Top 5 Considerations in Private Real Estate…
There are many moving parts when it comes to private real estate investment, especially in the middle market space. Investors are confronted with a myriad of choices and considerations, from asset type and strategy to investment method and due diligence considerations. This eBook provides a high-level summary of some basic definitions and concepts important to understanding private real estate, the middle market, the types of people that invest in it and why, as well as the nut and bolts of how these investments are actually carried out. It is not intended to be comprehensive or definitive.
This eBook is being provided for informational purposes only and is neither investment advice nor a solicitation of the sale of any securities. All views expressed in this eBook are based on Fairway America, LLC’s beliefs and experiences about the asset class or markets described and other individuals and entities may have other beliefs. Fairway undertakes no obligation to update this information. No investment decisions should be made based on the information presented in this herein. Please consult with your professional advisors to understand and assess the risks associated with any investment opportunity.
What is Middle Market Private Real Estate
And how about the middle market? What or where is that? Believe it or not, most places throughout the United States are part of the middle market. Everything that isn’t a major gateway city like New York or Los Angeles is considered the middle market. These places are sometimes also referred to as “Secondary” markets. Don’t let the title confuse you. These markets are in no way second class. They are where the lion’s share of growth in the United States is going. Places like Atlanta, Austin, Denver, Charlotte, Nashville, Orlando, Phoenix, and many, many more.
The specific properties within the middle market can be nearly any type of real estate: apartments, offices, shopping centers, industrial warehouses, self-storage facilities, single-family rentals, etc. Generally, they are divided into four main groups: multifamily, office, retail, and industrial. There are a plethora of choices within each of these categories.
In addition to different sizes and types of real estate, there are also different strategies that can be pursued to generate returns. Some strategies have a “value-investing” and cashflow orientation while others are focused on momentum and growth. While any strategy can be successful, their individual probability of success is based on multiple factors including but not limited to local market dynamics and the macro real estate business cycle.
Now that we’ve defined what middle market real estate is, let’s cover who typically invests in these opportunities. People that invest in middle market real estate are oftentimes individuals who have generated prior wealth and savings through their work: doctors, attorneys, engineers, professional athletes, executives, and entrepreneurs. Investors are often married couples, or sometimes are stewarding family trusts for their relatives. Due to federal regulations, investors must meet the SEC’s definition of an “Accredited Investor” in order to make most passive private real estate investments, such as those described in this eBook. Why do Accredited Investors choose to invest in private real estate? There are many reasons…
Possible Private Real Estate Benefits
- Passive Investment
- Non-Correlation to Public Markets
- Inflation Hedge
- Stable Cash flow
- Wealth Creation and Capital Gain
- Higher Risk-Adjusted Returns
- Tax Benefits
These investors seek the investment benefits associated with real estate without the hassle that comes along with direct ownership and landlord responsibilities. Private real estate investing can deliver this sought-after combination. Passive investing in real estate is a relatively new concept for some people, which naturally causes wariness and sometimes confusion about how it works. The purpose of this eBook is to help those with interest in private real estate investment better understand the nuts and bolts, which should enable them to make better investment decisions for their individual situations.
In addition to the possible benefits described above, there are significant potential risks inherent in investing in private real estate. These risks include, but are not limited to pricing fluctuations driven by market conditions, local events such as natural disasters that may impact property values, and various risks associated with the illiquid nature of these investments. Also, the fees charged by sponsors may not accurately reflect the value of the work performed by the sponsor, and often also give rise to conflicts of interest. The precise risks will vary depending on the location of the real estate and the asset class among other factors, but any of these risks may lead to underperforming investments, including a complete loss of investment capital. Investments in private real estate are not insured and results are not guaranteed. The risks associated with investing in private real estate also depend on your sponsor partner. Many sponsors may lack experience, fail to maintain a high standard for due diligence in underwriting deals, or advertise projected returns for deals that are based on unscrupulous underwriting or unlikely assumptions. In order to mitigate the risks of investing in private real estate, it is important to work with trusted manager partners who have a proven track record of experience in the industry.
