This guide provides a blueprint of everything the accredited investor needs to know when considering investing in private real estate.
Editor’s Note: This Investment Insight was co-written with our partners, Origin Investments.
INTRODUCTION
Private real estate is an important part of a diversified asset allocation, but it is still an unfamiliar asset class for many investors—especially given the prevalence of the 60% equity/40% bond portfolio, the baseline that has been popular since the 1950s thanks to its simplicity. Market forces, such as rising inflation and the swing from historically low interest rates, have led stocks and bonds to rise and fall in unison, diminishing the performance of this one-size-fits-all approach. Vanguard data shows it is not any better than other balanced portfolio formats, while advisors have long known that it is not ideal for young investors who have decades to grow their wealth or aging investors who need to reduce risk.
These realities, coupled with a wide range of alternatives that have become available to investors in recent years, have led to a boom in new investment options. Private commercial and multifamily real estate, once accessible only to institutional investors and recognized for its outsized returns, became popular immediately after the Global Financial Crisis of 2008 as the asset class bounced back more quickly than many others. Since then, investors have experienced a number of periods of increased volatility, including three bear markets. It is no surprise the folks at global alternative investment firm Preqin observe that investors like the lower-volatility, stable, income-yielding nature of private real estate.
As inflation and interest rates rose in 2022 and 2023, real estate as an asset class stumbled, but the multifamily subset turned in strong performance and has remained one of the most reliable property types for long-term investment in 2024 and beyond, Wealth Management noted.
THE BENEFITS OF PRIVATE REAL ESTATE
This guide provides a blueprint of everything the accredited investor needs to know when considering investing in private real estate. First, we explain the building blocks: how private real estate benefits portfolios, the most common real estate investing strategies, and how much of a portfolio should be invested in private real estate. Then, we help investors move beyond glossy real estate brochures to ensure a potential investment is aligned with their personal risk tolerance and is backed by a feasible business plan. We detail the types of risk encountered in private real estate investments, the most common forecasting metrics, and the fees managers collect during the complex, multiyear investing process.
Private equity real estate investing is direct ownership of physical real estate, whether it’s in the form of land, office buildings, rental homes, apartments, shopping centers, hotels, self-storage facilities and so on, with the intent of making a profit. Ownership means an interest in a piece of property. Individuals can invest in private real estate by acquiring assets actively as a direct buyer or by investing passively with private real estate investment firms, online platforms or private real estate investment trusts (REITs).
Private real estate can offer many benefits to individual investors, such as portfolio diversification, tax efficiency and the potential for high returns and regular payouts. Institutional investors rely on this asset class in their portfolios to balance market volatility. Case in point: Yale University’s endowment is considered the gold standard for its exceptional performance from 1985 to 2021 under its late chief investment officer, David Swensen, who shifted investment priorities from traditional stocks and bonds to alternative assets, and typically allocated from 9% to 11% of its portfolio to real estate. This strategy became known as the Swensen model and initiated a sea change in the standard investment approach for most large university endowments.
Not surprisingly, many other institutional investors, particularly pension funds, foundations and sovereign wealth funds, follow this strategy today. We have known about the attractiveness of the asset class since Origin Investments was founded in 2007 and are pleased that individual investors have begun adding private real estate to their portfolios recently.
Benefit 1: Private Real Estate Generates High Absolute Returns
Private real estate offers the potential for high absolute returns. An absolute return considers appreciation, depreciation and cash flows. It measures the amount of money an investment earns over time and is expressed as a percentage gain or loss on the initial investment.
As the chart below shows, the NCREIF Property Index has marched steadily higher over the past 25 years with few interruptions to the “up and to the right” trend. An investor who put $100 to work in June 1999 would have $649 if they had used only real estate, $634 using only the S&P 500 or $259 with the Bloomberg U.S. Aggregate Bond index (of course, one cannot invest directly in an index). Adding to the allure of real estate, we are big fans of the distributions that come from this class, with the U.S. NAREIT REIT index paying a 4.5% yield—a handsome improvement to the U.S. Aggregate Bond index’s 3.7% and the S&P 500’s 1.3%. Because every real estate investment strikes a different balance between capital appreciation potential and investor yield, we think it’s an important feature to discuss with your financial professionals when selecting an investment vehicle.
Benefit 2: Private Real Estate Has Low Correlation to Other Asset Classes
The goal of every portfolio is to create the highest total return with the lowest risk. Most investors are comfortable with a mix of stocks and bonds in their investment portfolios—until the market’s gyrations start making them nervous. Private real estate can help investors improve their allocations by offering stability and income during times when traditional stock-bond portfolios experience challenges.
The value of a private real estate fund is based on the actual value of property held by the fund. Conversely, in a public real estate investment trust (REIT), the share price is determined on a minute-by-minute basis by market forces. That means the share price of a public REIT may not reflect the actual value of the underlying real estate. In some cases, the disconnect between actual value and the share price can exceed 30%—not a great attribute for investors thinking they are getting lower-volatility real assets.
