Private real estate investments offer many opportunities for high net worth investors, family offices, and RIA’s, but with opportunity comes risk. Along with your standard due diligence of an investment opportunity, there are several basic questions every investor should ask before committing capital to an individual syndication, fund, or other private real estate investment vehicle.

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17 Questions to Ask Before Investing Your Money

Private real estate investments offer many opportunities for high net worth investors, family offices, and RIA’s, but with opportunity comes risk. Along with your standard due diligence of an investment opportunity, there are several basic questions every investor should ask before committing capital to an individual syndication, fund, or other private real estate investment vehicle.

1. What is The Investment Structure?

There are many ways to organize a private real estate investment and whether it is an individual syndication, niche fund, diversified fund, or other type of specialty structure, each provides a distinct set of opportunities and risks.

For example, an individual syndication where you invest in a single property could provide above average returns if the investment is a success. For example, if you invest with a developer in a ground up multi-family development, and the demand for the units meets the anticipated projections. On the flip side, if market conditions, cost overruns, or financing do not play out as projected, you stand the risk of a total loss on the investment.

If you invest in a niche fund model, you have the advantage of investing in a portfolio of real estate properties, spreading out risk (depending on the concentration of the portfolio), although typically concentrated on one asset type in a specific region. A diversified fund can provide exposure to multiple asset classes, across multiple geographies, with multiple managers. Private real estate investment funds can help you gain real estate exposure to your portfolio, while at the same time spreading out risk and outsourcing risk management to a real estate investment manager with the established and time-proven expertise to manage such risk.

2. How Does the Investor Get Paid?

While “return on capital” is the term most investors are thinking of when discussing a real estate investment opportunity, “return of capital” is a question of equal importance to consider. It can be advantageous to consider investments where the investor gets paid before the manager, or the structure has some type of “equality” to it.
In a situation where the 100% of the cash flows from an investment are paid to the investor until they have received an investment return plus a full “return on capital”, the manager has the incentive to pursue only the best deals as they gain little from taking every deal available.

3. What is The Preferred Return, Hurdles, and Promotes?

While most investors focus on the risk/return of their investments, the fee structure is just as important a variable to analyze. In many cases, high fees can eat up a substantial portion of your returns, which considering the risks and illiquidity of the investment, may make the investment potentially not worthwhile.

Unlike in other alternative investments that use the “2 and 20” model (management fee of 2% of invested capital and 20% carried interests in any profits) [1], the private real estate investment model structures distributions in such a way that Limited Partners (investors) receive a specific return on investment (as well as a return of capital) before profits are split between the Limited Partner and the General Partner (the manager of the investment). MLG Capital typically charges 1.25% on invested equity for their fee and then split profits at 70/30. We charge a lower fee upfront and seek a larger portion of the backend profits to reward us for successfully producing an 8% rate of return combined with a 100% return of original equity. The pressure is on us to produce with this mentality. Keep an eye on asset management fees when charged on valuation. For example, it is hard to draw an equality line between a manager and an investor when the manager is receiving a fee off total value of an asset or fund (who is defining the value) vs. simply on invested equity.

For clarity, MLG Capital targets an 8% preferred return to our investors. This means that investors accrue to an 8% preferred return, and are paid 100% of cash flow until the 8% is achieved. After investors are paid their 8% preferred return, MLG Capital must then return 100% of originally invested capital. Only then do we then split “profits” at 70/30 (investor/MLG). While this 8% return is not guaranteed, it ensures that MLG must deliver (at the minimum) a reasonable return on investment, and then return of original capital, before receiving a “promote or profit” for their services. As a result, our investors can target overall distributions that generate a 13-15% net annualized return. Approximately half of this is from “cash flow” and the other half from appreciation over time.

4. What Are the Targeted Returns Relative to Risk?

To truly analyze the attractiveness of a transaction, one must look at the potential returns relative to the risk of the investment; for example, you would not typically invest in a high-risk deal where the projected return on investment was barely above yields available in liquid or public opportunities.

All real estate investments are different; based upon the type of investment strategy, age, class, and geographic location of the property/properties, your risks will vary. In addition to the asset and location, you must consider debt, occupancy, proforma projections, and operational targets for the asset. For example, investing in a core strategy transaction (purchasing a stabilized property in a very good location – think downtown NYC) will typically produce lower potential returns vs. an opportunistic or value add investment (where the property is converted/improved to materially increase operating income/property value). The perceived risk of investment losses in a “core” asset will typically be lower as the property already has stable tenants, and is producing a consistent income stream.

5. What Type of Assets Will Be Purchased with My Investment?

Property type is an important factor when considering a real estate investment: as mentioned earlier, all real estate investments are different, bringing to the investor a distinct set of opportunities and risks.