How to Invest in Private Real Estate
Debt investing comes in the form of loans made to a real estate borrower to acquire and improve target properties. The purpose of the loans will vary according to the business plan for the property itself (acquisition, construction, operating cash, etc.). Investors can also purchase existing non-performing loans and tax liens at a discount to their stipulated amounts in an effort to collect and make a profit. The loans that debt investors extend to real estate borrowers can either be in a senior position (which means it gets paid back first, before everyone else) or in a junior position (which means it gets paid back after the senior lender, but still before any equity investors or the real estate borrower). Junior position loans typically pay a higher rate of interest than senior loans, since there is more risk involved with being lower down on the repayment pecking order.
Equity investing usually comes in the form of purchasing membership units in a special purpose corporate entity (typically an LLC) whose sole purpose is to act as the owner of record for a property purchase. The percentage ownership an equity investor has in the LLC helps determine the percentage ownership they have in the underlying properties owned by the LLC. An Operating Agreement controls roles and responsibilities amongst the various members of the LLC, including key items such as capital calls, major operational decisions, and other administrative obligations.
There are two classes of equity investor members: they are frequently referred to as General Partners (GPs) and Limited Partners (LPs). GPs are typically the party who originally identifies, takes charge, and administers the investment, while LPs are passive investors who are not involved in the day-to-day operations of managing the real estate. LPs typically supply at least 90% of the total equity needed to purchase a property while the GP usually supplies the remainder. Most investors believe it is important that the GP provides a non-trivial amount of their own money into the deal in order to have “skin in the game.”
Whether a person is interested in making an investment via debt or equity, there are two primary ways to deploy one’s capital: single asset syndications or multi-property funds. There are different benefits, constraints, and considerations for investing in single asset syndications or multi-property funds, and these are described in more detail below. In general, single-asset syndications give the investor more control and choice over what their capital is purchasing (a single asset), while a multi-property fund provides less individual choice, but more insulation from asset specific risk (i.e. diversification across multiple assets subject to specific fund’s investment mandate).
A syndication can be defined as a group of investors who collectively hold a single asset. This could be as LP and GP members of an equity investment LLC, or as Co-Lenders who pool their money and make a single loan to a borrower. In either case, they are considered a syndication. Here is a list of some pros and cons of investing into a syndication as opposed to a multi-property fund. These are in addition to the more general pros and cons involved in investing in real estate covered in Chapter 1:
Syndication - Pros
Syndication - Cons
Pooled Investment Fund - Pros
Pooled Investment Fund - Cons
There are two broad types of pooled investment funds that investors will typically encounter; Open-End (or “evergreen”) funds and Closed-End funds. It is important for investors to understand the differences between fund structures since the nuances will have material impacts on return profiles to investors. Both types of funds typically have what is called a “preferred return,” as well as a profit-sharing structure that compensates the fund manager for performance above the preferred return hurdle. Note that the preferred return is not a guaranteed return to investors, it’s just a threshold that the fund’s performance needs to crest before the manager begins sharing in the profits.
Open-end funds are an investment vehicle that can continuously raise new capital from investors, so that the fund can theoretically exist in perpetuity. These funds typically have redemption mechanisms in place to allow for investor liquidity after certain minimum holding periods. Open-end funds will often agree to pay out quarterly cash distributions to investors, subject to fund performance. While not always the case, open-ended funds tend to invest more heavily in higher cash flowing properties, so that the fund manager can meet and exceed the baseline preferred return and share in the excess profits.
Another key component of an open-ended fund is the unit share price. Each quarter the manager updates the estimated asset values across the portfolio, which sets the share price for that quarter. Investors who purchase shares in open-ended funds buy in at the value of the most recent mark. Like a publicly traded stock, when an investor later wants to redeem (or sell) their shares, pricing is based upon the most recently updated values. When investors are calculating their total return for an open-end fund investment, they must factor in both the cash distributions and the share price changes. The specific structure of a fund may vary and investors should read the offering documents closely before making investment decisions.
Unlike open-end funds, closed-end funds have a defined life cycle that is divided into several phases. The phases typically include a capital raising period, an investing period, and a selling (or “harvesting”) period. Closed-end funds generally do not provide mid-term redemption (selling) rights. Like a single asset syndication, investors are in for the long haul. Exactly how long that is depends on the fund, and investors should read offering documents for any investment closely before deciding to invest.
