As a due diligence analyst for private alternative investments, I often get this question from financial advisors: “A few clients have asked me to help them invest in private real estate. Where do I start?” In this blog I’ll cover what financial advisors need to know about investing in private real estate on behalf of their clients.
Before we get started, my name is Logan Moore.
I’m a due diligence analyst for private real estate transactions. I work with financial advisors, family offices, and high net worth individuals to help them identify alternative investments that align with their values. For a couple of past interviews I did on the topic of evaluating private investments, check out the links below.
Investing in private real estate – where to start?
You’re a financial advisor and you’ve been approached by one of your clients, saying something like, “I’d like to diversify my portfolio and get into real estate, but I don’t know where to start. Can you help me?”
Understanding the client’s situation
Like all good financial advice, the starting point is understanding the client’s situation. Here are five things I would ask anyone – a financial advisor, a family office, or a high net worth individual – who wants to learn how investing in private real estate works so they can invest on behalf of their clients.
- What is the client’s objective (income, capital appreciation, tax breaks, etc.) and by what time do they wish to achieve it?
- How much risk are they willing to take?
- What are their liquidity constraints and do they have a cash flow plan / financial plan in place that clearly identifies cash flow sources other than the money allocated for this investment?
- How much are they looking to invest and how much of their total wealth would this be?
- How much prior investing experience do they have?
It may seem like an obvious point but be sure to document all the client’s responses, either in your CRM or in whatever notetaker you are using. Real estate investing is a major decision, and the dollars can be substantial. Take copious notes whenever a client tells you something material and have them ready if you are ever called to justify why you made a recommendation.
Once the intake process has been completed, the next step is to begin the process of fitting the client’s profile into the world of real estate. To do so, you’ll have to gain a solid grasp of how real estate investing works. We’ll get into that next, starting with the people who are typically involved.
The parties typically involved in a real estate transaction
These are multidimensional decisions and for that reason there is often a team of people involved with the transaction.
Financial advisor – a stockbroker may offer real estate investments from his or her firm’s inventory in exchange for a commission, while a fee-only advisor is usually not affiliated with a brokerage and may only recommend third party deals. Fee-only advisors are fiduciaries who cannot accept commissions. The financial advisor advises the client on how the investment fits into their overall wealth plan, the dollar amount they should invest, and what their risk profile is.
Due diligence analyst – this must be an independent third party (or member of the fee-only advisor’s team) who cannot be affiliated with the real estate investment firm in any way, financially or otherwise. A due diligence analyst is tasked with making sure that the asset is sound, both from an operational and an investment perspective. This person is critical in protecting the client from fraud or from allocating funds into assets that do not fit the client’s investment objectives.
Fund sponsor – this is the party offering the property up for investment. They manage the investment and coordinate with the investors. They are often called the “General Partner”, or “GP”, and these parties often have a portion of their own capital in the deal; if they don’t, that is concerning. GPs make their money by putting in the “sweat equity”.
Limited partners – these are the investors who co-invest their capital along with the General Partner. The total amount in the deal from the Limited Partners (or “LP’s”) typically outsizes that of the GP. LPs do not have active involvement in the day-to-day operations of the property or the investment.
CPA – an accountant who provides clarity as to the tax implications of the investment. The CPA will advise the client as to the classification of investment returns (ordinary income vs. capital gains) and/or the tax benefits that may arise as a result of investing.
Attorney – this is the party who advises the client from a legal standpoint. They will review any documents from third parties such as the Fund Sponsor. Their job is to protect the client from undue liability associated with participating in the transaction.
These parties should work together and share information to make the deal a successful one for your client. Choose these team members wisely and try to avoid conflict of interest, or bias, that results from a misalignment of incentives between the client and a party that is assisting them with the transaction.
How real estate deals are structured
Once you have appointed a team of professionals to work alongside you and the client, it’s time to start thinking about what type of deal would be best for your client.
There are multiple ways to invest in private real estate, such as syndications, crowdfunding, and private REITs. A common type of deal for directly investing in a property is a real estate syndication, a deal in which investors (LPs) pool their money together in exchange for a pro-rata share of a property. These deals typically are organized in the form of a real estate partnership.
- The General Partner finds a property, buys it, manages it, and receives a cut of the profit (which is called carried interest or “carry” for short).
