The following is a guest post from Michael Episcope, a co-founder of Origin Investments which was started to provide access to real estate investments and management expertise previously available only to institutions. Although this is not a sponsored post, Origin Investments is a paid advertiser on this site.]
Individuals who want to passively invest in private real estate essentially have two choices: Invest in real estate funds or build their own portfolio by investing in individual real estate deals. This is akin to selecting their own stocks or investing in a mutual fund. Websites like Fundrise, Realtymogul, Origin Investments and RealCrowd [Editor's Note: Some of these are affiliate links] provide investors with more private real estate investment choices than ever before. These sites allow you to invest with professional managers by selecting individual deals or investing through a fund structure.
There are pros and cons to each strategy. Investors looking for individual deals have the freedom to pick and choose what deals they invest in, but this is also the most time-consuming option and may not result in the most diversified portfolio. Investing in a real estate fund means investors give up the control of selecting deals but are able to save substantial time by outsourcing that function to a professional manager.
5 Factors to Determine Which Real Estate Investment Strategy is Right For You
1. Time Commitment
Advantage= Real Estate Funds
When an investor commits to a fund, they make a commitment to the fund and it’s the fund manager’s role to build them a portfolio. In other words, the investor selects the manager and it’s the manager’s responsibility to select each deal and build the portfolio. The individual is obligated to invest in every deal the manager acquires, but only to the extent of their commitment. If an investor commits $100,000 to a fund, the manager can only call up to that amount. It typically takes a fund manager two to three years to invest all of the fund’s capital and the only requirement by the investor is to send a wire to fund each investment. In a deal-by-deal strategy, an investor would have to source a large number of deals and evaluate every opportunity. Additionally, investing with a dishonest manager increases as the number of managers in the portfolio increases. In a fund, there is one manager and anyone who has been in private real estate long enough understands that returns and headaches are highly correlated to the quality of the manager.
2. Reporting
Advantage= Real Estate Funds
In a fund, investors typically receive consolidated quarterly performance reports on their entire portfolio rather than dozens of individual reports. Each update will follow the same format and illustrate how the individual deals are doing and the overall investment performance at the fund level. An individual who assembles a portfolio made up of twenty individual deals with several managers will receive 20 individual reports that all may look very different. There is also no aggregation of performance and this is something an investor must do by hand if they want to better understand their portfolio’s performance.
Additionally, year-end tax reporting is much easier in a fund structure because k-1’s, a tax document sent to partners that lists out their share of income and loss for the year, are consolidated into a single document for tax reporting purposes. But an investor in twenty individual deals will likely have to manage twenty K-1’s and the costs associated with filing them.
3. Diversification
Advantage= Mixed
Diversification is one of the easiest ways to reduce risk. In real estate, investors need to make sure they are not overexposed to any one deal, geographic region or sector.
Capital Diversification
Michael Episcope
Advantage = Real Estate Funds
Diversifying your capital across a large number of investments is a great way to reduce risk. Generally, any portfolio, whether it be stocks, bonds, or real estate, that has less than ten assets, is considered highly concentrated. Often times, funds have minimums in excess of $100,000 but that capital will be spread across 15 to 20 deals.
Participation in individual deals can sometimes be obtained for as little as $500 but the higher-quality investment opportunities tend to have minimums greater than $10,000 and often times more than $50,000. Investing $100,000 on a deal by deal basis could easily lead to a portfolio of 4-6 deals and a single property could easily make up 30% or more of the portfolio.
Geographic Diversification
Advantage = Tie
Funds can be geographically concentrated or diversified, depending on their strategy. Some fund managers focus on a particular region or even one city. An investor with a limited amount of capital would want to find a fund with broad geographic diversification or invest in several funds. Real estate downturns can often be isolated to a single city or region and having too much concentration in one area can lead to unnecessary risk. For example, in the last five years, Houston real estate has suffered due to a decline in oil prices and lackluster economic growth, while real estate in Austin, TX has performed quite well. A deal by deal strategy could serve as a better way to geographically diversify a portfolio.
[Editor's Note: I disagree with this one as a “tie.” Funds and individual syndicators are generally fairly geographically concentrated. If not in one place, usually in just a handful. If you're buying the deals yourself, you can diversify as much as you like. Of course, once you start doing multiple state tax returns, you may not like all that diversification.]