Private real estate values don’t move daily, which creates a sense of reduced volatility relative to other investment options. Public markets offer liquidity at the expense of higher volatility. Private investments offer investors lower volatility at the expense of illiquidity. There’s no free lunch, for sure, but there are optimal choices for your personal financial situation.
An investment portfolio benefits from reduced risk in the form of volatility when it includes asset classes that are not correlated to each other (e.g., the asset prices do not move in tandem). The table below illustrates how private real estate has minimal correlation to stocks, bonds and even public REITs, as measured by the National Council of Real Estate Investment Fiduciaries (NCREIF) Property index. The index tracks the returns of private, institutional-grade commercial properties. A correlation coefficient of 0 means prices do not move together. A coefficient of 1 means the assets move in tandem; a negative correlation means they move in opposite directions.
Benefit 3: Private Real Estate is Tax Efficient
Investors who focus solely on underlying return and ignore after-tax yield overlook a big benefit of real estate investing. Income generated by properties is generally shielded through depreciation, providing investors with the long-term benefits of substantial cash flow and very little tax burden.
IRS rules allow owners to take annual losses in the form of depreciation to smooth out eventual capital expenditures as buildings age. However, only the physical elements of a property are subject to depreciation. Land can’t be depreciated and must be separated from the physical property value. For example, a multifamily property can be straight-line depreciated over 27.5 years. If the property was acquired for $6 million and is sitting on land worth $1 million, it will produce $181,818 in annual non-cash depreciation ($5 million divided by 27.5 equals $181,818).
The length of time you hold an investment determines whether you pay short- or long-term capital gains on a real estate investment. In general, long-term capital gains will apply. That means individuals pay up to 20% in taxes on real estate investments versus 37%, the highest tax bracket on ordinary income. If a property generates $100,000 of cash flow and $50,000 in depreciation, then the individual’s taxable income is reduced to $50,000.
However, the depreciated portion of the property is subject to a recapture rate of 25% upon sale. Here’s how it is applied: If a property is acquired for $10 million and depreciated by $2 million, the cost basis for tax purposes would be $8 million. The difference between the cost basis and the original purchase price is taxed at the recapture rate upon sale.
Assuming a property has been held for more than one year, any investment appreciation above the original purchase price is subject to the long-term capital gains rate of 20% when sold. Expanding on the example above, if the property is sold for $13 million, the difference of $2 million (from the IRS tax basis of $8 million to the purchase basis of $10 million) is subject to the recapture rate of 25%. The gain from $10 million to $13 million is taxed at the capital gains rate of 20%. The effective overall tax liability at sale is $500,000 plus $600,000, or $1.1 million. The diagram below details how this works.
The ability to defer taxes into the future is one of the greatest attributes of owning real estate directly. Through a 1031 exchange, such as Origin Investments’ Origin Exchange, real estate owners can sell one property and buy another without incurring capital gains taxes. In theory, an investor could buy and sell properties without ever paying taxes on the gains. Investors who no longer wish to find replacement properties through a 1031 exchange can diversify their holdings through a 721 exchange, which allows them to contribute their real estate into the operating partnership of a real estate investment trust. Another way to defer federal income tax on eligible capital gains realized from the sale of a previous investment is by reinvesting those capital gains into a Qualified Opportunity Zone (QOZ) fund. Investors pay zero federal taxes on the appreciation of a QOZ fund investment by holding the investment for 10 or more years.
Finally, private equity real estate is typically held in a limited liability corporation (LLC), considered a pass-through entity by the IRS. That means 100% of the income, losses and expenses pass through to the owners. Unlike corporations, where owners may be subject to double taxation (the corporation pays taxes on corporate net income and the owner pays on any dividend income they receive), the LLC itself does not get taxed. Instead, individual members are taxed on their share of the income, expenses and losses reported on their year-end tax document, the K-1. They are taxed at their tax rate, which is often lower than the corporation’s.
Active Versus Passive Investing
Active investing in real estate is when buyers own and operate an asset outright, either by themselves or with family, friends or acquaintances. They can make swift decisions and take advantage of opportunistic ventures because they typically are making decisions alone or with a limited number of partners. However, given the substantial capital and expertise required to acquire and operate investment-grade commercial real estate, there are high barriers to entry for buyers.
Acquiring property alone isn’t impossible, but it does take a lot of work and responsibility. The investor or owner needs to source the property, negotiate the price, obtain financing, collect rent, handle repairs and maintenance and manage daily activities from garbage disposal to renting vacant units. These responsibilities multiply with the number of properties needed to build a diversified portfolio. And capital requirements increase when tenant improvements, leasing commissions and renovations are needed.
Unfortunately, in many cases investors don’t have the necessary expertise. They may unwittingly buy real estate assets that require more time, resources, renovation and maintenance than originally expected. They may not have developed the right business plan to make the investment profitable or have focused on too few assets to build a diversified portfolio. Or they may be exposed to unlimited risk through liability and debt guarantees.
Passive investing is when an investor chooses to outsource their real estate investments to a manager and pays them a portion of the profits for their services. Managers pool money from numerous investors to buy larger properties or entire portfolios, and they run all day-to-day operations for the assets. They acquire the properties, execute the business plans and report to investors. Passive investing applies to different types of funds, such as QOZs, growth and debt funds as well as 1031 exchanges. In all these cases, individuals directly own the underlying properties and receive all the benefits of passive investing.
