investors, I've gotten back every dollar I've invested in those as well as every penny of interest I was owed. Usually on time, sometimes early, and occasionally late.
My last remaining investment, however, was a 1 year, 10%, $5K loan made via Fund that Flip. I am currently 26 months into that 12-month loan and the project is still only 75% complete. To be fair, I am still getting paid that 10% interest (several payments were a little late and I got paid a fee to extend the loan), but if someone really needed their money back in 12 months, the illiquidity of this investment could be a big problem.
Origin Fund III Takes its Time Calling Capital
I committed $100K to Origin Fund 3. They take their time calling the capital, only investing when they have a good opportunity. I appreciate that (so I can remain fully invested elsewhere rather than having cash sitting around), but many investors may have been surprised to see just how long it took to become fully invested. The fund's first investment was in July 2016. I started investing in October 2017 and here we are in December 2019 and the last of my capital has just been called this week. The investment seems to be doing just fine, but my point in including them here is to discuss the illiquidity with these investments. You make a commitment up front and then you're stuck with it for years–both contributing capital and getting your capital back.
My Indianapolis Apartment Building
I was going over my investment spreadsheet lately and checked on my Indianapolis Apartment Building ($10K purchased through crowdfunding site RealtyMogul) and noticed that I didn't get a payment in August like I usually do (they've been coming twice a year.) And February's payment wasn't anything to write home about either. So I decided I better pay a little more attention to their recent notices and see what's going on. As a reminder, this is a 5-7 year equity, value-add investment in an apartment complex. This month I'm 5 years into it. Well, here's the latest updates. First from the Spring:
It looks like even the pros hire bad property managers sometimes. I've never been a Class B Apartment manager, but apparently 54% retention is pretty typical. Obviously 88% occupancy is a little on the low side. But with income per unit increasing and expenses decreasing, things seem pretty positive. Then I get this in the Fall.
Okay, that sounds good, right? Occupancy up, collections up, rent up, NOI up. But no distribution. What happened?
Ugh. The cash got eaten up again. This property has been a chronic underperformer, at least compared to the proforma. Take a look at the most recent charts (I actually love the format of RealtyMogul's charts, even if I don't like what they're telling me):
My XIRR verifies their cash on cash return of 4.4% annualized. Not quite the 7.3% I expected. Now it's hard to make any final judgments before the round trip, but it seems unlikely that this one will hit the proforma IRR of 15.5%, although I doubt I'll lose money. Stay tuned!
I share this experience to point out that once the decision to invest is made, all you can do is hold on for the ride. When things are going well, that means you're not getting 3 am toilet calls and all you have to do is collect your mailbox money twice a year. When things aren't going well, there's no mailbox money and you wonder how much of your capital you will get back. As was carefully explained in the subscription document:
They really do mean it when they say that.
My Houston Apartment Building
I have a $20K preferred equity position in an apartment building in Houston through Equity Multiple, one of the sponsors at the recent PIMDCON. I bought in almost two years ago and everything was hunky-dory. The plan was to provide investors a 10% preferred return and then another 5% return upon sale in 3 years.
Okay, did you get all that? It was 86% occupied, it was going to be thoroughly renovated and rents raised, and then sold or refinanced in 3 years, paying me off and providing a 10-15% return. So what happened?
Well, all through 2018 I got my monthly payments like clockwork. Then all of a sudden they stopped at the end of 2018. If you read the updates, the occupancy dropped to 75% early in 2018 as renovation proceeded. Then later that year, I get this update:
In case it isn't clear, notices like that are bad when it comes to real estate investing. Now you would think the place was hit by a hurricane, but Hurricane Harvey occurred in August 2017, 4 months before I bought in. But either way, the renovation is not going well. The sponsor may have intended to “advance funds”, but it actually hasn't “advanced funds” in 2019 at all.