Sector Diversification
Advantage = Individual Deals
Funds tend to be specialized in one or two asset classes so an investor looking to gain exposure to a handful of asset classes may want to consider building their own portfolio. If you have millions of dollars to invest, this probably isn’t an issue. You could easily spread your capital across multiple funds to gain exposure in debt, apartments, office, retail and industrial buildings. That being said, it is not common but there are funds that invest in multiple asset classes that could provide the requisite diversification for an investor.
[Editor's Note: I'm going to add one more section to this, I'll use the same format used above:
Manager/Platform Diversification
Advantage = Individual deals
With minimums often as low as $2-10K, you can buy properties from many different syndicators and through many different online platforms with a limited amount of capital. A significant risk in real estate investing is manager risk- the fund manager, the syndicator, and the online platform can all have something bad happen to them. You can't get “Bernie Madoff'd” if your money is spread among many managers. The downside, of course, is that the more managers you hire, the harder it is to do real due diligence on them. ]
4. Fees
Advantage = Tie
Real estate investing is a complex people-intensive business. Everyone in the chain is crucial and fees are the way the team gets paid. Someone must find the property, negotiate the price, create marketing materials and legal documents, raise equity, manage the day-to-day activities at the property, formulate and execute the business plan, report to investors, provide K-1’s, sell the asset and distribute the proceeds.
The amount you pay to a fund manager versus a manager syndicating individual deals will be nearly identical when all is said and done. They each charge different fees but they are just different ways of getting to the same place. A common list of fees and their purpose is outlined below:
- Organizational and Set up Costs: Both fund managers and deal syndicators charge an upfront, one-time fee between .5% and 3% of invested equity. These fees pay for fund formation, legal, and capital raising. In a deal by deal structure, these fees are sometimes tough to identify as they are simply added to the overall cost of the deal. They are always detailed out in the sources and uses of capital.
- Acquisition Fee: This is a fee charged by deal by deal syndicators that equates to between 1% and 2% of total deal size. This is a market rate fee to pay for the sponsor’s operational costs. Funds don’t typically charge this fee but instead start charging the asset management fee from the day the fund begins.
- Annual Asset Management Fee: The asset management fee is charged by both fund and deal by deal managers and are used to pay the manager’s overhead including the acquisition and asset management teams, accounting group, investor reporting, office rent and administrative staff. A typical management fee is around 1.5% of committed equity per year.
- Annual Administrative Fees: These fees cover fund administration, tax reporting, dead deal costs, and third-party software. They are variable costs found in both structures and typically range between .10% and .25% per year on invested equity.
- Performance Fees: In nearly all private real estate investments, managers receive between 20% and 30% of the upside when the deal goes well. This is meant to incentivize them and align their interests with those of the investor so that everyone wins and loses together. While the fees are similar in both a deal by deal and a fund structure, the mechanics are very different.
In a fund, the performance fee is paid based on the overall performance at the fund level. In contrast, managers of individual deals get paid based on the performance of each and every deal. This is important because if one deal generates a 20% annualized return and another deal generates a 20% annualized loss, the manager is entitled to an incentive fee on the deal that did well. This is a ‘heads they win and tails you lose’ structure and, over time, will erode returns. It doesn’t work that way in a fund structure. Additionally, the manager operating in a deal-by-deal structure may be more incentivized to focus on the deals doing well and ignore those doing poorly where they are least likely to earn a fee. The fund manager is highly incentivized to revive underperforming deals.
It is not uncommon for managers to have other fees embedded in their structure such as refinancing or disposition fees, and there are plenty of fund managers who attempt to charge every fee imaginable. Make sure that the fee structure aligns interests because they can often tilt risk towards the investor. Do you really want to pay a $300,000 disposition fee to the manager if your investment loses money?
5. Other Considerations: Manager Benefits
Advantage = Real Estate Funds
We’ve talked about the pros and cons to the investor, but what about to the manager? One of the first items the seller of a property asks for when selecting a buyer is proof of capital. They want to know that the buyer has the capital on hand to be able to close a deal. A fund provides a base of permanent capital that allows the manager the ability to show proof of funds and transact quickly when they find a good opportunity. In a deal-by-deal structure, capital is raised after the deal has been negotiated and many sellers are wary of awarding deals to syndicators, unless the manager can convince them of their ability to close the deal.
