By Dr. James M. Dahle, Emergency Physician, WCI Founder
If you've been hanging around the physician financial blogosphere (podcastosphere? facebookgrouposphere?) you've surely heard about private real estate investments like syndications, funds, and REITs. If so, there's a decent chance you have only heard about the positives of these investments. I have yet to see a single blog post or podcast dedicated to their downsides. So I thought I would do that today.
Why do you never hear about the cons of investing in real estate? Well, because the articles tend to be written by two types of people:
- Those who absolutely love all things real estate and believe real estate can do no wrong (i.e. the naive), and
- Those who somehow make money from them (i.e. the incentivized).
Naturally, this includes the bloggers, podcasters, and group owners, including me. For years this blog has been sponsored by real estate platforms, syndicators, and fund/REIT managers, and that hasn't changed and probably won't change any time soon.
Don't get me wrong, there are a lot of cool things about private real estate and 15% of my portfolio is dedicated to it (10% equity, 5% debt). Upsides include:
- High returns
- Low correlation with stocks, bonds, and even publicly traded real estate
- Opportunity to be paid an illiquidity premium
- Tax-sheltered income due to depreciation (on the equity side)
- The ability to invest in smaller properties than publicly traded REITS but larger than you can afford to invest in directly
- Easier diversification than direct real estate investing
- Far less hassle than direct real estate investing
But you have likely already heard about all those. Today we're going to talk about the downfalls of investing in real estate. How do I know about these? Because I have experienced all of them. Let's get started.
18 Negatives About Private Real Estate Syndications and Funds
Some of these will matter more than others to you, but they can all be significant to somebody.
One of the biggest cons of private real estate investing is being locked into the investment. A typical debt deal locks up your money for 6-18 months. A typical equity deal locks up your money for 3-10 years. Usually, you will know upfront about how long your money will be illiquid, however, when things go wrong, that period of time is often extended. Sometimes by years. I had one debt investment that was supposed to be a 12-month investment turn into a 25-month investment. When people say you should not invest money into real estate that you need any time soon, they aren't kidding. Hopefully, you're being paid a premium for that illiquidity, but there's no way that happens every time. More traditional investments like stock, bond, and REIT mutual funds can be turned into cash in minutes (or at most a few days if it is a long weekend). Don't put more of your money into illiquid investments than you can afford to have illiquid even in a worst-case life scenario.
#2 High Minimums
The minimum investments on private real estate investments can range from $2,000 to $1 million but generally, cluster in the $20,000 to $250,000 range. I suspect the better investments often have higher minimums, too, because experienced operators already have a long list of willing repeat investors who have only become wealthier as they've been working with the operator. These minimums are not insignificant, even for my audience of high earners. Consider doctors making $200,000 a year who are investing 20% ($40,000) a year for retirement. If they've dedicated 25% of that portfolio to real estate, that adds up to $10,000 a year. If an investment has a $50,000 minimum, that's five years just to save up enough to get into one investment! And the $100,000-250,000 investments (now most of my real estate portfolio) are simply out of reach for most doctors. They are often limited to the investments available on online platforms with lower minimums, which often means working with less experienced operators, or working with access funds. Either way, you will be paying an additional layer of fees that threatens to eat up any illiquidity premium or tax benefits you may have been earning.
#3 Multiple State Tax Returns
Unfortunately, this downside often comes as a surprise months or even years after investing. You can try to minimize it by only investing in syndications in your state and the seven tax-free states or making sure the partnership will be filing composite returns on your behalf, but the truth is that if you put any significant amount of money into these investments over any significant amount of time, you are highly likely to be filing tax returns in multiple states for many years to come. There is a cost to this, both in terms of hassle/time, as well as in actual tax preparation expense, whether that means paying $50 per state with Turbotax or paying an accountant. Just figuring out which states you need to file in is quite a chore. I still think filing your own taxes as a direct real estate investor is harder, but not by much. The funny thing about this particular downside is that real estate investments are often sold as being “awesome for taxes”. They're clearly talking about taxes paid, not the preparation of the returns. Real estate is most definitely NOT awesome for keeping your tax returns simple.