As with open-ended funds, there is usually a preferred return threshold that a manager is trying to exceed in order to share in the fund’s profits. The preferred return will typically accrue (as a running tab owed to investors) until the assets begin to sell. Unlike open-ended funds, the manager typically won’t share in the profits until investors receive all of their invested capital back plus an amount equal to their accrued preferred return. Any profits beyond that will be split between investors and the manger according to a predefined profit-sharing schedule.
Because a closed-ended fund manager’s compensation is back-end loaded, these funds tend to focus more on capital gain-oriented strategies, where the bulk of profits are made upon disposition of the assets (i.e. buy low sell high). Investors in closed-end funds typically receive little to no cash distributions during the early and middle years of the fund’s life cycle. This is an important factor to consider when deciding whether to invest in a closed-end fund.
Choosing the Right Fund
The decision to invest in a pooled investment fund, whether open-ended or closed-ended, first requires the investor to have great confidence in the ability of the manager. An informed investor’s decision to invest in one fund format or another is usually based on many factors including, but not limited to: income and liquidity needs, whether the investor wants to focus on capital gain, and whether the investor is in a position to await deferred income. Regardless of fund format, it is of utmost importance that investors understand exactly how the fund is structured and what the performance expectations are for its life cycle.
Common Investor Mistakes
Making a decision to allocate some amount of your capital to private real estate is a big first step, but that’s just the beginning. There will be many tasks that need to be accomplished before you can confidently make an investment into a specific real estate deal. Inexperienced investors can quickly find themselves in hot water because they’ve made simple and avoidable mistakes when assessing the viability and suitability of an investment opportunity.
Without understanding the investment risk profile, it is impossible to answer this question accurately.
At its core, real estate investing involves placing a wager on a set of assumptions about future outcomes with consideration of the risks involved. Factors to be considered include the investment strategy, the financial profile, market factors, and the manager’s ability execute on the business plan, among other things. The four main investment strategies come with different levels of risk, and therefore, investors expect different levels of returns in order to make the risks worth bearing.
Capitalization & Leverage
One of the areas investors commonly overlook is the investment’s capitalization structure. A careful study of the total capital needs of the business plan will often reveal financial pitfalls. For example, is the manager funding capital expenditures and working capital needs up front? Is any future capital needed, and will it be funded by debt, equity or both? What type of reserves and contingencies are being funded, and how much? These are all questions that need to be answered satisfactorily before making an investment.
Every deal will be capitalized by multiple sources. In the case of an equity investment, an investor’s capital will be subordinate to investors supplying the debt. This means the equity has a lower repayment priority and is thus at high risk of loss. The proportion of debt in a deal as compared to equity is often referred to as leverage. The more debt used to acquire a deal, the higher the “leverage” is said to be.
Leverage has many of the same attributes as dynamite. When used properly, dynamite is a powerful tool that can accelerate what would otherwise be slow and laborious pick-axe work. Debt is no different; it can greatly accelerate financial gains. Also like dynamite, if leverage is handled irresponsibly, it can become financially deadly. Investors should review leverage assumptions to make sure they align with the deal’s overall investment strategy. A mismatch can light the fuse on major problems down the road.
Supply & Demand Analysis
Understanding the capitalization profile of a deal is one thing, but just as important is an assessment of the fundamental economics driving the marketability of the real estate in question. It isn’t as simple as “if you build it, they will come.” In truth, if a property was developed in the wrong place, or in the wrong way, or at the wrong time, chances are pretty good that no one will come. A property’s location, layout, and broader economic and demographic trends will all contribute to the investment’s success or failure. Without strong demand for its use, the property’s beauty or uniqueness matters little.
Similar Asset Comparisons
Different real estate investment strategies have varying sensitivities to supply and demand. A further analysis of the competitive set will allow you to understand how forecasts compare to other similar properties in the market. Comparable properties are analyzed from acquisition, sale, and rent perspectives. An “attractive” or “low basis” is always relative. “Booming rental growth” is relative. The property should be analyzed in the context of the broader market, and supply and demand dynamics have shaped how the asset type has performed historically, and how a specific property compares to similar properties.