Several types of companies offer passive real estate investing opportunities, including private equity real estate firms, online crowdfunding platforms and non-traded private REITs. With these options, the real estate is typically held in an LLC, which protects investors from the potential unlimited liability associated with owning a physical asset in the event of a lawsuit or some other unforeseen event.
WHO CAN INVEST IN PRIVATE REAL ESTATE?
Accredited investors must meet income, net worth or educational requirements that allow them to purchase financial investments, including securities or real estate that are not registered with regulatory authorities. Individuals or entities can be given accredited investor status under any of these conditions:
A person’s net worth, or joint net worth with spouse, exceeds $1 million. The value of a primary residence must be excluded.
A person’s annual income exceeds $200,000 in each of the past two years and is expected to reach the same level this year.
A couple’s annual income exceeds $300,000 in each of the past two years and is expected to reach the same level this year.
A business, investment company or family office holds more than $5 million in assets, or all its equity owners are accredited.
A person is licensed or registered as an investment adviser or is a knowledgeable employee of a fund.
There is no one place to register accredited investor status, confirm income levels or tax returns, or be certified as an accredited investor. The government does not review individual investor credentials or certify financial statements. Instead, companies that offer investments must determine who is an accredited investor as part of their due diligence process.
Real Estate Strategies and Risk Levels
Private real estate investors should consider the level of risk they are willing to take to achieve their investment goals, and how long they are willing to wait before they begin receiving returns. Some investors may focus on long-term gains that have enticing yields but little to no liquidity, while others may want to generate steady income and more frequent dividends.
To offer options that achieve these goals, real estate managers and operators focus on four main types of real estate strategies: core, core plus, value-add and opportunistic. Each occupies a different point on the risk-versus-return spectrum and requires different types of leverage, since debt has a direct impact on the level of risk.
The matrix below helps guide investors on which type of private real estate investments may make the most sense, based on time horizon and risk tolerance.
Portfolio Allocation Guidelines
How much of an investor’s portfolio should be in private real estate? As much as we are fond of real estate, the old saying “don’t put all your eggs in one basket” applies to the class. Private real estate is cyclical: It goes up and down over time like stocks. Fortunately, over longer periods of time, investors in stocks and real estate have enjoyed strong performance, and we think marrying the two in an asset allocation is a terrific combination. Of course, liquidity is an important consideration, and every situation is different, so we encourage investors to consider their full picture before structuring their investment portfolio.
That hasn’t stopped investors from buying into this lucrative asset class. According to Tiger 21’s Q1 2024 member Asset Allocation Report, its high-net-worth investors had an average of 26% of their portfolios in private real estate investments. But the ideal allocation depends on an investor’s unique situation, which is a combination of factors like their net worth and time horizon.
For example, a family office worth $300 million may find an allocation with more than 50% of their investable capital in illiquid assets to be acceptable, while an accredited investor with $1 million in investable capital may feel more comfortable with a more modest position in illiquid assets. Another investor may be comfortable with a large illiquid position in their retirement account, but not in their savings account.
Illiquidity must be managed appropriately. How much liquidity should be reserved for an emergency? The illiquidity from private real estate investing isn’t a problem if an investor has enough savings for emergencies.
One of the most common bad investing decisions is precipitated by panic when the market turns south. The pain of a stock market crash is so great that investors flee at the bottom—precisely the time they should stick with it.
Solid evidence substantiates this point. History shows that even in uncertain economic environments and periods of broad market downturns, investing in private real estate can pay off. Our research shows that investors with a time horizon of seven or more years can achieve returns that top the risk-free rate over the long term. The chart below shows this can hold true during economic downturns and recessions.
The matrix below helps guide a potential private real estate investment allocation, based on time horizon and net worth.
Investing in Funds Versus Deals
An investor should consider how much time and effort they want to put into real estate investing before they get started. If the investor has deep market knowledge, the time to find properties, and the ability to execute a business plan by improving and managing properties, they can build their own portfolio of deals. Or they can invest in a diversified fund. There are pros and cons to each approach.
INDIVIDUAL REAL ESTATE DEALS
Many platforms, such as RealCrowd and Crowdstreet, offer access to individual deals and act as middlemen between the investor and real estate operator. Many investors choose this option because they prefer to pick their own deals rather than trusting the process to a manager.
PRIVATE REAL ESTATE FUNDS
Funds such as the ones we offer at Origin Investments usually include multiple deals, each with its own business plan. This allows investors to diversify easily and efficiently. A single investor may have the resources to buy a few buildings, but by investing the same money in a well-run private real estate fund, they get stakes in many deals, vetted by experienced professionals, that they wouldn’t be able to access on their own. These deals can range from apartment buildings to industrial complexes and can be in many cities to take advantage of thriving market conditions.
Owning multiple properties also limits risk: If one property underperforms, it doesn’t drag down profits across the board. Individual deal investments do not offer this same benefit. If a deal fails, investors suffer a painful loss.
