I believe real estate can be a wonderful investment and encourage people to include it in their financial plans. The real question is HOW to do it – there are a number of ways to get exposure to this asset class. A starting list is below:
- Publicly traded real estate investment trusts (REIT) such as those offered by Vanguard
- Personal investments in existing real estate, such as a single family rental home
- Developing real estate, for example building a home on land
- Crowdfunded equity investments, for example CrowdStreet
- Alternative private REIT structures, for example Broadstone
- Private funds, usually institutions who invest a fund across many properties
- Private deals, specific one at a time deals with their own dynamics
Over time I plan on writing about as many different kinds of real estate investing as I can. Today we’ll talk about private deals.
What’s a private deal? It often looks like this: a friend of friend has a property under contract that’s a screaming buy. He got it for 20% less than he thinks it’s worth, but it’s bigger than he has money for so he wants to spread the risk a bit. He is inviting people to invest alongside him and take a share of property. He’ll run it and get a fee for it, and if it works, he also gets a success fee. All you have to do is put up $50,000 and wait for the checks to roll in!
This could be any kind of real estate – a fix and flip, a piece of land, or an office building.
The difference between a private deal and a private fund, is that a fund usually raises money for a general purpose and then secures properties. In private deals, you are evaluating a very specific real estate investment and you are usually provided financial models and significant qualitative information to assess the investment yourself.
Should you invest in private deals? The answer is almost always no, and here’s why.
- The most successful investors often don’t need anybody else’s money. Managing other people’s investments is a pain.
- Those who have a long history of success don’t usually ask anybody new for money. The best sponsor I know sends an email out to his list of previous investors and the deal is usually filled within 3-5 minutes. They’ve made money with him and they don’t even doubt his performance. He doesn’t spend a second recruiting new sources of funds.
- You lose virtually all of your flexibility vs. owning something yourself. The sponsor may believe that the property will sell within 5 years, but wait 10 years. You might prefer a conservative cash generator and the sponsor might decide to do a massive renovation that chews up cash. You really relinquish control so financially you will have to take it as it comes.
- You will pay a significant share of the gain to the sponsor. Management fees, acquisition fees, disposition fees, legal fees, you name it. These add up really fast. Can the investment handle a drag of 10% or more on it? They have to be quite a bit better than you to justify the differential.
- Evaluating these deals properly requires knowledge of real estate that most investors don’t have. To assess a deal you need to look at market dynamics, rent trends, economic factors, zoning risks, incentive structures, etc. If you aren’t comfortable evaluating these things on your own, it’s hard to diligence the investment properly.
- The sponsor usually has an incentive to put excessive leverage and risk into the deal. Usually a sponsor is paid based on a return on equity. You can make more money on equity with more debt. But there’s a much greater chance of the project going bankrupt.
OK, have I scared you enough? While I said that in most cases you should run away from private deals, there are some ways to do this more wisely. My tips:
- Be ridiculously skeptical of everything you are told. Sponsors are in the business of getting investors. You are in the business of making money. Sponsors have an incentive to paint rosy pictures, use big rent assumptions, and make the deal seem like a screaming buy. Even if this is your best friend, take everything with 10 grains of salt. Think like a lawyer. Imagine the worst case. It happens a lot.
- Understand how every single financial assumption was made, especially rent and vacancy. You should be provided with a financial model that details things like rent assumptions, operating expense assumptions, vacancies, rent growth etc. You need to understand how every assumption was come to, and stress test it. Questions to ask include: “what’s the worst case scenario”? “Where did you get the data”? “Is what your providing me what is actually happening in the market”? And so on. I’ve seen people show rent growth in markets that are declining in population. That’s just very unlikely to happen. Is the operating cost a guess or do they have experience operating similar assets?
Be especially skeptical of anything that shows a significant increase in rent.
- Be very clear about what it is they are doing that you can’t do on a smaller scale. Are they buying a ten unit building in your neighborhood? Can you buy a 2 unit building and hire a property manager for it and do better? At least understand what you are paying them for – is it expertise, management, etc? Quantify it and make sure it makes sense to you.
- Understand how the sponsor’s incentives and payment change under different scenarios. It’s easy for a sponsor to be motivated when things go well. But what happens when things go badly? Is the sponsor going to make nothing unless he makes you 8%? If so, what happens when it only makes 6% per year? Why would he still spend time on it? You need mechanisms for the sponsor to be engaged through tough times and good times. Run through the actual economics of every scenario and make sure the sponsor won’t just walk.
Only invest with sponsors who have a large chunk of their own money in the deal. If they aren't willing to put their assets at risk, why should you? It should be an amount that would be painful for them to lose relative to their total financial position. You want them to be more scared than you if things go badly.
- Know exactly why and how this deal came to you. If the sponsor has done many deals before, why didn’t other investors take it? A good answer would be that the sponsor has done similar deals, but this one is at a larger scale. Or that the sponsor is growing their deal flow quickly. Most other answers are bad.
- Pick super expert sponsors. I don’t just mean someone who has “invested in multifamily” before. I mean someone who has owned, sold, and flipped 41 similar properties in the same neighborhood in the last ten years, and is simply doing the same thing they’ve always done. If they aren’t the expert in it, somebody else is and probably passed over the deal. An acquaintance has specialized in Austin duplexes for years - and has probably touched 500+ of them in the last decade. THAT'S the kind of expertise you are paying for.
- Verify their background. You might think that it’s a friend of a friend, so you can trust them. I don’t recommend this. Sit down with the person or at least talk to them on the phone. Listen to your intuition. Ask for 10 references and call all 10, even if it’s a friend. If people aren’t glowing, move on.
In the end, if something doesn't feel like a slam dunk - you probably shouldn't do it.
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