Real Estate Investing - Beyond the Basics - KingsCrowd

December 15, 2020

Real Estate Investing – Beyond the Basics

Introduction

This is the fourth article in a 4-part series about getting started as a real estate investor. In the first article, we discussed why adding real estate to your portfolio might be a good idea. In the second article we introduced the basics of real estate sectors, property types, and REITs. The third article covered some basic real estate investment options — which is what we’ll finish talking about here.

REITs Basics Continued

Before we dive into more REIT investment options, we need to add to our knowledge about REITs. If you didn’t read the Real Estate Investment Basics section in the second article, or your memory is a little fuzzy, I’d recommend reading that first before finishing this article.

In the last article, we talked about publicly-traded REITs (Traded REITs). But, there are two other forms of REITs that we will talk about today

Sponsor

First a little terminology. The Sponsor” of a real estate investment opportunity is the individual, fund, or firm that is offering the opportunity to investors. As an analogy, think of the REIT Sponsor like you would a VC firm and its general partners that offer VC Fund X to investors.

Fees

Fees are also something that you should pay close attention to. All else being equal, lower fees are better — but don’t expect to find a no fee option like those offered by online stock trading apps. For REITs, here are a couple fees and ranges to use as a benchmark:

  • Expect to see total management fees between 1-2% per year. Avoid investments that stack multiple annual fees that cumulatively add up to more than 2%.
  • Expect to see some form of profit sharing, typically called “promote” or “carried interest.” Promote kicks in only after the Sponsor has achieved a minimum return target, typically called the “preferred return”. Promote fees are typically 20-30% of profits after preferred returns to investors.
  • Avoid investments that charge upfront or one-time fees that reduce your principal going into the investment. Your principal investment amount — or capital account — is used to calculate not only your fees, but also the proportion of dividends and profits you receive.

Private REITs (aka “Traditional” REITs)

This is a REIT that is not registered with — nor regulated by — the SEC and does not trade on exchanges. These “private placements” are exempt from SEC regulation through Regulation D of the Securities Act of 1933, which limits their availability to accredited investors only. This is the same “Reg D” often used to raise money for startups. Historically, they’ve been reserved for the most wealthy investors because of their $100k to 250k investment minimums.

Private REITs come with a professional management team that deploys the funds across multiple properties, providing diversification (depending on the strategy) with a single investment. Returns average around 8-10% per year with roughly half of the return coming via dividends. In addition, private REITs that are often structured as an LLC that may (confirm with the Sponsor) pass through operating losses to investors to offset taxes on dividend distributions, similar to a direct real estate investment.

The convenience and advantages come at the cost of a 1-2% management fee and 20-30% promote fee for returns above a preferred return threshold of 5-8%. Your investment is illiquid, unlike publicly-traded REITs, but to make up for it private REITs tend to provide higher returns. While minimum investment amounts remain high, they have been trending down — some are as low as $50k, thanks in part to online private REIT marketplaces.

Private REIT Marketplaces

Unless you are a REIT industry enthusiast, I’m willing to bet that there aren’t many private REIT “brand names” that come to mind. That is why many rely on private brokers and wealth managers to sell their funds to investors. Historically, these sales commissions have been a significant upfront cost to a REIT, reinforcing their need to find large investors to make the sales commission worthwhile.

Thankfully, the rise of the internet and cheap software tools have given birth to private REIT marketplaces — like CrowdStreet, RealCrowd, RealtyMogul, and ArborCrowd (to name just a few). These marketplaces aggregate private REITs offers from a range of Sponsors and often perform some screening of offers before posting them. This has provided an efficient way for REITs to reach a wider audience of investors and has allowed many to reduce their minimum investment to $25k.

Much like startups on equity crowdfunding sites, private REIT marketplaces are typically not investing their own capital in the deals they post, nor are they endorsing them. So it is still up to investors to do their due diligence. Most marketplaces make money by charging a sales fee to the REITs whose offers they list, however, a few sites do charge investors. Be sure to double check the total fees charged between the REIT and the marketplace.

Public Non-Traded REITs

This is a REIT that is registered with and regulated by the SEC — just like Traded REITs. The difference is they are not traded on exchanges. Instead they are often sold by private brokers or directly by the REIT. Non-traded REITs are available to accredited and non-accredited investors alike.

Non-traded REITs have found favor among a new generation of REIT platforms born online, like Fundrise and DiversyFund. One reason for that is this structure allows them to accept non-accredited investors, since they are registered and regulated by the SEC. With a larger potential investor base, these sites reduced their minimum investment requirements to $500-$1,000.

Other than the regulatory differences, non-traded REITs share a lot of similarities with private REITs as both are illiquid (non-traded), offer similar investment options, have a professional management team, and deliver similar returns. Investors make one investment decision and the REIT management team deploys the capital into a portfolio of properties.