This is what I got early in 2019:
While I guess it is good to see EquityMultiple in there mixing it up trying to get me a better return, the fact that they had to is a pretty bad sign. Occupancy dropped from 74% to 59% between Q1 and Q2 (weird that no one wants to live in a construction zone), when this update came out:
Yup. Plenty of cash. We're covering expenses and paying the mortgage. But guess who gets paid after the mortgage? That's right. Me. And there's no cash flow left for me. Payments are now 11 months behind. I'm not nearly as optimistic as Equity Multiple about getting my 10% preferred return out of this, much less that 15%. In fact, I'm starting to worry a bit about my capital too. So I'm using this to demonstrate what a deal going bad looks like. Again, there is absolutely nothing I can do about it but hold on for the ride. No liquidity whatsoever. We'll see what happens in a year.
My Fort Worth Apartment Building
This one was purchased directly via syndicator 37th Parallel. A substantial investment for me at $100K, I'm about 20 months into it. My first three quarterly distributions were $1,243-$1,299, suggesting about a 5% cash on cash return. But the last two were only $671-676. What happened? Well, these are their explanations:
High supply and high property taxes.
High supply and a new manager.
My point of sharing this experience isn't that this is necessarily a bad investment. I certainly don't need this income and am in this one for the long haul hoping for a solid long term return. My point is that real estate income varies. If you were counting on income like this to live off of, you would need to be able to vary your spending accordingly. Once more, it really doesn't matter what the income is or what the explanations for it are. I'm stuck for a decade–good, bad, or ugly. It's very passive at this point, for better or for worse.
A Few Words of Advice
Most who read this will see a cautionary tale. Certainly, I am big on people understanding the risk they are taking with their investments and ensuring those are risks they are capable of handling. And it is only natural to expect the subscription documents to paint a fairly rosy picture of future performance.
But despite the hiccups seen above (even without any sort of general economic or real estate downturn), I still like investing in real estate and plan to do so going forward. Of the 21 private real estate investments I have invested in, 11 have gone round trip (1 equity, 1 preferred equity, and 9 debt.) I have received every penny of my principal back AND all expected returns from those 11 investments. The equity investments send me sometimes surprisingly high amounts of depreciation on the K-1s to shelter that income. But once you invest, these investments are totally passive, for better or for worse, and there is no liquidity.
There are other options. In 2019 and really over the last few years, those options did great. On the day I write this in early November, the Vanguard REIT ETF (equity REITs) is up 28.66% year to date (13.08% over the last decade) and the iShares Mortgage REIT Capped ETF (debt REITs) is up 15.44% year to date (8.61% over the last decade), all with daily liquidity. But they are terribly tax-inefficient and certainly subject to the whims of the overall stock market.
The choice is yours really, and truthfully most doctors with a halfway decent savings rate don't need to invest in real estate at all to be successful. But if you choose to go the private route, be prepared to buy and hold, because you won't have any other choice.
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What do you think? Does the illiquidity of private real estate deals bother you? Do you think it is worth it? Comment below!
Featured Real Estate Partners
Thanks for sharing.
The details are always what matter and they are hard to come by from colleagues and books.
Your conclusion is patience is required since this investing is illiquid. That is true.
But maybe crowdsourcing, high-return debt lending, complexity, far away places, and syndications you can’t control are part of the problem? Waiting and time might not magically correct all of those issues. Only time will tell for your portfolio. And for mine. I don’t know what the future holds. I have real estate along the entire spectrum of residential and some commercial. The ones I can control the most are the “real” real estate that I actually own outright.
Maybe Dr. Cory S. Fawcett is right? He seemed to have a lot of control over management, costs, and time to sell. He currently can live off the rental income in his early retirement. It is hard to argue with success.
Since Ken hasn’t commented yet, I will do that for him. “BOGLE & MALKIEL ONLY. SAVE. INVEST. LOW-COST INDEX FUNDS. FORGET THE REST”
As I’ve always said, it’s optional. Certainly a doc can retire without ever investing in real estate at all. Certainly one can do just fine investing only in investments that can be traded daily. But the question you must ask yourself is if you could have a higher after-tax return by giving up some liquidity, how much would you give up?