Funds also provide the manager with a steady stream of recurring revenue to pay employees and meet their overhead obligations. Managers who acquire individual deals tend to have less certain income and don’t get paid unless they do a deal. A manager struggling to pay their staff could be incentivized to do deals simply to generate fee income.
Overall Advantage
Real Estate Fund Investing
From an investment standpoint, the advantages of investing in a fund tend to outweigh those of investing in individual deals. But for many, picking deals is more of a learning process and education is more likely to be accomplished by evaluating individual deals and pouring over countless documents. For those who don’t have the time to evaluate each deal, fund investing is most likely the better route. And there is still a great opportunity to learn as well, as a good fund manager will keep you apprised of portfolio performance and details of their strategy. It also allows one to gain all of the benefits of private real estate with very little effort. Evaluating a single manager, who will be responsible for building you an entire portfolio, is much easier than spending the time evaluating twenty deals and the people behind them. In many cases, it’s not an either or and an investor may prefer a hybrid of both strategies. Understanding the nuances of each approach is the key to making an informed decision and investing successfully.
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[Editor's Note: I am currently invested in both individual deals and funds. Fund investing is likely a better choice for me at this time as I would rather spend my time growing my own business than evaluating deals. I also appreciate the dramatically increased diversification between notes/deals particularly on the debt side. The main downside I worry about with that approach? Manager risk.]
What do you think? Are you using individual deals, real estate funds or have you chosen a hybrid of both to invest in real estate? What strategy would you recommend? Comment below!
Being an index fund guy, it is very hard for me to ignore all of those costs. Even at the low-end when you add them all up the expenses are 3.5%… so how guaranteed are the returns on these platforms?
I mean, I understand the idea of diversification and wanting low correlation with the market, but it hurts most low-cost investors to see expenses that high when we have become pampered by low-cost expense ratios to run index funds. I would want a very secure return on my investment if I was going to pay 3.5-5%. It looks like some of the fees are up-front only, but then others (as much as 1.75%) seem like annual fees.
How “sure” are the returns? After the expenses are taken out what are typical expected returns? Is the correlation really that low with the market to justify the expenses for diversification?
I am really intrigued by this kind of investing model, and plan on branching into real estate somehow in the next year or so. Trying to learn as much as I can before then.
TPP
I think you have to be careful to compare apples to apples. For example, if the ER on an index fund is 0.04%, that’s the additional fee the manager/computer buying/selling the companies charges. But it doesn’t include the business expenses of the various companies. When you buy a company that owns a single asset such as an apartment building, it’s going to have expenses just like Apple does. And those are being included in that 3.5%. But you can’t compare that to an index fund ER because it isn’t the same thing. The business expenses of Apple are “invisible” to the index fund investor, but the management fee for the apartment building is not.
That doesn’t mean that expenses don’t matter. They always do and come directly out of the pocket of the owner/investor. But they’re not the same thing as a mutual fund ER.
Well stated. Most people forget about the fact that there are underlying companies with management teams and admin costs underneath the mutual fund/ETF layer. Public REIT management expenses tend to be between 1% and 4% of total market cap, depending on the size of the organization. Thanks for clarifying.
Comparing these deals to index funds is very much Apples to Oranges as WCI suggests.
The article provided is very good.
I have about 70% of my portfolio in index funds, 5% in day trading, and 25% in these various real estate investments/funds.
Right now I am involved in 2 separate multifamily apartment buildings in 2 different locations. I have a oil/gas investment and also 2 different funds that have multiple holdings. There are some important things I have learned along the way, but at this point I like the idea of diversifying across these different real estate investments. It is more difficult to vet multiple different companies but it also dramatically decreases my risk of total loss from a Madoff like Ponzi scheme, or more likely a poor performing company that hides their books and goes bankrupt.
If you are thinking of investing in these avenues, the most important thing I would suggest is to know what your expected return should be on your money, and more importantly how they are calculating this return. I have one fund that claims to have a 30% return over 3 years, but unfortunately I have only seen about 10% of this due to the way they calculate the return on investment and taxes….That one is a learning experience. But, there are many other funds/syndicates that can consistently deliver expected returns on the range of 10-20%. These typically require an initial investment of 50K or more but you can and should use different types of accounts for these investments.
Good luck,
What kind of returns were projected for the two multi-family apartment buildings in the offer?
Just curious what made them interesting to you in the first place.
