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.