#4 Filing Tax Extensions
While we're on the subject of taxes, you should be aware that once you start investing in these investments, your tax day is no longer April 15th and you can just forget about getting your tax refund in February. From now on, you will be filing a tax extension in April (and probably a bunch of state tax extensions, too) and doing your taxes in September or October. Those of you in physician partnerships (paid on a K-1) may have already experienced this in a small way, but it only takes one K-1 coming in late for you to have to file an extension. Partnerships are supposed to have K-1s out to you by March 15th, but in my experience, most arrive in late March and early April with a couple coming after your tax due date. Just to give you an example, our 2021 tax return involved 19 K-1s, 14 of which were from real estate investments. No way are they ever going to all arrive by April 15th. No surprise it takes so long to prepare them when you see that many of them are 20-30 pages long.
#5 Difficulty Learning About Investments and Comparing Them
One of the best things that ever happened to the mutual fund industry is a company/website called Morningstar. You can go to Morningstar.com and in just a minute or two find out the track record, fees, and holdings of any mutual fund you want. You can compare them one to another very easily and very quickly. That is not the case with private real estate investments. Every investment is unique. There is no central database of information. You can never really be sure you've found the “best” investment. To make matters worse, a particular investment is often only available for a short period of time, and then never again. Yes, you can look at the operator's track record, but you can't look at the track record for a given investment because it doesn't have one. So you're forced into this bizarre universe of googling information, going to conferences, talking to other private real estate investors personally or in online groups, etc. And of course, conflicts of interest abound as most of the people telling you about an investment have a conflict of interest. This factor is so bad I feel compelled to routinely tell my real estate investing newsletter readers that “these are introductions and not recommendations” any time I tell them about an investing opportunity.
#6 Manager Risk
Long-time readers know I'm not a fan of actively managed mutual funds. The data is pretty clear that they don't add value overall compared to an index fund. However, in the private real estate space not only are there no index funds, but the manager is the most important aspect of the deal. A good manager can save a bad deal, but there is no deal good enough that an incompetent manager can't screw it up. My worst experience in this regard was a syndication manager who fraudulently obtained additional debt on the property and subsequently went bankrupt. It happens and that's part of the risk package of private real estate investing. I also hear readers complain about the communication from managers, or rather the lack of it. If you want a lot of communication, make sure you invest with managers who provide a lot. Not all do.
#7 Tricky Due Diligence Dilemmas
Naturally, given that manager risk, due diligence becomes paramount. However, due diligence has a cost, both in time and money. The savvy investor is left with an unpalatable choice. You can either spread your bets far and wide and hope for the best (deworsify?), or you can do massive, expensive due diligence on a few properties, funds, and managers. Consider the cost of actually flying out and walking the properties and interviewing the managers in person. Add on some money for background checks and some time for calling a handful of previous investors. Now imagine you do this four or five times for each investment in order to “find the good ones”. What does that cost? $10,000? $20,000? And you're going to do this for every $50-100K investment? No way. And you're certainly not going to do it for every $10,000 investment on a crowdfunded platform. So you're going to have to decide which corners to cut. Naturally, this all assumes that the due diligence you could do would be effective in ensuring you only invest in good deals with good managers, which is hardly a given. Most of us simply try to diversify reasonably and when we find an operator or manager we like, invest repeatedly with them to reduce the due diligence hassles.
#8 Accredited Investor Requirement
These investments generally require you to be an accredited investor. The general definition of this is a $200,000 annual income for each of the last two years (or $300,000 together with your spouse) or investable assets of at least $1 million. The idea here is that the government wants you to
- Be a savvy investor with the ability to evaluate these investments on your own, AND
- Be able to lose your entire investment without it affecting your financial life in any significant way.
Unfortunately, making $200K a year hardly ensures either of those things are true, much less both of them. Personally, I recommend you not only meet BOTH the income AND the asset requirement, but DOUBLE them both. Those numbers aren't indexed to inflation and haven't changed in decades. I think at an income of $400K/year and investable assets of $2 million you can start arguing that you can afford to lose an entire $50-100K investment without it affecting your life. But a doc making $200K with a net worth of -$100K? No way. A $100K loss would be a massive part of that doc's financial life. In addition, the accredited investor requirement doesn't actually require any investing knowledge! So before you invest in an investment that requires you to be an accredited investor, MAKE SURE YOU'RE ACTUALLY AN ACCREDITED INVESTOR! Do you actually have the ability to evaluate these investments on your own? Are you able to lose your entire investment without any effect on your lifestyle? If not, stay clear. There are no called strikes in investing and there will be plenty more real estate deals next year and the year after that.
