We have had four guest posts this week about real estate private placements that have given us all a lot to think about with respect to private placement investments. Physicians and other highly paid professionals, the targeted audience of this website, by virtue of their income and sometimes by virtue of their net worth, are generally considered “accredited investors.” This is defined by the SEC as someone with an income of $200K or more in each of two previous years, an income combined with their spouse of $300K or more in each of two previous years, or a net worth of at least $1 Million not including the personal residence. They don't actually specify what income is, but if you just use gross income at least half of physicians would qualify. The assumption, which in my opinion isn't justified at all, is that someone who can make that much money in a single year or who can amass that kind of net worth, is intelligent enough to be able to tell a good investment from a bad investment. Perhaps more importantly, the SEC knows that the general public isn't going to get upset when a group of rich docs loses all their money on a speculative investment.
Physician Private Investments
Many doctors are already involved in private investments of some type or another. Lots of radiologists own imaging centers. Plenty of surgeons own surgical centers. My hospital has a syndicated offering whereby physicians on the medical staff can buy shares and participate in hospital profits. Via an LLC, I own part of the building from which our partnership runs its business affairs. None of these investments is available to the general public. They aren't traded on a stock exchange and you can't look up their price each day in the Wall Street Journal. That doesn't necessarily make them bad investments. Each has to be evaluated on its individual merits.
Attractive Aspects of Private Placements
I find privately placed investments very attractive for several reasons. First, the market isn't particularly efficient. The stock market might not be completely efficient, but it's close enough that investing in it as if it were is probably the best course of action. You're just not going to know more about what the price of Apple shares ought to be than all the other people analyzing it. But when there are only a few investors looking at an investment, there's some real opportunity to use skill and knowledge to improve your returns.
Second, most of these investment opportunities are fairly passive. Rather than buying the triplex down the street, I get to just send my money in to the sponsor/manager and wait for the checks to show up in the mailbox. Yes, there is some due diligence required, especially up-front, but there aren't any toilets to fix or investment news to monitor on a regular basis.
Third, I've always said that I don't need all the liquidity I have. I could pretty much take 90%+ of my investments to cash this afternoon if I needed to. But most of this money I won't spend for 20, 30, or more years. If there were a way to get paid for it, I'd be more than willing to give up some liquidity. Privately placed investments generally have much less liquidity than public offerings. I don't mind that as long as I'm appropriately compensated for it. In fact, I am willing to seek it out as long as the compensation is there.
Fourth, I'm probably never going to be a real estate guru. If the return/risk proposition is favorable, I don't have a problem with a true expert making good money so long as I'm making good money. It's still true that every dollar spent on investment expenses and fees comes directly out of my return, but the goal in investing isn't to get the lowest average expense ratio, it's to reach your investment goals, and you can get to them faster using investments with a higher after-expense, after-tax return (for the degree of risk taken.)
Fifth, diversification is an important principle of investing. Many private investments wouldn't seem to necessarily have much correlation with the overall stock, bond, and real estate markets. All real estate is local. Condos in Florida perform very differently from single family homes in Detroit and duplexes in Dallas. It cannot be a bad thing to have more investments that zig when others are zagging.
Sixth, there are some behavioral finance advantages to a private investment in that it isn't revalued every day. Right now, I have no idea what my investment in my partnership's office building is worth. It only gets revalued once a year. There is zero temptation to sell it due to what some talking head on CNBC is saying or what I read in The Economist. It is easier to “tune out the noise” on privately placed investments since there is so much less noise to begin with.
Unattractive Aspects of Private Placements
There are a few unattractive aspects of private placements. The most significant for me is that there seem to be lots of scammers (and business idiots as noted in one of Mr. Reynold's posts) operating in this area. While there are bad apples in public companies such as Enron as well, that risk is easy to virtually eliminate by investing through index funds. With a privately placed investment, this risk cannot be eliminated, only managed. To manage it well (doing appropriate due diligence) requires significant time, significant money, and significant expertise. The SEC might think you're an accredited investor, but you'd darn well make sure you really are before heading down this road. Flying out to meet the important people in the firm and visiting the properties would be a good first start. Paying a few thousand for background checks would also be a good idea. Talking to investors in previous deals seems appropriate. Actually reading the entire prospectus/offering document and discussing it with appropriate advisors is also an important step.