For individual investors, finding the best private real estate fund is complicated. The best place to start is to ask a wealth manager for recommendations. Regardless, it’s critical for investors to do their own due diligence on every deal, fund and manager they hope to use. We provide tips for the due diligence process later in this guide.
Evaluating Real Estate Risk
Real estate values rise and fall. But by how much, and how likely is a move in either direction? More significantly, is the expected performance of the investment worth the risk? The larger the risk, the larger the reward one should expect. Put differently, high risk means there is a greater chance of failure.
For that reason, if one portfolio manager returns 20% on a real estate investment but takes twice as much risk as a manager who returns 15%, the smaller return is better on a risk-adjusted basis. That’s because the fund earning 15% is taking half the risk. The investment is more likely to offer downside protection and will have less variance around its forecasted returns. Every real estate investment should be evaluated based on its own risk-reward profile.
Here are eight risk factors investors should consider when evaluating any private real estate investment:
1. General Market Risk
All investments have ups and downs that are tied to the economy, such as interest rates, inflation or other market trends. Investors can’t eliminate market shocks, but they can reduce the volatility of their portfolio by diversifying across a wide array of investments, including stocks, bonds, public REITs and private real estate. A balance of public and private real estate investments helps diversify across geography and sectors and effectively manage liquidity.
2. Asset-Level Risk
In real estate investing, each type of property comes with different risks. For instance, there’s always demand for apartments in good and bad economies, so multifamily real estate is considered a low-risk investment. Office buildings are less sensitive to consumer demand than shopping malls, while hotels, which rely on business travel and seasonal tourism, pose far more risk than multifamily and office investments.
3. Idiosyncratic Risk
Some risks are specific to the asset and its business plan, which makes these risks idiosyncratic, or particular to a certain situation. Every deal has idiosyncratic risks. The construction phase of a building adds risk to a project because it limits the capacity for collecting rent during this time. Developing a property from the ground up can involve several types of risk: entitlement risk—the chance that government agencies with local jurisdiction won’t issue the required approvals to allow the project to proceed; environmental risks like soil contamination to pollution; budget overruns; and others.
Location is another idiosyncratic risk factor. Many office buildings in metropolitan areas went dark during the COVID-19 pandemic and have yet to recover in many markets. The same is true of suburban shopping malls, with some facing abandonment.
Even seemingly safe and passive investments are subject to idiosyncratic risk. Tenant bankruptcies have become commonplace in the retail sector as brick-and-mortar stores have been decimated by the competition of internet commerce. Fully leased properties or those with lower rent growth rates than expected can impact an investment’s performance and valuation. These issues, however, can be projected and accounted for with rigorous predictive analytics.
4. Liquidity Risk
An investor can expect dozens of bidders to show up in a metropolis like Houston, regardless of market conditions. A property in smaller Evansville, Ind., will not have nearly the same number of market participants, making it easy to get into the investment but potentially difficult to exit. When an investor can’t sell a property quickly, liquidity risk may be at fault.
Investors entering a real estate investment should already have determined a strategy for selling it. Smaller markets may be fine for investors planning to hold the property forever, but not for assets with a finite business plan or investors who may need their capital back at a moment’s notice.
5. Credit Risk
The length and stability of a property’s income stream drives its value. And there are always risks that something could change that. A property leased to Apple for 30 years will command a much higher price than a multi-tenant office building with similar rents.
The huge market in so-called triple-net leases, which require tenants to pay taxes, insurance and improvements, are often said to be as safe as U.S. Treasury bonds. The more stability in a property’s income stream, the more investors are willing to pay because it behaves more like a bond with predictable income. However, the triple-net lease landlord is taking a risk that the tenant will stay in business for the length of the lease and that there will be a waiting buyer.
6. Replacement Cost Risk
As demand for space in the market drives lease rates higher in older properties, it’s only a matter of time before those lease rates justify new construction and increase supply risk. What if a new, better building with comparable rates makes the investment property obsolete? It may not be possible for an investor to raise rents or even attain decent occupancy rates. This situation requires evaluating a property’s replacement cost to determine whether it is economically feasible for a new building to come along and steal away those tenants.
To figure out replacement cost, consider a property’s asset class, location and submarket. This helps investors know if rent can rise high enough to make new construction viable. For instance, if a 20-year-old apartment building can lease apartments at a rate that would justify new construction, competition may appear in the form of newly built offerings. It may not be possible to raise rents or maintain occupancy in the older building.
7. Leverage Risk
The more leverage, or debt, on an investment, the riskier it is, and the more investors should demand in return. Leverage is a force multiplier: It can move a project along quickly and increase returns if things are going well, but if a project’s loans are under stress—typically when its return on assets isn’t enough to cover interest payments—investors tend to lose a lot quickly. In general, investments capitalized with more debt should project a higher return on equity investment. As a rule, leverage should not exceed 75%, including mezzanine and preferred equity.
Example A below illustrates the difference in return on equity when using 85% debt versus 70%. The project financed with 85% debt requires only $3 million of equity and generates a total return on equity of 121%, while the project financed with 70% debt requires $6 million of equity and generates a total return of 65%.