Some investments (including one of my funds) actually have higher requirements than just being an accredited investor. They might require you to be a qualified client ($2.1 million in investable assets or $1 million with that advisor) or even a qualified purchaser ($5 million in investable assets).
#9 No SEC Oversight
The Securities and Exchange Commission oversees publicly traded investments like stocks, bonds, and mutual funds. The reason private investments require accredited investor status is because the SEC does not oversee them, at least not in the same way. Now one can argue how much that oversight is or is not worth, but it's hard to argue that it isn't worth anything.
#10 Diversification Challenges
In the publicly traded world, diversification is trivially easy. Buying a single share of a total stock market ETF allows you to buy a piece of thousands of companies for less than $100. That's not the case in the private real estate world, especially if you are trying to avoid funds. Imagine if you are only investing in syndications with a $100K minimum. Even if you put 20% of a $1 million portfolio into real estate, that's only two properties. Now imagine one of them goes belly-up. No sensible investor would only invest in two stocks, but real estate investors are often dramatically underdiversified. Maybe that matters less when you are the sole owner and manager of a property and know it better than anyone else (put all your eggs in one basket and watch it very closely), but it's hard to argue it doesn't matter when you're trying to invest passively. Once more you're left with a difficult dilemma—invest in deals with lower minimums (that may be inferior deals), deal with multiple state returns (due to using funds), wait until you're richer to get into the game, or be undiversified. Not an easy decision.
#11 Long Time to Get Money Invested
When investing in private real estate, you generally wire money (yet another risk—be sure to confirm wiring instructions on the phone) to the partnership bank account. Given how quickly wired money travels, I'm usually surprised how long it takes to actually get the money invested. One recent deal (from an operator with a great reputation) took 58 days from the time I wired the money until my money was put to work. That basically cost me two months of interest. Given our low-interest-rate environment, that's not necessarily a huge loss, but it's not one that happens with mutual funds. Money put in there starts working for you right away.
Some funds, particularly on the equity side, don't take your money all upfront. They do periodic capital calls. That isn't necessarily a bad thing, as I'd rather use my cash for something else until they're ready to invest it, but it does leave you in a situation where your money is committed but not actually invested. Right now I have seven equity real estate funds.
- The first called capital over a 28 month period.
- The second took it all at once.
- The third has been calling capital for 16 months and has only called 55% of it.
- The fourth called it all at once but then put it into a note paying 4% while it was slowly invested into real estate over about 16 months.
- The fifth called the first 10% upfront and the last 90% all at once with two weeks notice 9 months later.
- The sixth just had its first capital call for 18% of the investment.
- The seventh took the entire investment upfront (but averages one month of it sitting in their subscription account prior to actually deploying it).
The issue with these long capital call periods is that it makes it really hard to keep your asset allocation in balance. You may only have a few days notice to meet the capital call, so you can't go put it into another illiquid investment. But you can't really count that money that hasn't been called as a real estate investment either unless you've got it sitting in a REIT index fund subject to that volatility.
#12 Long Private Placement Memorandums
Private real estate investments are “sold via PPMs”, or Private Placement Memorandums. These behemoth documents are generally longer than 100 pages and sometimes longer than 200 pages. The expectation is that you'll read them before you invest. It's a rare investor that reads the entire thing, but I do recommend you do it once and then you can go to the most important sections when looking at other ones (particularly the sections on risks, liquidity, and fees). These things make the prospectus and annual report of a mutual fund look like child's play and they're not standardized. They're essentially the operating agreement for the partnership and are written by the partnership's attorney to protect the general partners from you coming after them.
#13 Confidentiality Clauses
Most PPMs include some sort of confidentiality agreement that is intended to keep the limited partners from doing or saying anything that might hurt the partnership. What I have discovered is that operators and fund managers love it when I say good things about their companies, deals, and funds, but if I want to say something negative about them (you know, like the operator was a fraudster), the company is quick to remind me of the confidentiality clause I signed. What that means for investors is that bad occurrences are not discussed as often as they should be on blogs, on podcasts, in groups, in forums, at conferences, or in person. That's not a good thing as it gives the asset class a better reputation than it deserves.