For example, while property types within a geographic area typically correlate with the economic health of that area, there can be situations where one asset type (such as multi-family properties) may outperform other asset type (office buildings for example), even within the same local market. The demand for housing may exceed the demand for office space. This is a common situation in the current real estate market, as residential rental properties have continued to climb in valuation and income, while office has been impacted as market and employer needs change or have reduced overall demand.[2]

Some real estate funds are diversified (investing in residential, office, retail, and industrial properties), while others focus on one specific property type. Depending on your personal investment objectives, you may prefer a specific type of asset type, or you may be interested in spreading risk via a diversified portfolio. Multiple asset type funds can achieve various benefits (Tax efficiencies, investment diversification, etc.).

6. How Long Can I Expect My Investment to Be Tied Up?

Like other types of alternative investments, private real estate partnerships entail liquidity risks: the sponsor cannot easily liquidate and return capital to investors. Real estate is inherently illiquid: you cannot easily sell an apartment building or a warehouse like you could sell a block of stock: as such, you must consider this illiquidity risk when assessing the potential returns of a real estate investment.

MLG Capital’s private funds typically have a holding period of 5-8 years, meaning properties are acquired, redeveloped/stabilized and sold within a 5-8 year time-frame. This holding period will enable the real estate investment to target projected IRRs that are typically higher than liquid alternatives. If your investment objectives require easy access to funds from your portfolio, this is an important factor to consider.

7. Will My Investment Be Passively or Actively Managed?

While you would assume that a private real estate investment would be actively managed, there can be situations where you are a “passive investor in a passive investment” – the sponsor of the real estate investment vehicle you have invested in may invest the proceeds in real estate deals managed by third parties. This produces additional due diligence requirements as you must take into consideration the investment objectives and risks of the individual third level managers. You may assume that the manager of the fund you have directly invested in will have the expertise to make those decisions, but you are still increasing your personal risk by ceding such control. Consider questions relating to the sponsor or fund managers asset management team as well as reporting, treasury/accounting, and other in-house capabilities.

8. What Are the Fees Charged/Associated with This Investment?

Along with the carried interest (or “Promote”) provided to the sponsor in terms of the real estate investment, there may be other fees charged by the sponsor for managing the partnership. These fees can also eat into your total returns, as the sponsor or fund are generating income (in the form of management fees, etc) that are not tied to the performance of the investment. Be aware of these fees before committing capital and understand the total impact of such fees. Does the sponsor or fund charge administrative fees to their investors, capital origination fees, when are the fees paid, is the fee on invested equity or asset value, etc.?

9. What Type and How Much Debt Will Be Used with My Equity Investment?

Real estate is typically a leveraged transaction. Depending on the type of real estate investment, the sponsor or fund will utilize some sort of debt financing to maximize returns. However, with debt comes added risk of capital loss. Different types of real estate transactions will utilize different types of debt. A lower risk real estate 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 (meaning in the event of a bankruptcy/foreclosure, the mezzanine debt holder’s claim will be paid before you receive any proceeds). It is imperative you assess the levels of debt to be used in your real estate investment before committing capital. If a highly speculative real estate investment involves the use of a larger share of senior and subordinated debt (and little equity), the chances of a loss of your equity investment can be materially higher, especially without reserves or a contingency plan. Typically, higher leveraged deals will promote a higher overall targeted return due to this risk factor. Do due diligence on how the manager feels about debt and dig into their targeted returns vs. their leverage points. For example, a value-add multifamily deal may be less attractive (in terms of risk) if it is levered at 80% LTC, hitting an overall return of 15% vs. a value-add multifamily deal targeting a 14.5% overall rate of return, at 67% LTC.

10. How Frequent Will I Receive My Return and/or Distributions?

Along with the holding period of your investment, it is important to consider the frequency of return distributions, as well as the return of capital. Time is money, and a longer time horizon to fully realize value of a property will reduce the IRR of your investment, potentially reducing the attractiveness of the investment as well.
In addition to reduced projected IRR, depending on your personal investment objectives, you may require distributions on your investment. If you are depending on your investment portfolio to produce cash flow to finance your personal expenses, it would make more sense to invest in real estate transactions focusing on income generation as opposed to capital appreciation over time, ideally both. Be keen on the overall business deal with investors on distributions. Check on targets for cash flow. Is cash flow expected right away? Is there NO cash flow for a period of time? If there is no cash flow does the sponsor still earn fees? What is the business plan on the deal? What is the overall target hold, etc.

11. What Are Your Historical Returns?

While past returns are not indicative of future results, a track record is an important factor to look for in a real estate investment manager. Real estate investment firms come and go, but a firm that has consistently produced IRR and equity multiples that are in line with expectations of the asset class and investment will indicate they have the expertise you are looking for when you commit capital to a private real estate investment. Typically, a positive historical track record is a sensible resume item for consideration on investment. Seek clarity on losses or deals that underachieved targets.