Debt works both ways, and returns can change quickly in a market where prices are falling (see example B below). If the market declines by just 5%, investors using 85% leverage would lose 79% of their invested capital, while investors using 70% leverage would lose only 35%. As a rule, leverage should not exceed 75%, including mezzanine and preferred equity.
A real estate investment should generate returns primarily from its performance, not through excessive use of leverage. However, highly levered projects shouldn’t necessarily be avoided altogether; investors just need to make sure they receive a return commensurate with the risk.
Unfortunately, no set rule or scale dictates the exact incremental return an investor should expect for one highly leveraged investment over another. When comparing investment opportunities, the great equalizer is how they look on an unlevered basis. Assuming all the inputs are realistic, the one with the higher unlevered return generally will provide the better risk-adjusted return once debt is applied.
8. Structural Risk
Structural risk has nothing to do with the structure of a building; it relates to the investment’s financial structure, or mix of debt and equity, and the rights it provides individual participants. In financial structures, a senior secured loan gives lenders a structural advantage over mezzanine or subordinated debt because it is the first to be paid. Equity is the last payout in the capital structure, so equity holders face the highest risk.
Structural risk also exists when multiple operators come together to own one investment property in a joint venture. Investors must be aware of their legal and profit-sharing rights, which are spelled out in an operating agreement that details how much compensation they will have to pay the LLC’s manager throughout ownership and when a property is sold.
If an investor is a limited partner, the gross profits will be diluted by the compensation paid to the LLC managers. The operating agreement’s terms tell investors how much of the profits they receive if the deal is successful.
The operating agreement also details the requirements to remove a manager, should that become necessary. While partnerships always start with good intentions, nothing is worse than having a bad partner who is incompetent, behaves unethically or is undercapitalized. An operating agreement’s terms should outline the standards for manager removal and what percentage of limited partners it takes to remove them.
It’s important to look for a manager who is heavily invested in the deal and is well-capitalized to ensure they are on equal footing with limited partners and are compensated when the deal succeeds.
Understanding Returns: Equity Multiple and IRR
There are two metrics real estate managers use most often to describe their return on investment: the equity multiple and the internal rate of return (IRR). The educated real estate investor uses both to evaluate and compare investment returns.
Equity multiple: The equity multiple reflects the amount of money an investor earns by the end of a deal and is expressed in terms relative to the original investment dollars. If an investor puts $1 million into a property and eventually gets back $2 million, the multiple is 2x. The equity multiple shows an investment’s true impact on wealth.
Internal rate of return: IRR describes the time-weighted, compounded annual percentage rate every dollar earns during the time it is invested. It accounts for the value of money over a certain period. IRR has inherent limitations (these are explored later in this guide), but its biggest challenge is that it doesn’t quantify the amount of wealth the investment created.
Most importantly, you can’t spend IRR.
COMPARING INVESTMENT RETURNS
An annualized total return is the average amount of money earned by a real estate investment each year. Many investors mistakenly compare IRR to the annualized return to make investment decisions, which can be a costly mistake. Private equity real estate investors can find many impressive IRRs available on short-term deals. But investors must pay close attention to the time it took to achieve the IRR and the real wealth that was created by using IRR in context with the multiple on invested equity.
For example, a 30% IRR over three months works out to a total return of only 7.5%. But because real estate is illiquid, its true potential return on investment can be unlocked by holding it for the long term. It’s better to have the investor’s capital generate a 12% annualized return over three years than an 18% IRR over three months.
Chasing high IRR with short-duration investments is one of the biggest mistakes investors can make. Before an investor commits to a private real estate investment, they should evaluate the manager’s IRR track record against the equity multiple track record to determine how much actual wealth the manager created for investors.
Example C below shows two $100,000 investment scenarios. In both, investor money was tied up for three years. And both scenarios generated a 15% IRR. But the investor in the second scenario made far more than the investor in the first. The first scenario produced a 28.5% total gain on equity, compared with a 52% total gain on equity in the second. In scenario one, the investor would have needed to immediately invest any cash flow they received into other investments. However, it’s impossible to predict what investments will be available in the future, and it takes time, energy and discipline to find a suitable place to reinvest distributions.
To be fair to the concept of IRR, getting money back sooner rather than later helps reduce risk. Cash flows expected far in the future generally are riskier than cash flows expected sooner. And cash flow presumably would be invested into other investments at the time it is received.
HOW IRR CAN BE MANIPULATED
IRR is calculated using dollars that flow to and from investors. The shorter the duration between contributions and distributions, the higher the IRR. However, IRR is susceptible to manipulation by managers because they can influence the timing of cash flows. This makes it difficult to tell the difference between managers who create value and managers who financially engineer returns.
The most common abuse in manufacturing IRR among fund managers involves the use of a subscription line, a credit facility provided by a bank that is collateralized against investor commitments. Fund managers use subscription lines to close deals quickly and manage cash flow. The bank knows the fund manager always can call capital from investors to pay down the line, which is why they are willing to extend affordable credit. Subscription lines generally mature at the same time the fund’s investment period ends, which can be three to five years after the fund’s final close.