There are a few differences though that tend to benefit investors. Online non-traded REITs tend to offer lower fees than Private REITs. Using Fundrise and DiversyFund as the example, both are vertically-integrated REITs handling all operations in-house. Neither charges promote or carried interest fees. Fundrise charges an all-in 1% management fee, and DiversyFund does not charge any management fee. Now, the devil is in the details, as DiversyFund receives 2-8% “project” level fees, which are presumably operating expenses that any REIT would incur. The question is if the lower fee and cost structure translates into better returns than traditional “high cost” REITs? Looking at the returns, Fundrise boasts historical returns of 8.7-12.4% net of fees and DiversyFund says it targets 10-20% IRRs at a property-level. These are solid returns that would be a welcome addition to any investor’s portfolio, but there are other REITs that offer similar returns.

The other difference with this new breed of REIT has less to do with investing and everything to do with being built online. Many of the online REITs offer a great investor experience through easy to use web and mobile apps as well as a high-level of transparency about the properties acquired and detailed updates about fund performance. This allows investors to stay informed, learn, and have confidence in their investment decisions, while letting the professionals do their work.

Private REIT marketplaces have taken note of the convenience and popularity of online REITs’ fund approach. CrowdStreet and RealtyMogul have added fund options of their own, some are independently managed portfolios and others package individual REITs from their platform into a diversified fund.

How to Evaluate REIT Investment Options

Since there are a wide variety of REITs and real estate investment options, there is no single “right” criteria or metrics for making an investment decision. That said, here are some metrics that tend to be relevant to a wide range of options.

REIT Profile
  • Real Estate Sector and Assets: You need to know what industry, region, and property types the REIT plans to invest in to understand the risk-reward.
  • Sponsor Experience: Just like founders with a startup, you want an experienced Sponsor — ideally with experience in the sector or strategy the REIT offers.
  • Debt, Equity, or Both: You need to know what type of securities the REIT will invest in in order to understand the risk-level and have reasonable return expectations.
  • Hold Period and Liquidity: Verify the target fund life — often 3-10 years — and if there is a plan to support redemptions. Redemption policies are more common with evergreen funds that don’t have an end date.
Risk and Return Metrics
  • Historical Returns: If the Sponsor has managed prior funds, it is a good idea to check the returns they delivered.
  • Use of Debt: The use of debt can magnify returns, but it also increases risk. This is usually measured using a Loan-to-value (LTV) metric. Generally speaking, 50-70% LTVs are common. You might also look at debt and interest coverage ratios discussed in the third article.
  • Capitalization (Cap) Rate: This metric is used to measure the profitability of a property, but it also serves as a benchmark for comparing the market value of properties. Cap rate is the ratio of net operating income (NOI) divided by the market value of a property. Cap rates will vary by sector, geography, and quality of a property. Currently, cap rates range from 4.5% to 7.5%.
  • Dividend or Cash Yield: Confirm the target percent dividend yield, as well as how often it is paid. Dividend yield often ranges from 3% to 6%, but could be higher/lower depending on the REIT’s strategy. Quarterly is the most common payout frequency.
  • Equity Multiple or Cash-on-cash Return: This metric provides the total return target that investors should expect. Equity multiples range from 1.5x to 3.0x, where a 2x means that for every $1 investors put in, they will get $2 back over the life of the fund. This metric does not account for the timing of payments.
  • Target IRR: Percent IRR is another total return metric and is similar to an annualized rate of return. The difference is that IRR takes into account the timing of returns. For two identical 10-year funds whose only difference is Fund 1 returns 50% of principal in Year 5 and Fund 2 returns 100% of principal in Year 10, Fund 1 will have a higher IRR, but they will have the same equity multiple.

Residential Debt Investments

One of the areas within real estate investing that has taken off in recent years is real estate debt — in particular, “fix-and-flip” loans for residential real estate (single family homes, duplexes, or small multi-family). Much of the innovation in this space has come from online marketplaces like PeerStreet, Fund That Flip, and LendingHome. These platforms appeal to borrowers (contractors, sponsors, flip investors) looking for short-term project financing, as well as to lenders (debt investors) through the allure of 7-12% cash dividends over a relatively short time frame.

In a yield-starved world, the opportunity is enticing. However, there is a lot to be wary of here. Not only are you investing in individual properties that definitely need work, you are investing in the person managing a construction process and re-sale. There is often limited information to evaluate either of these key factors. Additionally, key assumptions like the time required, funding required, and After Renovation Value (ARV) are difficult to verify and good-faith estimates could be wrong. You also need to double check the actual security you are investing in. Some platforms have created unique securities and structures that may not operate like a plain vanilla investment.