Why would there NOT be an illiquidity premium?
Has the overall return on the 11 investments been that much higher to balance the lack of liquidity?
Difficult to say. How many years would you say is a fair period to compare? Certainly this year publicly traded REITs trounced just about anything. The Vanguard REIT index fund is up 28% YTD. On the debt side, the iShares ETF REM is up 17.38% this year. But if you look at 5 year returns, REM is up 7.98%. My Broadmark fund did something like 11% over that time period. I think a 3% higher return is enough compensation for me. But my Arixa fund is below 7.98%.
Really I think any fair head to head comparison probably requires more time than I’ve been investing in private investments.
Some syndications allow you to sell your interest to other participants in the syndication. Some allow you to sell your interest to outside participants. It depends on how it is set up. Fundrise has solved some of this problem by allowing you to get out of it, although at a slight discount if done early. There is a company called “Quick Liquidity” that can buy your interest in the syndication if the fine print states that this is allowed. There is a market for Tenant In Common Interests (TIC) that allows supposedly illiquid TIC interests to be sold for cash. All that said, the price is typically not favorable for the seller and many syndications do not allow this. Enjoyed the update very much and yesterday’s podcast as well.
It looks like it is hard to adequately diversify unless you have a real ton of money. To the point that you are trying to make not every deal is as rosy as it claims it will be so having a wide variety of then can help if you have some losers. Also real estate and the market in general have been booming this past decade. Who knows what will happen when things slow down. If a fund cannot meet expectations now I would hate to think what it would have done in 2008.
If the market tanks I have enough “faith” in vtsax to hold the course and wait it out. Avoiding selling low. I wonder how many people have that same ability to stay the course with one of these much smaller deals during rough times.
Fantastic insights. How much does learning about these investments so that you can write about them play into your choice of investing? Either way that’s for doing the work for us!
Whether they have the faith or not, it doesn’t matter. They can’t sell out because they can’t. Some would argue that’s an advantage. I don’t buy that though. You’re right though that investments like these got hammered in 2008.
I think for me the capital call period of waiting is the hard part as once I make a commitment I feel that money is tied up in a low risk low return savings account. But I have rationalized this away by deciding that a long capital call period is a sign that the syndicator is doing due diligence and just not buying up properties just for the sake of buying and having a lot of capital to tap.
I have diversified among several syndicators and several individual offerings and hopefully if one asset has a hiccup (I am in the same investment you are in that 37th Parallel example) the others pick up the slack.
As mentioned above, there are some options to get out if financial hardship strikes. Typically you can sell out to other investors in most deals.
I avoid that by staying fully invested elsewhere and meet capital calls from current income. That of course limits how much capital you can commit to the investment.
I agree with you that I don’t have a problem with a long capital call period or even if the capital isn’t called at all. A little inconvenient if you’re not sure what the period will be up front, but beats bad investments.
My biggest illiquidity problem isn’t these investments anyway. It’s my own businesses!
There is an interesting common denominator in all these deals: They are short term speculating in real estate. I’m not a big fan of speculating. Buying an apartment with the notion of selling in in three years is not a great plan for my retirement. Then I have to invest the money again. Kind of like having a job. I tend to think of real estate investing as purchasing a property that I plan to have for several decades of cash flow and appreciation, and real estate speculating as something I’m planing to cash in after doing something to improve the place over just a few years. Speculating caries a much greater risk. This is part of the reason I don’t advise people to buy a home they will live in for less than five years. They are speculating. This list of things in this article are eight places you put a small amount of money into speculating. That is a lot of extra work to follow and vet eight deals. A different alternative might have been to pool that money and make one real estate investment that you will have for many years. Seems a lot like the difference in owning eight individual stocks vs one index fund. Although the diversity issue would be different. Best of luck as you wait out the results. I’ve been in your shoes with non-liquid assets that I don’t control. I hope they all come in as planned.