Well, I see it as a spectrum. There are many ways to invest in real estate: REITS, crowdfunding of debt or equity, syndication of multifamily homes, single family homes, industrial, storage facilities etc. Each has pros and cons. I have dabbled in almost all of these and still enjoy income from many. It isn’t a dichotomy. There are strong arguments all around, but we are all biased by how we get paid I suppose.
This is a very high quality post and love the breakdown between two competing ways of investing capital into real estate.
Although I have concentrated a lot currently on private syndicated individual deals I am intrigued with the funds side of it now.
What are some of the tax implications of a fund? Specifically if a fund has properties over many states do I have to file a state income tax for each one?
Also one thing I am not a fan of is the late recieval of my K1 returns (often giving me just a couple of weeks before IRS deadline. Can I expect the same with a fund.?
This is key, whether or not a separate state income tax must be filed in each state where a fund owns its properties. I believe Origin’s answer is that no it does not, and that everything is bundled into a single K1. Am I wrong on this?
I am currently on the wait list for the Origin Fund 4, as the Fund 3 that Jim bought into is now closed. They have not given me a solid date when Fund 4 will be open for investment…
You’d think they would fully invest Fund 3 before starting on Fund 4 eh?
Correct. We will begin taking commitments for Fund 4 when Fund 3 is close to 80% invested. So far, we have invested 48% of the capital in and will be calling another 15% in the next couple of months. Fund IV will officially open after Fund 3 is 100% invested.
If you are invested in a partnership/LLC that is taxed as a partnership, you must file a personal state tax return in the states where the properties are located (assuming those states have personal income taxes), unless you are included in a composite tax return filed by the entity (but you still end up paying state taxes but the composite payments are shown on the federal K-1 as a capital distribution from your investment).
If there is a single partnership that owns properties in multiple states, the partnership would be required to file tax returns in those states (assuming those states have an income tax). You would then be provided with a K-1, which would include the federal K-1, plus various state K-1s, which would need to be picked up on your individual federal and resident/non-resident state tax returns.
If the sponsor/company is saying there is no state filing obligation for your personal taxes, it could be due to a couple of reasons: 1.) you are investing in a C-Corp/REIT, 2.) the partnership isn’t investing in states that have personal income taxes, 3.) someone is lying to you, 4.) you misunderstood what was presented to you.
5.) You have elected to be included in a composite return for each state where a filing obligation exists (inferred from my first paragraph).
Composite returns simplify state taxes, but almost always increase your state tax liability compared to if you were to separately file an individual state return (although there is added time/cost there). This is due to composite returns not allowing the filer to use any itemized deductions or tax credits to reduce their tax liability, but the worst part is all the state-sourced income is taxed at the highest individual rate (all/nearly all states don’t allow graduated rates for composites, so in CA, you’re looking at 100% of your non-resident income being taxed at 12.3% if you choose to be included in a composite return there). Additionally, if you have more than one source of income from a state that isn’t your home state, composites usually aren’t allowed (meaning, if you have two different K-1s that generate income in the same state, a composite would not technically be allowed, but this varies by state). Again, composite returns ease the individual partner’s filing burden, but can lead to significantly increased tax liabilities depending on the state/level of income.
I don’t think it’s as big of a deal if you’re in the top bracket, which many accredited investors will be.
I would normally agree about composite returns, except in the case of rental real estate, as many rental properties generate tax losses from operations each year due to depreciation (except some of the crowdfunding deals I’ve seen that simply give the crowdfunded investor entity a Guaranteed Payment each year based on their initial investment). If you elect into a composite return, these losses are gone forever and can’t be carried forward to offset future income (i.e. the eventual sale of the building). The losses that these accredited investors can pile up is sometimes massive (easily into the millions of dollars by the time a building is sold, at least in the geographic area where I work), and to give that up for the sake of saving yourself or your tax preparer from having to file a non-resident state tax return is not a good thing.
Excellent point, and in some states with high tax rates, I suppose that could make a significant difference.
There is only one federal K-1 for a fund but there could be multiple state filings required by the investor, depending on the state and how the fund manager handles state taxes. At Origin, we file a composite return on behalf of those investors who opt in for this feature. Most states allow us to do this but some states do not. For states that don’t allow composite returns, we withhold taxes and pay them on behalf of the investor so there is not a tax liability but a filing would be required. You also need to consider that a fund can roll up several properties into one state filing. For example, in the case we owned 5 properties in Texas, and they didn’t allow a composite return, there would be only one state filing for all 5 properties. Hope this clarifies the issue.