Several companies have struggled to create and sustain a fix-and-flip lending marketplace. It is a highly fragmented market. Scaling volume while maintaining quality has vexed early entrants as they saw default rates rise. For investors, the necessary due diligence is a lot of work as well as being sure to select enough loans to diversify away default risk.

AlphaFlow — who recently completed a Reg CF round on Republic — is one of the more exciting entrants in the space. Market fragmentation has kept large institutional investors out of the residential fix-and-flip market also. To attract them, AlphaFlow has focused on data collection, offering a one-click diversified portfolio and building a slick software solution that addresses investors’ portfolio management needs. Unfortunately, they only offer an accredited investor option, Titan by Alphaflow, and it comes with a $100k minimum.

Concreit is another new entrant in the real estate debt space, focused on commercial debt or “hard money” loans. With Concreit, investments get diversified across multiple loans backed by commercial property assets. Concreit is available to non-accredited investors and has a low minimum investment of $1. The fund pays a 5% preferred return net of fees and dividends are paid weekly in-kind. While 5% may not seem that exciting at first, here’s why it’s interesting. Investors can withdraw any amount at any time — there is no lock-in. That level of flexibility and liquidity is unique in the real estate world. It may not give you a 2-3x payday, but it might have a place in a well balanced portfolio.

Fractional Real Estate

The last area we’ll discuss is fractional real estate ownership. This is one of the more recent innovations, and with such a limited track record it is difficult to generalize risk and return potential. Be extra judicious before investing in fractional real estate. Do your best to understand the property, your exit options, and to what extent your exit is contingent upon the platform or an investment manager, other co-investors, or a liquid secondary market.

Fractional ownership investment opportunities come in a variety of forms, but the basic idea is simple. It lowers the minimum investment requirement for investors to participate in direct property ownership — just as equity crowdfunding and fractional public stocks have lowered the entry point for startup and public equity investing, respectively. The result is you own a small portion of a property, rather than the entire property.

Republic — Fractional real estate

Compound — acquired and renamed Republic Real Estate — pioneered fractional real estate investing. Since then Republic has expanded the range of offerings from individual condos to single family homes and buildings. Everything is available to non-accredited and minimums range from $100 to $1,000. Volume on the site tends to be low, which isn’t uncommon.

Roofstock — Fractional residential rental ownership

You may remember Roofstock from the third article where we discussed residential rental property platforms. In 2019, the company launched RoofstockOne, which addresses some of the investor pain points of buying an entire rental property. With this new model, equity ownership of each house is broken into 10 shares, allowing you to buy as little as 1 share for $5,000. No more mortgage in your name. Roofstock will retain ownership in 1 share also, so they have skin in the game as well. Second, all asset and property management are handled by Roofstock. No more maintenance or renters to worry about. If you want to sell, you are likely dependent on Roofstock’s offer. But that might be a fair trade-off for testing the waters of rental ownership.

Lex — Fractional commercial building ownership

Lex offers fractional ownership in commercial buildings for as little as $250. Lex screens properties for their ability to deliver consistent dividends before posting them on the site. Lex is a relatively new site with only 3 properties listed and a waitlist for new investors. While you still have single property risk, it is intriguing since you get a more substantial asset (an entire building), rather than a fix-and-flip loan or fractional ownership of a condo. Read the details carefully to understand what you are getting, who the owner/manager is, what is motivating the partial sale, and what the financials of the building look like.

Fractional home equity

The last two platforms we’ll talk about are Point and Noah. Today neither have an offer for investors, but I thought they were worth mentioning as I could see them (or similar companies) offering an individual investor option in the future.

Here’s what they do. Both companies allow homeowners to cash out a portion of their home equity — with no debt or monthly payments — and continue to live in the home. In other words, Point and Noah will buy a portion of your home’s equity from you. As your home appreciates, Point and Noah share in the appreciation. You can buy back your equity later (at the higher price), or sell your home and split the proceeds.

Summary

Congratulations, you made it to the end! Hopefully, you learned a lot and found a few real estate investment options that make sense for you — or at least feel better equipped to evaluate the next real estate deal you look at.

Like equity crowdfund, there is a lot of activity and innovation happening in online real estate investing — in fact many of the companies mentioned are start-ups themselves. I expect the innovation trend to continue and more fund-style options to emerge that give investors an easy way to participate and manage more and more forms of real estate.


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About: Mike Cozart

Mike is a senior product leader and angel investor. Mike started his career as an investment banking analyst and venture capital associate before taking on general management and product management roles with Amazon and Axon Enterprise. He earned an MBA from Columbia Business School in New York City, a BA in Economics from The University of Texas at Austin, and a BS in Geographic Information Science from Texas A&M University at Corpus Christi.

View Mike Cozart's articles

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