Dr. Cory S. Fawcett
Prescription for Financial Success
BS. A 10 year fund is far from a short-term speculation. Loaning money for a 6 or 12 month flip is far from a speculation. Give me a break. That’s the same old nonsense you hear from anyone “if you don’t do it exactly the way I do it you’re doing it wrong.” It’s nonsense. There’s no requirement to hold a property for 60 years for it to not be a speculation.
There is nothing wrong with speculation. Speculators provide liquidity to markets and help set prices.
My concern is not the dirty word of speculation but rather whether the time and effort are worth it.
For WCI, part of the return is giving him interesting things to write about and drive business to his blog. For someone without a blog but with his resources I would think this only worth it if most of the dollar amounts were at least an order of magnitude higher. As it is, it seems a very small part of the portfolio demands a large share of attention. Not clear that this is any better than just buying a REIT fund.
If the $100k investments were typical of the deals pursued I could at least see the point. $5k and $10k investments seem a waste of time. Say you managed a 2% higher annual return on a $10,000 investment. That is an extra $200. How far into a shift in the ED do you have to go to make $200? With no risk of losing money?
For someone who has or is willing to develop the expertise to evaluate real estate deals, this may pay off. But you need to have the time and inclination to learn how. Then you need to spend more time investigating potential deals. You may have to travel around the country inspecting sites. If you focus on the area where you live you can hope your greater knowledge will compensate for the loss of geographic diversity.
But to go through all of this for small deals does not appear remotely worth it.
When I think of speculation I think of Bitcoin, not a 10 year real estate fund.
I agree this 15% of my portfolio takes up the vast majority of time spent on the portfolio. Great criticism. Certainly wasn’t better than a REIT fund this year, REITS did great.
Bear in mind these are relatively long term investments. So when I was investing $5-10K a few years ago, that was a significant amount of money to me. What was $10K back then is perhaps $100K now as far as affecting my personal finances. Maybe in 5-10 years when these investments go round trip $100K will seem like chump change to me.
” Of the 21 private real estate investments I have invested in, 11 have gone round trip (1 equity, 1 preferred equity, and 9 debt.) I have received every penny of my principal back AND all expected returns from those 11 investments.”
If just one of the remaining 10 investments become a complete loss, it will wipe out the gains on the other 20. Ask me how I know. I had 2 go bankrupt with no recourse and lost my entire principal. The others have at least made money, although many well below proforma.
What investments did you make that you had a complete loss? How much were they leveraged?
Both were small subdivisions of higher end single family houses. One in the suburbs of Chicago and one in the suburbs of NYC (in CT). The original LTV was around 70%, but the high end housing markets in both area apparently weren’t performing well, there was a primary lender ahead of us, and potential shenanigans from the borrowers. Both were through Realty Shares. I did have 4 other investments on that site that went fine.
That stinks. Sorry to hear it.
It seems like lack of control over the investments is a bigger problem than the lack of liquidity. All of the deals involves multiple investors (crowdfunding, REIT, private equity) where you’re taking a junior position (or no enforceable position at all) with the investments being fully managed by someone else. That’s great for being hands-off, but poor for forcing changes such as actually paying back loans or issuing distributions.
All the hard money loans I took were funded by individuals. We both knew perfectly well that a loan default meant the investor could take the property in any state of repair and either finish it themselves or sell it to another investor as-is. The process isn’t particularly expensive or time consuming. When you’re lending against 60 – 70% LTV, the project really has to go off the rails for the investor to lose any capital much less have it tied up for a significant amount of time (12+ months). Hands-on RE is time consuming, but offers far greater control with better ownership rights.
Too many moving parts in the syndicated deals for my taste.
Yes, you definitely have a loss of control. No doubt about it. You also have a lack fo work. Control = work. How much control do you want? You can have as much as you want. Just go buy an apartment complex down the street. You can manage it, you can do the maintenance etc.
But it’s really about finding your place on the spectrum. I’m maxed out between my practice and my online businesses. I don’t have the bandwidth to manage real estate in any sort of active way. If that costs me some money, so be it, I’ll more than make up for it elsewhere.