12. How Long Has the Firm Been in Business?

With time and experience comes wisdom – ESPECIALLY when surviving market cycles such as 2008-2010. A real estate investment firm that has survived several downturns in the real estate market will again indicate to you that they typically have the expertise and skills necessary to generate risk-adjusted returns in line with your investment objectives.

13. How Did You Weather the “Savings and Loan Crisis”? How About The “Dot Com Bust” or the “Great Recession”?

In the past 30 years, the commercial real estate space has been through several major downturns that resulted in reduced demand for real property. After the “Savings and Loan Crisis” of the late 1980s (as well as the 1986 tax reforms that reduced the tax benefits of passive real estate investments[3]), real estate entered a serious recession that depressed property values for nearly a decade[4]. The “Dot Com Bust” and the resultant recession of the early 2000s also produced a depressed market for real estate[5]. “The Great Recession” of the late 2000s produced an even greater depressed market for properties, as the rising valuations produced by easy credit came halted as financial institutions scrambled to stay solvent[6].

A firm that managed through these cycles and remained in business through these massive downturns in the real estate market will indicate to you that it has the experience to weather the storm and understands how to deliver to their investors.
Managing through cycles brings a slew of potential questions to ask, including leverage targets, overall investment objectives, investor distribution models, etc.

14. How Are You Not Going to Lose My Money?

This may seem like a no brainer question, but with the myriad of risks inherent to real estate, this is the most important question to ask before investing. The cardinal rule of investing is “Do Not Lose Money.”

A real estate investment firm should tailor their strategy to consider the risk of capital loss. Whether this is built upon diversification, optimal use of leverage, proactive deal sourcing, or adequate due diligence before engaging in an acquisition or redevelopment, the sponsor must have a reasonable, substantial answer to this simple but important question.

15. Do You Accept IRAs or 401ks?

While tax-advantaged investment vehicles such as IRAs and 401ks are typically invested in public equity, self-directed accounts can, at times, invest in alternative assets such as private real estate. However, because of regulations put in place by the IRS to prevent tax-exempt entities from engaging in active business without paying taxes, investments through IRAs and 401ks should consider the impact of triggering UBIT (unrelated business income)[7]. Triggering UBIT could result in an additional tax. UBIT could be triggered if you invest IRA/401k assets in a real estate transaction if the IRA/401k invests in a real estate partnership through a pass-through entity (such as an LP or LLC) that has leverage involved (Debt). An opportunity to eliminate the potential impacts of UBIT should be discussed if available by the sponsor or fund. A tax professional should be consulted to advise you on the tax implications of an IRA/401k real estate investment.

16. How Do You Source Your Deals?

The sourcing strategy of a real estate investment firm can be the “secret sauce” that can give one firm an edge over others. When it comes to finding opportunities that produce the Internal Rate of Return (IRR) you expect on your investment, finding the best opportunities and having a deep sourcing funnel are key. Real estate is a relationship business, and 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. Real estate is more than having the money to commit to a deal: without the existing network in place, and relationships, the sponsor of your fund may be entering uncharted waters, adding potential additional risk to your investment. Ensure the sponsor or fund knows what they know and source what they know.

17. What Are the Tax Implications of My Investment?

Because tax situations vary from investor to investor, it is best to discuss tax planning with a professional such as a CPA or tax attorney. While real estate offers many tax advantages over other types of real estate investments, it is important to understand the nuances of these regulations, and discuss these with your tax advisor. The firm you plan to invest with may have in-house tax staff as well, but it is best to utilize your own tax advisors before making a real estate investment.

MLG Capital for example has several CPAs on staff as well as a tax director. For each of our investments we are able to demonstrate targeted overall returns, tax impacts, as well as historic performance relating to cash flows from funds and assets. You never know, a good sponsor deal or fund’s tax planning can potentially accomplish great things for your specific overall picture, or, potentially outweigh other investment opportunities.

References Cited

  1. Investopedia, Two And Twenty.
  2. Heschmeyer, Mark (2013), Changing Office Trends Hold Major Implications for Future Office Demand.
  3. Cordato, Roy E (1991), Destroying real estate through the tax code. (Tax Reform Act of 1986).
  4. FDIC, Commercial Real Estate and the Banking Crises of the 1980s and Early 1990s.
  5. Ren, Jing (2017), It’s Not A Recession You Should Be Thinking About…It’s Three Recessions.
  6. Levitin and Wachter (2013), The Commercial Real Estate Bubble.
  7. Bergman, Adam (2015), Beware Unintended Tax Consequences of Unrelated Business Income.