Taylor Larimore, author of The Bogleheads Guide To Investing, is fond of saying “There are many roads to Dublin.” Well, the motorway to Dublin is well-traveled and safe and you're essentially guaranteed to get your Guinness eventually if you stay on it. You might get there a little faster by taking a shortcut from time to time, but getting off the motorway is probably more often a bad idea than a good one. The motorway is a fixed asset allocation composed of low-cost index funds, rebalanced regularly, and contributed to regularly with ongoing earnings. There is little doubt in my mind that “Boglehead-style” investing ought to be the default method of investing and you ought to have a darn good reason to “leave the motorway to take a shortcut” in private placements. It might work out well, but you might also end up wasting a lot of precious time on two-lane carriageways.
The second issue I have with private placements is that you're generally taking on fairly concentrated risk. Rather than purchasing a REIT, which invests in dozens of properties, or a REIT index fund, which invests in dozens of REITs, you are putting $10,000 to $100,000 or more into a single property or even unit, which likely isn't even in your town. There are two approaches to investing that can both work well. The first is to not put all your eggs in the same basket. The second is to put them all in one basket and watch it very carefully. It's easy to see which this is. Even if the returns, on average, for this type of investment are higher, it doesn't take very many of them blowing up to cause you to have wasted all your time and effort messing around off “the motorway.”
No Called Strikes
Warren Buffett is fond of saying that there are no called strikes in investing. You don't have to swing at every pitch. In fact, you don't have to swing at any of them. You might not know of very many of these private investments, but I assure you there are plenty of them out there. I think I've had 6 or more come across my virtual desk this year already. I haven't swung at any of them. Have I missed some good opportunities? Probably. But I haven't lost anything. The money sitting “on the motorway” in my plain old boring index fund portfolio is up something like 15% year to date. I feel plenty comfortable watching pitch after pitch go by until I see a nice fat, juicy one to swing at. I also get to use the time and effort that would have been required to evaluate them properly riding my mountain bike, which is a heck of a lot more fun.
Hesitant To Pass On Guaranteed Tax Breaks
I'm also hesitant to pass on the tax breaks available in my Roth IRAs, my 401Ks, my defined benefit plan, 529s, and my HSA. I'm lucky to be able to put 25%+ of my income into these vehicles so they can grow in a tax-protected manner and provide some tax rate arbitrage between my marginal rate now and my effective rate in retirement. Retirement accounts also keep my portfolio simple, provide needed asset protection, and facilitate estate planning easily. While it is possible to invest in privately placed investments through tax-protected accounts (my Lending Club investments are primarily in a Roth IRA), it does add some additional complexity and cost. Plus, you often lose out on some of the tax breaks that make investing in real estate attractive in the first place. Since it is difficult for me to save much more than I can stuff into all these accounts, and most privately placed investments require a decent chunk of change just to get in ($50,000 is typical), I pass on a lot of them simply because I don't have the cash at this point in my life!
I hope you enjoyed this series and found it helpful. If you are interested in learning more about real estate, I would recommend checking out WCI's 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.
Please share your experiences and thoughts on private placements in the comments section.
I have a friend who runs a private equity REIT. I consider him to be a very honest businessman. However, he certainly lives the high life. Where do you think his money is coming from?
The investors are taking all the risk and being charged high fees for the privilege.
Are you looking to add more investment positions after your experience owning part of your business building? What led you to invest in that initially?
My ownership of the building is completely passive and it has a great tenant. If the rent is set too low, the tenant (my partnership) does a little better. If the rent is set too high, my investment does a little better. Win-Win. Plus I was able to get the shares at the same price as some of my partners paid several years before, essentially a guaranteed 20% return upon purchasing. Too bad they only let me buy up to 2 shares.