A manager can manipulate IRR by funding deals directly through the subscription line and then holding the deal there for as long as possible instead of calling capital from investors. With a flexible subscription line, a manager can delay calling capital for years. This greatly enhances the investment’s official IRR at the expense of the investor, who sits on their capital commitment and pays fees while the manager loads up the subscription line with deals. Even worse, managers typically receive higher incentive fees for higher IRRs, so a manager could use the investor’s balance sheet to obtain cheap capital to make more fees.
In example D, we show how IRR can be manipulated. In both scenarios, the investor commits $100,000, and all deals are acquired in the first year. In the first scenario, all capital is called from investors, resulting in an IRR of 14%. In the second scenario, the manager uses a subscription line to fund the deals and doesn’t call capital from investors until the second year, resulting in an IRR of 30%.
Investors should evaluate private real estate managers not only on their ability to produce IRR but their ability to invest capital in a reasonable period. Reviewing a manager’s track record is the best indicator of how a manager produces IRR. Though past returns may not be indicative of future returns, a manager with a history of manipulating IRR could use the same approach in the future.
What to Look for in a Manager
Projecting real estate returns is an inexact science. Hundreds of assumptions go into building a financial model, and every input is at the discretion of the investment manager. Every private real estate investment starts with a promise of high returns. Some will exceed projections while others fall short, and many will lose money. So the challenge for private real estate investors is figuring out which opportunities will meet or exceed expectations and which ones will be a learning experience.
In real estate, it’s more about who an investor invests with than what they invest in. The manager decides how much to pay for an asset, how to build value, the appropriate capital structure, how to correct course when things go wrong, and when to exit. A good manager is realistic and thoughtful about the assumptions. Finding a real estate manager who behaves reasonably and responsibly is paramount to success in this industry.
How is it possible to understand if a manager’s investment strategy aligns with an investor’s personal risk profile? Asking the right questions during the due diligence phase is critical. Think of it as a job interview, and the investor is hiring the manager to be a good partner and steward of their capital. Unfortunately, too many deals get funded with nothing more than great marketing materials. And there are many unqualified investment professionals passing themselves off as experts.
Below are 10 questions investors should ask to get a detailed picture of a real estate manager’s approach, ethics and potential performance—and what to look for in their answers to identify the best managers. Keep this caveat in mind: A manager may not meet every criterion on this list, but it doesn’t mean they should be written off. Listen for cues in their answers that shed light on their honesty and integrity.
1. How have your past deals performed?
Track records are hard to fake. Evaluating a manager’s past successes or failures is a great way to measure how well the current opportunity could turn out. Have they delivered consistent returns across all their deals? A manager who has produced a 15% IRR over the past 10 years without losing any money is far different than a manager who produced 15% IRRs but gained money half the time and lost money the other half. If the manager suggests that their new fund will generate 30% returns, but they’ve never generated 30% returns before, there is a low likelihood that they will meet their projections.
Good managers don’t lure investors with the promises of high returns. They set realistic expectations and then strive to meet those expectations in bad times and outperform them in good times.
2. How much of your own money are you investing?
Alignment is everything. The manager should be investing a significant amount of their own capital (capital not funded by others) along with investors. And the bulk of their earnings should come from investment returns, not transactional fees. “Skin in the game” ensures the manager is motivated by the best outcome for everyone. Managers should win when their investors win and lose when their investors lose.
3. How is your team incentivized?
It takes a team to see an asset through from acquisition to sale, and making sure the team is aligned through performance is critical. Investors should ask the manager if their team is incentivized based on transactions or performance; how they retain key team members; and what their retention rate is. Is the current team the same one responsible for delivering the manager’s historical returns?
4. What is your competitive advantage in the market?
It’s important to know what the manager believes his or her team does better than anyone else in the market. This competitive advantage generally is quantifiable.
For example, if they say their competitive advantage is in sourcing investments, ask how many deals they look at before they pick the best ones and where they find those deals. If their advantage is in operations, they should be able to benchmark themselves against an industry standard.
5. How do you communicate with your investors?
Communication is paramount to a successful relationship. Timely and accurate reporting is one of the most important elements of a good manager because there is nothing worse than being in the dark. Investors should ask for sample reports from a manager’s latest deals and pay close attention to the dates to make sure they are delivered regularly. Take note of what the reports cover and if the manager updates investors about both good and bad news. In the end, investment performance matters most, but a manager who communicates poorly can cause sleepless nights and a lot of frustration.
6. Are the assumptions in your financial model realistic?
No real estate manager is 100% accurate in their business plan assumptions. But projections are only as good as the inputs, and each input is at the manager’s discretion. It is important that the manager conducts a stress test of each input into their financial model, which means quantifying what the underperformance of each input would do to the expected outcome. The basis of protecting downside and limiting losses is understanding how an investment will perform if things don’t go as expected.
One of the best ways to learn about a manager’s approach is by inquiring about the assumptions they use in their model. What does the deal look like when those assumptions are taken to the extreme? Sometimes small tweaks to one or two variables, such as rent growth, the growth rate or cap rate, can vastly impact returns.
