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By Dr. James M. Dahle, WCI Founder
Many investors and potential investors in private real estate syndications and funds focus too much on finding the very best deal out there. That is a shortsighted approach for a number of reasons we won’t get into today. Instead, we’re going to talk about the three things that really do matter when it comes to private real estate.
Truthfully, the most important aspect is YOU, the investor. I think private real estate is great, but it was inappropriate for me for quite a long time. Let me describe for you the right investor, and you can decide if that description fits you. If not, you should simply avoid these investments.
Most private real estate opportunities require you to be an accredited investor. While there are a few trusts and other entities that qualify, an accredited investor, for the most part, has EITHER an income of $200,000 ($300,000 with a spouse) or investable assets of $1 million. The idea behind being an accredited investor is that the investor is 1) rich enough that a complete loss of their investment isn’t going to affect their lifestyle and 2) the investor is sophisticated enough to evaluate the investment on their own without the assistance of an advisor or the SEC.
Obviously, just having an income of $200,000 (like many doctors do) does not necessarily mean that either of those two statements is true. So, you should make sure they are true instead of relying solely on the minimum requirement for being an accredited investor. Personally, I think those dollar figures are way too low. They haven’t changed in years. I would double them, and you ought to meet BOTH of the requirements. That is, you should have BOTH an income of $400,000+ AND investable assets of $2 million+.
Why is that important? For a few reasons. The first is very practical. While you can find investments with minimums of $5,000-$50,000, the better investments tend to have higher minimum investments, usually in the $100,000-$250,000 range. Experienced operators/sponsors/managers have lots of previous investors and a great track record. It’s relatively easy for them to raise money. It’s a lot more hassle to raise money $5,000 at a time than it is to raise money $250,000 at a time. More layers of fees must be charged, and all fees must come out of your investment return. As operators/sponsors/managers gain experience, they all generally increase their minimum investment, and the returns tend to go up because of lower fees and better economies of scale.
But if you’re only making $200,000 a year and only have $1 million in assets, an investment requiring $100,000 is going to be 10% of your portfolio. If you’re only saving 25% of your gross income a year, $100,000 is two entire years worth of savings. You simply cannot build a diversified private real estate portfolio with good returns on that income, that level of assets, and those minimum investments. It’s impossible. Diversification matters more than a great deal.
The second reason—and the main reason diversification matters—is that not every deal and every sponsor is a good one. You need to invest in enough deals that you can get a reasonable average return out of them. The average is a good investment return. But not every deal provides that. And, in fact, some sponsors actually commit fraud or gross incompetence. How much of your portfolio can you afford to lose to fraud or incompetence and not have it affect your financial life? Certainly not $100,000 of a $1 million portfolio, much less $100,000 for an investor with a $200,000 income and a $300,000 portfolio.
The third reason is that there is no SEC protection. The vetting is all on you. It’s up to you to interview principals, do background checks, pore over the Private Placement Memorandum (PPM), talk to previous investors, and perform any necessary due diligence. There’s a cost to doing that, even if that cost is just your time. How much of your time is worth doing the due diligence on a $5,000 investment? Not very much. But it’s probably worth it on a $100,000 investment. So, your approach is one of two options: 1) Buy enough smaller deals that you can diversify against a fraudster or an incompetent manager or 2) Put enough money in that it is worth it to you to do real due diligence. Either way, you need to be pretty wealthy to get into this stuff. These investments aren’t for people having trouble maxing out their available retirement accounts each year either due to a low income or a low savings rate.
Fourth, many of these investments increase your tax hassle. Once you get into private real estate investing, you should expect to file a state tax return in multiple states every year, and you should expect to file an extension every year. There is a cost to this and some hassle. A higher amount invested minimizes that cost as a percentage of your return.
Can you get into private real estate with smaller amounts of money, dipping a toe in to test the waters and learn as you go? Sure. You can build a portfolio of real estate assets with $5,000-$20,000 minimums, and we have people on our real estate introduction list that have those lower minimums. In fact, that’s how I started. However, you will be far more likely to run into incompetence, fraud, tax hassle, and returns that are low enough (due to higher fees) that you’ll wonder if it was worth it. I still have a mixed opinion on whether I should have just waited until I was wealthier and could afford higher minimums.
Before you get into private real estate deals, be a real accredited investor. These investments are not required to become wealthy or to stay wealthy. They are completely optional. But you really should not invest in them before you become wealthy. You either end up with less-than-optimal deals or you end up with an undiversified portfolio.
The whole point of private real estate deals is that you don’t want to do the real estate thing yourself. You got rich enough to invest in these deals by doing something else well, and that something else is almost surely a better use of your time than being a landlord. If you’re not comfortable letting go of the reins and letting someone else manage the investment for years on end, you should avoid these deals. Go buy real estate directly. Some of these investments send out updates every month or even do webinars every month. If you care that much, these investments probably aren’t for you.
Eventually, you’re probably going to own a half-dozen, a dozen, or two dozen of these. Are you really going to spend 12 hours a month on webinars for your portfolio? Don’t you have anything better to do? I only want communication from my sponsors/managers when things are going wrong or when money is either going into the investment (capital calls) or coming out of it (distributions). Otherwise, once a year is plenty for me. On the other side, if you aren’t willing to read a PPM or spend some time on the phone with the sponsor or fund manager, you’re probably better off with mutual funds. You do have to put some time upfront into these investments.