#14 Complicated Fee Structures
A typical fee structure usually involves some sort of an annual fee (rarely less than 1%) plus a promote (split of profits) for returns above a certain preferred return. 1-2% plus 20% of returns over 8% might be typical. Every deal is different and it gets particularly complicated to compare one deal to another when the two deals use a different fee structure. You might like one deal better, but the fees are higher. Is it worth it? Hard to say. Obviously, only after-fee returns matter, but by the time you know those, it's too late to invest because the deal is already done.
#15 No Control
Along with the lack of liquidity, comes a lack of control. You're always a limited partner in these deals. They might go longer than you would want. They might go shorter than you would want. They might sell (and stick you with capital gains and recaptured depreciation) at a time you would not prefer. They may or may not allow you to exchange into another investment that you may or may not like. They may manage the property differently than you would. Basically, when you go from being a direct real estate investor to being a passive real estate investor, you lose almost all control over the investment. It actually cracks me up how often some of these investments update their investors. Some of them even hold monthly webinars. I don't see the point. I can't do anything about the investment now. I'm stuck in it for years whether I like what they're doing or not. Why would I want to watch a webinar every month about it? Just shoot me an email if there is something going wrong and spend your time working hard to ensure nothing goes wrong.
#16 Complex Mess for Heirs
Many of us love investing and getting into the nitty-gritty details. However, few of our spouses feel the same way and none of our heirs do. Now imagine you keel over while you own a dozen private real estate investments. What happens? Now it takes years to get your estate sorted out and thousands of additional dollars in probate and attorney fees. Simplicity has some real benefits, and it is just way easier when the estate consists solely of an IRA, a Roth IRA, and a taxable brokerage account invested in a handful of ETFs that can all be liquidated the week you die. You might not even have to die, either. What happens if you get divorced or lose the cognitive ability to manage these investments?
#17 Short Track Records
Unfortunately, you're doing pretty well if the company you're investing with has a seven-year track record. 15 years is almost unheard of. Sure, the principals might have been in the industry for a decade or two, but track records are usually pretty short, and sometimes only a year or two. I'd like to see a track record that covers at least a full real estate cycle. These days, that means going back to 2007. The problem is most of these operators and managers make a lot of money. They don't have to do this for 30 years to become financially independent, so many of them don't. Thus, there are few long-term track records available. Also, many of the most successful ones eventually just go public as an exit strategy and thus disappear from the private real estate space altogether.
#18 Overestimation of Returns
Most real estate investments state their projected returns upfront and often provide complicated spreadsheets (the pro-forma) showing how they are going to provide those returns. I love to see operators who underpromise and overdeliver, but in my experience, the opposite usually happens. I typically expect to earn a little less than pro-forma and that's often what I get. Certainly, it is more common to underperform the pro-forma (and sometimes substantially) than to outperform it. To make matters worse, some of them don't even seem to be able to accurately calculate an Internal Rate of Return (IRR). For example, one of my multi-year equity syndication deals projected 15-16% returns. When all was said and done, they told me I had earned 10% returns. I calculated them out at 8.84% returns. 9%, while hard to complain too much about, is pretty different from 15%.
The Bottom Line
I hope that discussion of the cons of investing in private real estate investments is helpful to you. Are these investments worth it? I think they are for a portion of my portfolio (15% in my case). Additional return, low correlation with the rest of my portfolio, and some depreciation-protected yield is particularly valuable when lots of very smart people are only projecting 5% returns for stocks and 2% returns for bonds over the next decade. I'm willing to put up with a lot to make 10%+ instead of 4%. But only you can decide if it is worth it to you to deal with the downsides of private real estate syndications and funds. All I can do is tell you about them. If you would like to learn more about these types of investments, be sure you are signed up for the free WCI Real Estate Investing Newsletter. If you're reading this on email, there's a link at the bottom you can click to sign up. If you're reading this on the website, go here to sign up.
What do you think? Do you invest in private real estate? Why or why not? Which of these downsides are most significant to you? What have you done to minimize them? Comment below!