The next input to note is net operating income. Good managers create value by increasing net operating income, which is impacted most by occupancy and rental rates. Look at their assumed growth rate of revenue and their occupancy assumptions. Every deal has an occupancy assumption at stabilization. Make sure the property is in line with the rest of the market, or slightly below it.
Investors also should understand how the manager treats expenses. Expenses will increase, and the manager should apply a realistic inflation rate to all costs associated with executing the business plan. For instance, property tax increases should be reset based on the new purchase price and not with historical figures. Also, the manager should take into account a rising interest rate market and rising cap rate environment in the underwriting.
Investors should understand how much leverage the manager uses with each deal. As discussed earlier in this guide, responsibly used leverage can enhance returns. But beware of deals that are financially engineered with mezzanine debt and preferred equity.
Ask if the manager cross-collateralizes assets. Cross-collateralization is when one asset is used to guarantee the debt on another asset. In a fund structure, assets should not be cross-collateralized because it destroys diversification and magnifies risk. This practice is a big reason that private real estate investors lost so much money during the Global Financial Crisis, and it is very prevalent in real estate debt funds, so investors must read the fine print.
Does the manager personally guarantee loans? Doing so can be catastrophic for a manager and the investors if that loan gets called.
Most important, be familiar with a manager’s business plan and decide whether it seems realistic. Use a common-sense approach—a business plan should be easy to understand and make sense intuitively. Most plans fail because they are ill-conceived from day one.
7. What was your worst deal, and what did you learn from it?
Every manager has multiple bad deals in their past. Investors should look for a manager who has been in the trenches and has battle scars to prove it. A good manager will be forthright about their mistakes, what they learned, and how those deals helped shape the firm’s investment philosophy. It’s the job of the investor to decide if these are isolated events or if there is a history of pursuing risky deals with ill-conceived business plans. It’s important to understand if—and how—the manager communicated to investors during any down periods.
How they treated the investor during a difficult period is an indicator of their integrity.
8. Can I speak with one of your investors?
Investors should ask to speak with one of a manager’s current investors or a former investor. Ask about their experience and if they recommend the manager. A creative investor could get in touch with a former employee through LinkedIn and ask them about the company.
9. How is your company funded?
It’s important to determine if the company has ample cash flow to pay the bills or if they will need to lean on investors for more capital. Study their balance sheet and assess if there is any risk they will go out of business. Avoid managers who operate on shoestring budgets or are just starting out. It may be better to wait until the second or third fund when the kinks have been worked out. Regardless, it’s important to invest with an experienced and well-financed team.
10. What’s included in your fees?
Real estate investing requires a dedicated team, and transaction fees help pay for that team. Someone must find the property, negotiate the price, create marketing materials and legal documents, raise equity, manage the property’s day-to-day operations, formulate and execute the business plan, report to investors, provide K-1s, sell the asset and distribute the proceeds. A great team does not come cheap, and fees help managers attract and retain high-quality employees.
Unlike the public markets, real estate decisions are not based on fees alone. There is a big difference between price and value, and low-fee real estate deals can end up being very expensive. The quality of a business plan and asset manager have the most impact on the success of a project. Fees are a function of a business plan’s complexity and should be correlated to the value the manager can create. How are a manager’s fees structured and charged? There isn’t necessarily a set market rate fee, but there is a range that is fair.
Investors should ask about every fee throughout the structure because sometimes fees are buried in other LLCs below the investment entity. Fees should be outlined in the Sources and Uses of Capital section of the marketing materials or the private placement memorandum—a must-read when evaluating any investment opportunity.
In the end, fees should guide, not drive, an investor’s decision about whom to invest with.
Private Real Estate Investment Fees
When vetting investment opportunities, look for a fee structure that is largely performance-based, so the manager wins when the investor wins. Some fees are used to create investment value; exorbitant fees make fund managers wealthy at the expense of their partners.
There are two main types of fees in real estate investment management: transaction fees and performance-based fees.
TRANSACTION FEES
Transaction fees are guaranteed. The manager gets paid these fees regardless of how the deal performs. Below are the most common transaction fees.
Acquisition fee: This is most common among managers syndicating individual deals. The acquisition fee is usually 1% to 2% of the total deal size and is generally on a sliding scale. The bigger the deal, the lower the fee. This is a market-rate fee and is justified because the manager probably looked at 50 deals to find this one and paid all the legal, personnel and dead deal costs out of their own pocket.
Acquisition fees are paid on the total deal size, as opposed to equity invested. This is a significant difference: A 1% acquisition fee on a $30 million property comes to $300,000. Most properties are typically leveraged using two-thirds debt, so the required equity may only be $10 million, meaning that $300,000 fee equates to a 3% cost of equity invested.
Committed capital fee: This fee is charged by closed-end called capital real estate funds and ranges from 1% and 2% on committed equity. The manager receives this fee even if the capital is not invested. However, if a committed capital fee is charged, then an acquisition fee should not be collected—this is what the industry calls “double-dipping.” Unfortunately, many managers try to get away with double-dipping with individual investors.