I like having real estate in my portfolio, but very much dislike both the volatility of REITs, their current low yields, and most importantly their high correlation with the overall stock market. They’re really real estate flavored stock, and I’m just not convinced that is the best way for me to own real estate for the long term.
WCI…
I agree with you on REITS. Also have already maxed out all other avenues for retirement (401K, HSA, Roth, Wife’s Simple IRA) and of course contributing a lot to 529 plan for my child (and hopefully future second child)…I have high amounts of disability and term life insurance. However, since my wife has a decent income and we live fairly frugally given our level of income, we have “cash left over”. I’m not complaining, as its a nice place to finally be in but have been sitting on the fence as to what to do with the rest. I have been deciding between 3 or 4 avenues for the extra cash. 1. Taxable Index Funds/accounts 2. Life Insurance (live in Texas and it is therefore less available to creditors/lawyers) 3. Private Investments such as private real estate, Fractional real estate, or Oil Royalty investment (would love a post on this) or 4. Paying down student loan debt (it’s hard to wanna pay this down when I’m only paying 2%).
Since I already have a lot of money tied up in the market I am leaning toward staying away from taxable funds as I would like to diversify into an avenue that is less market dependent. I may be one of the 1% that you mention is OK for Life insurance, but that money seems to be market driven as well. Therefore, it seems to me I should consider branching out a little into a possibly more risky arena with some of the “left over”. What do you think?
I do want to point out that the dichotomy between “private placements” and “tax advantaged” is not entirely sound.
Many of my best investors invest funds from their IRA’s (both Roth and conventional),401(k)’s, etc. There is a requirement that these funds be transferred to a Third Party Administrator (or fund manager for 401(k)’s) who allows such choices (known as Self-Directed) but lots of such TPA’s are available.
So it is possible to be both Private Placements and Tax Advantaged.
I’ve found IRAs that are self-directed tend to have significantly higher fees than a typical IRA at Vanguard or Fidelity. Of course, depreciation and other tax benefits from investing in real estate essentially disappear when you invest with IRA money. So you’re trading some tax benefits for others.
I really enjoyed this series. If nothing else this information is useful for physicians trying to understand how private placements are typically structured when they are offered investment opportunities in ASCs, imaging centers etc.
I’m in a similar situation to John in that we have a dual physician income and have some extra capital available for investment after maxing out all of our tax sheltered options. This sounds like something to carefully consider.
I too am in a similar situation with the bulk of my retirement in the stock market…looking to diversify a bit into other types of investments. I have a couple of residential rental properties with great returns that I manage myself. I actually enjoy doing that but don’t have the time to manage any more of them, and the deals have dried up in my area. I have started looking into commercial real estate…seems like I could get more bang for the buck with more rent per tenant(fewer management hassles). Any docs out there who have successfully done this?
I did manage and develop a fair amount of Commercial real estate in my 30 years in the business (in fact almost all of the properties I did were Commercial since the standard definition includes all residential properties with more than 4 units).
“More bang for the buck” largely depends on a bunch of factors other than the residential/commercial dichotomy. Like Leverage, for example. It is possible to leverage residential Real Estate to 100% or more– with a lot of increased risk in the process.
Another way to get more bang is to invest in ways that Add Value. Unfortunately this also requires a lot more management time. Of course my self-interest says that the response to that is to partner with somebody who has that time and expertise and keep your activity closer to home where you are likely more highly compensated. Or turn over your existing houses to a management company and re-invest the time into some new units until those are at the point where you are willing to let someone else manage them.
Finally you can get a lot more Bang if you spend a lot of time chasing bargains. Same problem.
“More rent per tenant” is almost certainly true. If you do true Commercial tenants– and especially if you concentrate on Industrial/Warehouse tenants you will not only get a lot more rent per tenant they are also likely to pick up almost all of the property management expenses. The ultimate version of this is a triple-net commercial tenant where you start to look a lot like a banker collecting a monthly check. Unfortunately as management hassles go down so does “bang for the buck”. Five minutes of research looks like a AAA national tenant NNN lease goes for something between 4% and 7% CAP rates these days. So much for a lot of bang for your buck.