- The Limited Partners contribute capital and in exchange receive a share of the profit or loss. They are typically paid a preferred return, or “pref”, which is a portion of the profits that are paid to the LPs before the GP gets its carry. Limited Partners usually have to be Accredited Investors, meeting certain net worth or income requirements, though some investment structures allow for a small number of sophisticated (i.e. knowledgeable) investors.
The deal sponsor charges various fees for managing the property to compensate them for the costs of tasks such as:
- Identifying and acquiring the property
- Creating the legal entity for the syndicate
- Maintaining books and records
- Managing the property
- Reporting to investors
- Managing the flow of capital to and from investors
- Selling the property
In addition, the sponsor earns carried interest, or a percentage of the return after the Limited Partners have earned their return. A common profit split is 80/20 (80% to the LPs, 20% to the GP), but if it is a well-known sponsor they may able to earn a higher split.
All of the terms of the deal are typically written up in a document called a Limited Partnership Agreement (LPA) or Operating Agreement (OA), depending on the legal structure being used, that is distributed to all Limited Partners before any of their capital is accepted by the General Partner. This document is critical to understand as it outlines all the major terms of the deal. Your client’s attorney should review it before they sign the deal. You should also receive a Private Placement Memorandum (“PPM”) which discloses material information about the investment, including potential risks, the business plan, and background on the sponsor. This should be reviewed in conjunction with the LPA/OA.
Now that we have provided an overview of how investing in private real estate works, the next question that people usually ask is about how to find these real estate deals. The answer is that you don’t as far as the property is concerned; that is the General Partner’s job. You don’t have to find the physical real estate on your own. However, limited partners and their advisors still have to find the syndications, whether it be through GPs reaching out to them, hiring a due diligence analyst, or being referred to them by third-party contacts such as attorneys or bankers. All of this is to say that it is a good idea to be familiar with the types of investments that you’ll most likely see in a syndicate.
Private real estate asset classes
Here is an overview of the various types of private real estate investments.
Single family
These are one-unit residences. Single family structures tend to offer less rental income than multifamily and there is more risk intrinsically, because there is only one source of income. If the renter defaults, the investor’s income invariably suffers.
Multifamily
Multifamily real estate means residential structures with more than one unit within a single building, such as an apartment building. They usually offer high income potential due to their multi-dwelling unit status and, depending on the area, may also be suitable for investors seeking capital appreciation. They offer some diversification compared to single family investments because there are multiple tenants so revenue does not decline as much if one resident stops paying or vacates.
Office
Office space is a type of commercial real estate used for business purposes that can offer either rental income or capital appreciation. It can range from a single tenant building to multiple tenants.
Industrial
The industrial real estate category applies to facilities used for the production, manufacturing, and storage of goods.
Retail
This asset class comprises retail stores that sell goods to the public. These are typically malls or shopping centers. Location, demographic trends, and foot traffic play a big part in the valuation of these investments.
Build-to-rent
This is a type of residential real estate consisting of single-family homes built to be rented rather than sold, offering the investor income as well as capital appreciation potential. They are commonly built as subdivisions with multiple homes but could be a single unit/property.
Self-storage
These are facilities that house storage units where people store possessions for a fee. Demand varies based upon demographic trends and location. Two common types are climate controlled and non-climate controlled.
Manufactured housing communities
Manufactured homes are built in factories and commonly organized into communities on leased land. These homes appeal to buyers due to their affordability. This is a sub-category of multifamily.
RV Parks
Recreational vehicles, or RV’s, are a type of vehicle that travelers tend to use when on vacation or traveling on business. RV parks offer a place for these vehicles to park. They may be designed for short-term (overnight or weekend) stays for purely recreational purposes, or may be designed for longer-term, seasonal living.
Senior living facilities
These are facilities that are built for older adults, ranging from seniors needing no care (independent living) to 24-hour skilled care. As seniors age, they may seek out facilities to house them that reduce the burden of typical homeownership, provide community, and/or provide healthcare needs as they age.
Raw land
Raw land offers little to no income potential, as there are no structures to be rented. Other than cases where the land is rented to farmers, raw land is entirely a capital appreciation play. Usually called “unimproved land”, there has never been any development on it.
Did we inspire you to get your clients started investing in real estate?
Thanks for reading to the end of this blog about getting into real estate investing . Did you decide that private real estate investing is worth it for your clients? If so, let’s set up a time to talk. I am a due diligence analyst and financial advisor with over eleven years of experience evaluating investments and would be happy to provide insights that can help you get started.