Investment management fee: This fee is charged by both funds and managers sponsoring individual real estate deals and is sometimes called the asset management fee. This fee replaces the committed capital fee once the capital is invested so that investors are not charged on the same capital twice. The committed capital fee is reduced proportionally as money becomes invested. This fee ranges from 1% to 2% of invested equity and pays for investment management services. It should be a function of invested equity, not total deal size.
Set-up and organizational fee: Both real estate funds and managers of individual deals incur set-up costs. These are typically passed through to the investment entity and paid by all investors. One-time upfront costs include legal, marketing, technology, investor relations and other costs associated with capital raising and forming the investment company. This fee is typically from 0.5% to 0.2% of total equity.
In individual deals, this fee is generally not easily identified in the marketing materials and could be lumped into the property’s acquisition cost. Investors should be aware of this fee, however, and ask the manager to explain the terms in detail so they know exactly what this fee is being used for.
Administrative fee: These fees cover tax reporting, audits, fund administration and third-party software. They typically range from 0.1% to 0.2% per year on invested equity.
OTHER TRANSACTION FEES
Debt placement fee: Outside brokers who line up debt typically earn from 0.25% to 0.75% of total debt, depending on deal size. Good brokers can save projects much more than this cost, but some managers add an additional internal fee of 0.25% to 0.75%.
Refinancing fee: This is like a debt placement fee. Some managers charge 0.25% to 1% for this service.
Wholesale marketing fee: Typically paid to broker-dealers by non-traded REITs for product distribution, this fee equates to roughly 3% of equity.
Advisor/syndication fee: Some real estate companies such as private REITs use broker-dealers to distribute their products through advisors, who are typically paid a one-time upfront fee of 4% to 7%. Some sponsors charge a smaller upfront fee but add acquisition or transaction charges—commissions that are often hidden in the fine print.
Joint venture fees: Joint ventures don’t add another layer of fees, but investors then pay two managers. Investment managers simply providing access should receive much lower fees than managers who execute business plans.
Selling fees: It’s good practice to take projects to market to generate the highest value. Typically, brokers earn from 1% to 3% of the sale price, depending on project size. Some managers charge their own internal fee of 0.25% to 0.75% on top of that.
While this may seem like a lot of fees, a good manager will limit what fees they charge and how high they are. Transaction fees are meant to keep the lights on but not be a profit center for the company. While we don’t believe fees should guide a decision, they can tell you something about the manager. A manager trying to extract every last penny out of the deal through guaranteed transaction fees is a clear sign that they don’t have the investor’s interests in mind.
PERFORMANCE FEES
Performance fees are variable and based on the success of the real estate investment. They are common in nearly every private equity investment and are used to align the interests of the manager with those of the investor. The typical performance fee entitles the manager to anywhere from 10% to 20% of profits.
An investment waterfall is a method used in real estate investing to split the cash profits among the manager and the investor to follow an uneven distribution. In most waterfalls, the manager receives a disproportionate amount of the total profits relative to their investment. For example, a manager may only put in 5% of the investment capital but be entitled to 20% of the profits.
Performance fees are usually subject to what is called a preferred return hurdle, which is the rate of return tier (usually as defined by a certain IRR or equity multiple) that must be met before the manager begins to participate in the profits. These tiers define the various profit splits. The preferred return typically ranges from 7% to 10% annually and can be viewed as an interest rate on investor capital, but it’s not guaranteed.
Two common types of waterfall structures, European and American, are used in real estate funds and individual deals. In a European waterfall, 100% of all investment cash flow is paid to investors in proportion to the amount of capital invested until the investors receive their preferred return, plus 100% of invested capital. Once these distributions have been paid out, the manager’s portion of the profit increases. This is the most common waterfall used in real estate fund structures.
In an American waterfall, the manager is entitled to receive a performance fee prior to investors receiving 100% of their capital back, but usually after receiving their preferred return. To protect investors, there typically is a caveat in the documents that states the manager is entitled to this fee only if they reasonably expect the fund or deal to generate a return higher than the preferred return. It’s not uncommon for income products that have longer hold periods, or deals with hold periods longer than 10 years, to employ this type of waterfall.
Waterfall structures can impact investment behavior, and investors should make sure the manager is motivated by the investment return—if the investment doesn’t perform as planned, the manager doesn’t take a performance fee. Getting into a structure where everyone’s interests are aligned from day one is the key to successful investing.
ABOUT THE AUTHORS OF THIS GUIDE:
Origin Investments
Founded in 2007, Origin Investments is a private real estate manager that helps high-net-worth investors, family offices and registered investment advisors grow and preserve wealth by providing tax-efficient real estate solutions through private funds. We build, buy and finance multifamily real estate projects in fast-growing markets throughout the U.S. In 2023, we founded affiliate firm Origin Credit Advisers, an SEC-registered investment adviser that provides yield-focused multifamily debt investments for qualified purchasers. Through our Origin Exchange platform, introduced in 2024, investors can complete a 1031 exchange of their properties for professionally managed, institutional-quality assets. To learn more, visit origininvestments.com.
The Prudent Speculator
The Prudent Speculator is an investment newsletter owned by Kovitz and has been published without interruption since March 1977. For more information about Kovitz and The Prudent Speculator, please visit theprudentspeculator.com/wealth-management/.
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