As an investment banker that specializes in the healthcare industry and who has consulted with over over a thousand physicians, I can understand the apprehension of investing in opportunities that are not generally available to the public, in this case real estate private placements. The notion of investing in an opportunity that seems “exclusive” with the potential of an exponential return can lead someone to believe that if it sounds to good to be true then it must be, particularly among physicians who are used to being courted all the time by third parties interested in their business (either directly or indirectly through their referrals). However, while I agree it is necessary for anyone who is considering investing in a private placement to conduct a thorough due diligence, I also think that physicians who qualify as accredited investors shouldn’t discount private placements as a viable way to diversify their portfolios, especially if its in an area in which they may have some knowledge or professional interest in such as medical device companies or bio-techs that are startups or looking to grow. My feeling is that if a physician was presented with an investment opportunity in a business with which they can relate to, they may be more inclined to take on some risks if doing so meant bringing to market a product or service that could benefit their patients or the healthcare community at large.
One of the critical things both authors left out of their posts is the importance of diversifying with PPM investments. On average, the long-term angel investor gets about 30-40% annual returns (solid numbers are very hard to come by) according to a recent comprehensive analysis by the Kaufman Foundation. Those are fantastic numbers and certainly in the ballpark from private tech investors that I know personally (both angels and VCs).
However, investing in a single PPM is like a buying a lottery ticket. Investing in five PPMs is like buying five lottery tickets. The most successful investors have participated in several DOZEN different investments. That’s a whole lot of cash on hand that you should absolutely be able to lose without any pain and suffering along with expecting zero liquidity for 7-10 years.
If you can afford to invest in ten deals (preferably 25+) simultaneously along with lengthy due diligence and intimate knowledge of the market space, you will likely enjoy fantastic returns with PPM deals. Anything else is pure speculation and you’ll get about the same results at any craps table.
I enjoyed reading this series and have come to a point in my financial life that I not only have considered but actually taken part in investing with a syndicator (which really was due to being a longtime reader of WCI and coming across posts by Dennis Bethel (NestEggRx) and his association with 37th Parallel (the syndicator).
I have built up a nice portfolio using the Boglehead method of passive index investing and even through in Vanguard REIT to have a little bit of real estate flair to it, but as most have already mentioned, REITS are really just real estate flavored stocks and still have a higher than wanted correlation to stocks in general and not getting as much diversification bang for the buck.
My radiologist partner has been accumulating a mini real estate empire of single family residences and always extols the benefits of owning real estate (particularly the tax advantages (depreciation, 1031 exchanges, possible legacy transfer to heirs with step up in cost basis, etc). However having had 2 prior condos that I tried to manage personally (subsequently lost in a divorce) where the cash flow was so minuscule compared to the headaches it generated and time involved, I really did not have the desire to become a landlord/property manager again.
However the posts by Dennis kind of inspired me to dip my toes in real estate again through fractional ownership. I did not take this step lightly as there was, as previously mentioned, high minimum investments needed to participate ($50k). But the more I read, the more I felt that this was my best chance to have a true real estate allocation to my portfolio with essentially passive income (granted this comes at a price due to fees, etc).
Hopefully this is indeed a great way to take advantage of tax breaks and build a completely passive income stream. It is too early to tell with my initial investment (less than 1 month) but if it does seem to produce along the lines the proposed, I think I may allocate a larger percentage of my future investments into this (it would be nice to be able to do what Dennis did and retire early living off positive cash flow from real estate investments without ever having to touch principal).
I am curious if anyone out there has invested with Dennis/37th Parallel and if so was it positive experience or not.
I don’t think Dennis is retired. I think he’s working for 37th parallel instead of seeing patients, but hey, retirement is squishy right? I haven’t had any bad feedback from a 37th Parallel investor yet.