While the best managers have intuition and can see and create value beyond the historical market average, comparing assets will help you contextualize the business plan assumptions. An investor can validate a manager’s thesis and gain confidence by reviewing sales activity, existing rents at nearby properties, and historical market data. A manager should always be able to clearly articulate the reasons why their business plan is rational, based on what is currently happening in the submarket and what has happened in the past.
Manager Due Diligence
Once an investor understands the investment strategy and completes financial due diligence and market research, they may be satisfied with the opportunity and business plan. Without a competent manager to implement the plan, there may as well be no plan. This is the item investors are least equipped to address, but it is by far the most important factor of all. So how can investors verify the caliber of the managers they’re getting involved with? Managers should be readily able to provide the following to substantiate both their character and competence:
Alignment of Interests
Even if the manager aligns with an investor’s core values, presents a compelling real estate investment opportunity, and passes manager due diligence with flying colors, the nature of how the sponsor and investors get compensated, and in what order, will affect how the sponsor makes decisions. A close inspection of the offering documents and operating agreements will readily identify clauses that are at cross-purposes with investor interests, but it takes experience to parse dense legal texts and interpret how certain terms will influence behavior.
There are also many fees that will (or should) be disclosed in the offering documents. These fees are not always the result of arms’-length negotiations and may create conflicts between the manager’s and investors’ different interests. Examples of typical fees include management fees, leasing fees, financing fees, construction management fees, asset management fees, and disposition fees. These fees enable the manager to cover the costs of implementing the business plan, but investors must clearly understand what value is being provided in exchange for each fee, and how particular fees may impact decisions the manager makes throughout the life of the investment.
Accounting, Reporting & Uncle Sam
Capital Account Statements
Account statements will usually show a few pieces of data – some of which are important and relevant and others of which are less important or can even be misleading. The numbers and metrics will be different for a fund investment vs. a single-asset syndication
- Capital Contribution: This number reflects the amount of capital an investor originally contributes to an investment.
- Market Value / Net Asset Value: Often abbreviated as NAV – this is used for Open-end funds and estimates the current net value of all the assets in a fund’s portfolio. Syndications and closed-end fund statements usually do not provide market values.
- Income: This is the amount of the asset’s income that has been allocated to the investor during the most recent accounting period, and is calculated using U.S. Generally Accepted Accounting Practices (GAAP). Note that this number will not line up with the annual tax statement, since GAAP and tax accounting differ significantly.
- Distributions: This is the amount of cash that has physically been distributed to the investor. Distributions occur independent of allocated GAAP income but tend to be related in size and timing. The type of investment strategy (cashflow vs. growth) will make a big difference in the frequency and size of distributions the investor receives.
- Capital Balance: This is a running net calculation that keeps track of the total amount of money in, money owed, and money returned to the investor.
[Paid in Capital] + [Total GAAP Income] – [Total Distributions] = Current Capital Balance
When reviewing your capital account statement, ask yourself the following questions: Does the Capital Contribution match what I originally invested? Have I received distributions (either now or in prior periods) that relate to the total income I’ve been allocated? Can the manager clearly explain the reason behind the difference?
Clear, concise, and accurate reporting is key to tracking the execution of your investment’s business plan. As a part of your due diligence when reviewing an investment opportunity, it is recommended that you request copies of sample reports. Quality mangers will not hesitate to share their reporting capabilities with you. There are some minimum elements that you should expect to see within a report. They include:
- A narrative that outlines the work done during the reporting period as compared to the business plan, and how the manager intends to mitigate any deviations
- Near-term, forward-looking expectations compared to the business plan
- How the actual execution of the business plan compares to the expected timeline
- An accounting of the financial performance achieved in the period, down to net income
- A balance sheet that shows the assets, liabilities, and equity at the end of the period
At a minimum, an investor should make sure the manager will deliver the reporting on a quarterly basis. This is enough time for the manager to make meaningful progress on the business plan but does not allow too much time to pass without disclosure of any unexpected issues. Most importantly, if you have any questions, comments, or concerns related to the manger’s report, contact the manger. A quality manager will be available and responsive to your requests as a valued investor-customer.
Nothing in this eBook is or should be construed as tax advice. Consult with your tax professional to understand how the tax implications of investing in real estate apply to your individual situation.