Texas doesn’t have an income tax. 🙂
I could not seem to find the answer to this.
How much is the income tax on the income from property tax. Does it depend on your income. If I fall in high tax bracket, do I pay more.?Thanks
Income from property tax? I’m sorry, I’m lost. What do you mean? The income from investment real estate is taxable so those in high tax brackets do pay more on it.
Sorry ” income from rental income”-
So if I am collecting $3000 in rental income and I am in 33% tax bracket- so does it mean I am paying 33% on $3000 income? or does the rental income fall in the lower tax bracket.
sorry for the confusion
No. You pay taxes at your marginal rate. There is no capital gains or dividend rate. That income may be partially sheltered by depreciation though.
You don’t have to pay payroll taxes on that income though.
Excellent post. I invest in both individual RE deals and private equity RE funds. Both have their place. The biggest benefit for a fund is the instant diversification. Also, the fund portfolio contains properties that I would not invest on my own. Not because the deal is bad, but simply because of my own selection bias and ignorance of local markets. Sponsor quality is key. Sponsor co-investment is important too. It gives investors confidence that the sponsor has “skin in the game” and is invested side-by-side with the LP. I’ve found that funds are more common in certain asset classes like multifamily, office, mobile home parks, and industrial. On the other hand, self-storage, student housing, senior assisted living investments tend to be more individual deals. I’m also liking debt funds (hard-money loans) more than choosing individual loans on crowdfunding sites.
We certainly have different investment criteria. My top three items (cashflow, ROI and taxes) didn’t even make the list.
While those are relevant, the comparison is really about how you choose to enter into the market. Do you want to be more of a passive investor in a fund or spend your time sifting through deals and building your own portfolio? There are common misconceptions about funds which is why I wrote the post. Cash flow is more about your personal investing goals. If you are a cash flow investor, you would be comparing funds that focus on income to cash flowing deals. I assume by ROI, you mean track record or potential return. That’s certainly important and part of the criteria in evaluating the manager but not as relevant to whether you choose deals or funds. Lastly, neither deals nor funds have a tax advantage if they both utilize a partnership structure. In both cases, it’s a pass through entity and the investor benefits from tax shields. REIT’s and funds are treated differently from a tax perspective though. Thanks for the comment.
Agreed.
A better comparison would probably be real estate funds vs. mutual funds, not real estate funds vs. individual property deals. In that context, the only real differences are the underlying assets being purchased by the funds. I’ve never considered REIT investing to have much in common with owning rental properties. REITs are basically managed funds with limited visibility and disclosures more akin to hedge funds. Caveat emptor.
I have used private money from individuals to buy single family homes where I rehab and resell. Lender makes a 7-10% return and receives a first mortgage on the property.
They also receive a before and after appraisal to enhance the comfort level. The only thing the lender doesn’t like is when the property is sold and they get their money back. They want to know when the next deal is coming to reinvest the money. This is all tax free to the lender since they use a self directed IRA or 401K.
What you’re doing sounds an awful lot like a job. I think I’d prefer to be the lender!
No doubt.
Both hard money lending and equity sharing arrangements are much better real estate angles for anyone like WCI (i.e. high disposable income, no need for immediate cash, long-term horizon). That’s ideal for hands-off investing. BTW, the 401K investment proceeds are tax-deferred, not tax-free (FBN’s post). There’s no special tax break for investing in real estate using retirement funds.
Like several others have commented I have invested in both individual deals and funds.
Over the years I still maintain a mix of both, although the funds are usually easier to deal with.
The key is properly screening the sponsors and evaluating their track records.
A second key in my opinion is to diversify by sponsor, by geography and across asset classes, multi family, office, etc..
Michael, I enjoyed the post. If you are still taking questions: can a fund accept a Starker Tax deferred exchange? If so, is it practical? Does Origin accept them? Thanks!
That’s the first time I’ve seen a 1031 Exchange called a Starker Exchange. Thank you to Mr. Starker for challenging the courts!
There are many ways to invest in real estate: equity or debt crowdfunding, REITS, syndication of multifamily homes, single family homes, industrial, etc. Each has pros and cons. I have invested in all of them. It just depends on how much you have to invest and how much time you have to manage the property.