Many of these investments have zero liquidity for 3-10 years. You absolutely cannot put money into one of these investments that you might even possibly need in the next 3-10 years. Even if they tell you it’s a three-year investment, something can go wrong, and it might take you five years to get your money back. Ideally, these investments pay you an illiquidity premium. But if you can’t be illiquid, you’ll never earn it.
More information here:
The Case for Private Real Estate
Whether they are called a sponsor, an operator, the general partner, or the fund manager, the person in charge of the investment matters dramatically more than the investment itself. Let me explain why.
When an investment goes bad or simply runs into a challenging macroeconomic environment, a capable, experienced manager can make lemonade out of lemons. But a bad manager can ruin even a great deal through fraud or incompetence.
There are probably some operators that are always going to be bad operators, but for the most part, the difference between a good manager and a bad manager is experience. How long have they been doing this? Have they done it through at least one full market cycle? How many deals have they done? How many deals like this one have they done? Is this their full-time gig? Do they seem to treat you in a fiduciary way and like a real partner? Have they put together an appropriately competent team? What is the succession plan if the operator gets hit by a bus? Do you like their communication style? If you want monthly webinars and they provide quarterly emails, you’re probably not going to be happy with them.
How do you find a good operator? You can start with recommendations from investors you trust. But be aware that is just a starting point. When people ask me about my experience, I’m always careful to tell them how limited it is. For example, I may be asked about a sponsor, and I’m only two years into a 10-year fund with them. They may not have even finished calling the capital. How much is that recommendation worth? Not very much.
That’s why we always tell people our real estate list is simply an introduction list, not a recommendation list. Spend some time with the sponsor, in person if possible and on the phone if not. Talk to the longest-term investors of that sponsor that you can find. Pore over the PPM. Compare it to others you have read. Is the fee structure average, above average, or below average? If they’re charging you more than everyone else, why would you invest with them? If there is no incentive for them to perform, why would they perform? How much skin (their own money) do they have in the game (real estate investment)?
The good news is that you don’t have to find dozens of good operators. You only need a few. Once you find one you like, you can simply invest with them again. Fund managers either run evergreen funds you can put more money into, or they repeatedly open and close funds (Fund III, Fund IV, Fund V). Syndicators will have a new deal several times a year. You can acceptably decrease manager risk and build a solid, diversified real estate portfolio with only 3-10 different operators/managers.
More information here:
The 18 Downsides of Private Real Estate Investing
Finally, you need to make sure the deal fits your needs and desires. This is easy to do and has nothing to do with whether it is a good deal. For example, let’s say you’re investing for growth. You don’t need any extra income whatsoever right now. It would just raise your tax bill. Yet the only place you can hold an investment is in your taxable account. A real estate debt fund that pays out its entire return as unsheltered ordinary income every year is probably not a great fit for you at this stage of your life. Yes, it would provide some diversification for your portfolio, but you would be far better off with a fund that didn’t send you any income at all for several years and then provided your return as income sheltered by depreciation and long-term capital gains.
On the other hand, if you need income now to live off of so you can retire or cut back on your clinical practice or supplement your lifestyle, you want an investment that actually kicks off regular income, preferably income sheltered by depreciation. You don’t want a syndication that is going to be built from the ground up, filled with tenants, and then sold off. That’s a bad fit for you.
If you have money that you need in five years, you had better not invest it in a fund that is planning to hold it for 7-10 years. That’s a bad fit. If you need money in two years, you’re probably not going to put it into an equity investment at all, but if you want to earn a higher return/take more risk than a CD or a bond fund, you might be willing to put it into a private lending fund with quarterly liquidity.
We talked about minimum investment amounts above, and it is important to have a fit between the size of your portfolio and the minimum investment in the deal. But that works on the other side, too. If you need to write $5 million dollar checks, you can’t go looking at $2 million syndications and $20 million dollars funds (where 1/4 of the fund would be from you). You will be limited to larger deals.
If you like picking your own investments, invest in syndications. If you don’t, invest in funds and let the manager pick the deals for you.
The three most important things when it comes to private real estate investing are the investor, the sponsor, and the fit with the deal—not the deal itself. Get those right before you ever go looking for the deal.
What do you think? What do you think matters most with private real estate? What has been your approach to picking real estate deals? Comment below!
Solid advice on an important topic.
Although I wouldn’t hesitate to invest in real estate before reaching the Both/Double criteria.
For example, with no debt, a broadly diversified $5M in financial assets, and an income of $350K. There are a lot of doctors with salaries in the $300k-$399k. You wouldn’t necessarily exclude them all from this type of investing, right?
Some people don’t like rules of thumb and seek to find exceptions to them. Let me give you the counterpoint.
A doc two years out of residency earning $200K is an accredited investor even if he or she owes $650K in student loans, has two car loans, and not a dollar in investments. I don’t think that person has any business looking at an investment in private real estate. But the line must be drawn somewhere. So I drew one.
“ But if you’re only making $200,000 a year and only have $1 million in assets” — sad but true. That seemed like it would be a lot of money while in medical school but once you get there it doesn’t seem like much!
Well, it is a lot of money. But that’s the point. You need more than JUST a lot of money to really build a substantial, diversified position in investments with $50-250K minimums.
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