Investing in Real Estate often confers significant tax benefits to investors. Tax benefits may come at a bit of a cost. Preparing tax returns for a syndication (and even more so for a fund) can be quite complex and time-consuming, often resulting in the need to file an extension with the IRS. Most experienced real estate investors understand and accept this trade-off as the cost of investing in real estate. While some may be concerned that filing an extension exposes them to additional audits or other risks, our conversations with tax experts and former IRS agents suggests that this is not necessarily true. Investing in real estate has the potential to generate tax advantages in three primary ways:
- Long-Term Capital Gains: Most successful real estate projects will generate a sizeable amount of capital gain at the sale of the property. Capital gain is the difference between the net proceeds received at closing and the total cost basis up to that point. Long-term capital gains are treated at a lower tax rate than ordinary income for the vast majority of investors. However, a real estate investment needs to be held for at least one year to be granted long-term capital gains treatment.
- Interest Deductions: As described in Chapter 2, most real estate projects are financed using a combination of debt and equity. For equity investors specifically, another source of tax relief is that the IRS allows the interest paid on the principal mortgage to be expensed. Unlike depreciation, there is no requirement by the IRS to recapture interest expenses at the time of sale.
- Depreciation: Most real estate projects include a significant opportunity to claim depreciation. Depreciation is treated as an expense, often generating significant tax losses, and thus offsetting operational income that is being generated. A sophisticated manager may even perform what is called a cost segregation (or “Cost Seg”) analysis. This analysis identifies the useful life of various elements of a property. The IRS has specific guidelines for how long a building and its various internal components can decline in value over a set time-period. A close analysis of the tax code can enable the Cost Seg to accelerate the amount of depreciation claimed on an investor’s K-1 tax statement. Note that this acts merely as a deferral of taxes; when the project sells the IRS guidelines require a “recapture” of the depreciation. This creates a separately categorized gain that is taxed at ordinary income tax rates. The extent of the tax benefit an investor could receive from depreciation depends on the investor’s specific circumstances.
Taxes are a highly complex and specialized area and each individual investor will have a unique set of circumstances that should be taken into account. We strongly recommend finding a CPA that has experience in real estate taxes and K-1 filings.
Your Next Steps
- Is cash flow important to me? Or am I focused on increasing my wealth?
- Do I prefer down-side safety or upside potential?
- Do I need frequent distributions, or are my living expenses being met already?
- How important are tax considerations for my investment?
- Are seasonal fluctuations in performance acceptable, or would I prefer more stability?
- Am I comfortable illiquid investments, or do I need an escape hatch?
- How am I going to be impacted if the investment takes longer to fully mature
There are no right or wrong answers to these questions, but they can help you set the parameters and guidelines when making investment decisions. When investors first ask themselves these questions, very often the response is “I want the lowest risk, highest return, most liquid, tax free, sure thing…” The perfect investment, however, does not exist. There are always trade-offs. It is also important to periodically revisit your analysis to determine whether your investment needs have shifted.
For first time investors, it can be very helpful to speak with a real estate manager that has a variety of investment options, so that you can compare and contrast to see what choices may best fit your objectives. The challenge for investors is that most real estate managers only offer one investment at a time, or one specialized strategy over and over, so the opportunity to compare and contrast becomes limited. For better or worse, most real estate managers are great salesmen, which when combined with inexperienced investors, can lead to buyer’s remorse or possibly worse outcomes.
Before diving head first into the middle market private real estate investment world, it is important for investors to define their objectives and identify the appropriate investment strategies and methods. Don’t shy away from asking a lot of questions, and complete as much due diligence and verification on both the investment and the manager as possible. There is a world of opportunity out there, and although finding the right fit is hard work, the juice is absolutely worth the squeeze!
About Fairway America
Established in 1992, Fairway America is a leading alternative investments manager focused on middle-market private real estate. We partner with carefully selected real estate sponsors to source, capitalize and execute on investments spanning multiple asset types and investment strategies. Our 30 years of value investing alongside accredited and institutional investors has resulted in a well-established track record of generating superior risk-adjusted returns while emphasizing capital preservation. Most importantly we know that the key to establishing long-term relationships with our investors is to provide transparent, responsive, and thoughtful support. Let Fairway America put our experience to work helping you find the right private real estate investments for your portfolio and contact us today.