I like to control my own dirt, but that’s just me. I know too many fast talking real estate fund developers. And the more I understand about how buildings work, how plumbing, electrical and HVAC systems work, how tenant functions work, how financing and property improvements work, I find my niche. There is a lot of room in the real estate market for smart, ethical, kind and “long haul” folks to make money. Because there are a lot of opposite types of people trying to do it. Be good and you will stand out. I love the sense of pride in my company, the creation of homes for people which they love, the development of community (which is so sorely lacking now, like water to a desert), and the dollars accumulating on the paper while I do that. It’s a good business.
That’s exactly the right attitude for an active investor–that you’re running a business that provides housing to people. The issue is what is the best way to get the returns of this great investment without actually running that business.
Agree. Additionally, if someone thinks their 10-year plan is out and real estate, I do think having at least one or two pieces of real estate to manage to practice on is a good thing. It is encouraging how much can be learned when a plumbing part goes out. There are people with advanced degrees in building construction or management who have excellent online videos demonstrating the science of a building, very fun. I get that breakdowns will usually happen at the wrong time, but even if not actively doing medicine, this is true, too. It’s also amazing how fast properties pay themselves off or with 2 or 3 properties – how the accumulated cash flow can combine to create paid off properties in just a matter of a few years. Good luck, either way!
I wanted to share my experience with these deals, and it would be interesting to see what others have found with these. I have done 3 deals with Equity Multiple, and so far, all 3 have under performed the pro forma. Only one has come full circle. It was an equity deal with a projected IRR of 17%. I invested 10k. After 6 mos, the deal ended as the Sponsors had some internal issues and sold their company. I did get my principal back + $200 for a 4% annual rate of return. Not awesome.
The 2nd and 3rd deals are faring worse. They are both involved in litigation (multiple parties all laying claim to the assets) with interest payments suspended and I am worried that I won’t get my capital back. Maybe I just have bad luck here? It’s definitely nice to hear the WCI experience, but it would be nice to get even more data on these things. My N of 3 hasn’t turned out so hot.
Needless to say, I agree with the some of the above comments that doctors don’t have to take these chances, there IS work involved in trying to do due diligence on these (for what it was worth) and the lack of control is frustrating. The bottom line though is, how many of these are working out for folks?
I think this WCI quote is very appropriate for investing in these syndicated real estate deals: “The more I learn about investing, the more I realize it is about controlling risk and accepting the returns you get than it is about chasing the returns you want and accepting the risk you get”
I find it interesting you have had so many hardships. I think it is also interesting that with the advent of being able to invest in crowdfunding may have actually amplified these types of transactions to be more risky. In the past, lets say 50-70 years, you would generally have a small group of people, typically you have a financial advisor putting together a deal with a realtor or a real estate investor and the two people partner to find clients to fund a deal. This is a much more personal approach, yes, you can still lose money, but at least you know who is accountable and you shook their hand.
I am more aligned with Kelly, and the other type of people that want to control their own dirt and bricks. I would never invest in a crowdfunded sourced investment, the risk of diversifying across 20 investments with $15k in each with unknown people in unknown areas is too high of a risk, I would much rather own a $1M investment property within a 30min-2hr drive and hire the right property management firm and build that relationship. I would also consider investing with people I know and have known to be successful over the long haul.
Not sure “hardship” is the right word here. I’m simply pointing out how lots of these investments go and issues being illiquid could cause for you. I’m pretty happy with the performance of the real estate section of my portfolio.
If you want to shake hands, you can go out and meet the GPs face to face. I know some of mine personally and don’t know others except by phone or email.
There are risks to putting all your real state money into a single property too. That’s the fun thing about investing- you get to choose the risks you will take.
I agree that as the space becomes more occupied by platforms looking to finance deals, there are likely fewer and fewer good deals out there, but the pressure to find the deals doesn’t stop. It’s easy to take risks with someone else’s money.