As an alternative to the typical investments in stocks and bonds, real estate offers many opportunities for high-net-worth investors, family offices, and investment advisors. In addition to the standard due diligence of a specific investment opportunity, it’s important that investors also understand the intricacies of investing in any private real estate vehicle.
This 4-part series will outline the core focus investors should consider and the types of questions to ask to make an informed decision before committing capital to an investment in private real estate.
- What is the Investment Structure?
There are many ways to organize a private real estate investment. Whether it’s an individual syndication, niche fund, diversified fund or other type of specialty structure, each provides a distinct set of opportunities and risks.
An individual syndication, for example, is an investment in a single property. If you invest with a developer in a ground up multi-family development, and the project goes well, that investment could generate extremely attractive returns. However, because all of your money is invested in a single property, you stand the risk of a total loss on the investment if the project doesn’t go as planned. With an individual syndication, there is no diversification achieved and, therefore, more risk.
Another example is a fund structure. A fund can provide exposure to multiple asset classes, across multiple geographies, with multiple managers, thus providing diversification within your investment and reducing the risk of capital loss. A fund structure focuses first on preserving your capital, but also makes it less likely that you’ll hit a home run.
While both structures have their place within a portfolio, it’s worth taking some time to determine your risk tolerance as an investor and do your homework to make sure you’re investing with a thorough and experienced sponsor (we’ll talk more about this in Part Three).
- What Type of Assets Will Be Purchased with My Investment?
Every asset class carries a unique set of opportunities and risks, so it’s important to be informed on what you’re investing in.
Some real estate funds are diversified (investing in residential, office, retail, and industrial properties), while others focus on one specific property type. As you make your decision, it’s important to think of the risks involved.
For example, retail and office properties can generate nice cash flow, but often can be burdened with extremely heavy turnover costs when tenants leave. By contrast, multifamily properties tend to trade at lower cap rates and produce lower cash flow, but have other benefits like appreciation, tax efficiencies, and the ability to be a hedge against inflation.
Depending on your personal investment objectives (e.g., tax efficiency, liquidity or growth, to name a few), consider which type of strategy you’d prefer.
- How Do You Source Your Deals?
Real estate is a relationship business. An experienced operator with deep ties to the markets in which they invest will typically have a stronger sourcing strategy than a less experienced operator looking to enter a specific real estate market without an existing network.
The deal sourcing strategy of a real estate investment firm can be the “secret sauce” that gives one firm an edge over others. Inquire about the manager’s sourcing strategy how it might overlap with their existing network and partnerships.
- How Will this Investment Be Financed?
Almost every investment will utilize some form of debt financing to maximize returns, so it’s important to note that with leveraged transactions comes added risk of capital loss.
A lower risk investment (such as the purchase of a stabilized property) may only involve a mortgage on the property, while a more speculative investment (such as a conversion/renovation) could involve types of real estate debt (such as mezzanine debt) that is senior to the equity invested in the project. This means that in the event of a bankruptcy/foreclosure, the mezzanine debt holder’s claim will be paid before you receive any proceeds.
Understanding how a project will be financed enables you, as an investor, to evaluate the risk profile of each investment more accurately and determine whether the investment is a fit for your portfolio.
- What is the Holding Period of My Investment?
While private real estate can produce above-market returns in many cases, investments in real property tend to be illiquid, so investors need to be aware of how long they are tying up their cash. Some funds or syndications have a buy and hold strategy, while others will look to fix and flip an asset in a shorter period.
If you have a need for immediate cash flow, for example, a buy and hold strategy may not work for your portfolio. Further, depending on the structure of the entity, liquidating your investment may not be a simple process. Get clarity on the details of the investment before committing capital.
- What Are the Targeted Returns Relative to Risk?
All too often, investors are drawn in by shiny return numbers, but don’t dig in to understand the amount of risk they are taking. It’s important to remember that not all returns are created equal – asking the above questions can help you to weigh the risks of an investment against the targeted returns.
In addition to the variables of diversification, asset class, and leverage we’ve talked about, investors also need to consider other important factors like location, vintage, and economic drivers.
This list of questions can be daunting, so it becomes imperative to stick with a sponsor that you trust and has a demonstrated track record of adding value and achieving targeted returns.
In our next article, we discuss the intricacies of the different investment vehicle structures, and how it can impact your investment returns.
Nathan Clayberg is a VP at MLG Capital, splitting his time between working with investors and chasing joint venture acquisitions in the Midwest. Outside of work, Nathan cherishes time with friends and family and enjoys working on his own real estate portfolio.
