Commercial Real Estate (CRE) Investor Question #56: I am looking at a CRE deal. Can you explain the sources and uses of funds?
Sources and uses of funds is a summary view of capital needs of the deal (uses) and how the capital will be raised (sources). This should be a key part of any pitch of the sponsor and should give a high level idea of the capital stack (debt vs. equity) and the overall costs including fees to close the deal. An example snapshot is provided in the featured image.
Commercial Real Estate (CRE) Investor Question #55: I am looking at a real estate syndicated / private placement / private equity deal. Who is a General Partner(GP) and who is a Limited Partner(LP)?
General Partner is typically the sponsor or operator responsible for finding the deal, setting up the deal, handling the transaction, securing the financing, managing the investment, and eventually selling it.
Limited Partners are passive investors and they contribute capital to the syndicate to earn a return on their investment. LPs benefit from having limited liability in the investment.
For a more detailed treatment, check out the article.
#finyork #100crequestions #cre #commercialrealestate #investing #creinvesting #alternativeinvestments
Commercial Real Estate (CRE) Investor Question #55: I am looking at a real estate syndicated / private placement / private equity deal. Who is a General Partner(GP) and who is a Limited Partner(LP)?
General Partner is typically the sponsor or operator responsible for finding the deal, setting up the deal, handling the transaction, securing the financing, managing the investment, and eventually selling it.
Limited Partners are passive investors and they contribute capital to the syndicate to earn a return on their investment. LPs benefit from having limited liability in the investment.
For a more detailed treatment, check out the article.
#finyork #100crequestions #cre #commercialrealestate #investing #creinvesting #alternativeinvestments
We looked at how understanding our risk tolerance and setting goals is the first stage of investing in a previous post. What do we do once we understand our risk tolerance and the goals are set? The next step is to have a basic idea of the investing universe and determine the areas to put investment dollars to work.
Many individual investors have a typical journey when it comes to investing. We would have started with savings accounts or CDs and then moved to dabbling in stocks and bonds. It is also very likely that many were forced to manage our retirement portfolios when we started working and got introduced to mutual funds and index funds. Along the way, some may have got exposed to real estate, commodities, or derivatives.
In essence, many individual investors do not have the opportunity to look at their portfolio holistically. After all, most of our time is consumed with our daily job and family commitments. The purpose of this article is to provide a holistic picture of investing. We will go through the various investment options available for investors to put their assets to work. We’ll get some ideas from top institutional investors who have performed well in the long run.
An investor has a myriad of investments to choose from these days. We may have heard about many of these investments, but we may have just invested in one or two of them. It can sometimes be confusing and sometimes daunting.
Unfortunately, investing is not taught for many in school or college and hence we don’t have any structured approach or framework for investing to follow. Let us first understand the myriad of investment options available. In the financial world, the various investment options are also called asset classes.
An asset class is a grouping of investments that exhibit similar characteristics and are subject to the same laws and regulations.
https://www.investopedia.com/terms/a/assetclasses.asp
The major asset classes are depicted below. Historically, the popular asset classes have been stocks, bonds, cash-equivalent, commodities and real estate as depicted below. This misses some of the relatively newer investing options like private equity, hedge fund, derivatives and cryptocurrencies.
If you’re interested further in evaluating the various asset classes, nerdwallet has a detailed review of major asset classes.
Understanding asset classes provide a lay of the land or big picture that will help you chose the asset classes that you can invest in. Understanding various characteristics of the asset classes helps you diversify your assets (the often used “don’t put all your eggs in one basket”).
The key is to understand the characteristics of an asset class, whether you invest in it or not. For e.g. when one thinks of transportation, one intuitively understands the difference between various modes of transportation – cars, trucks, trains, buses, planes, etc, and their characteristics. Assets classes are similar when it comes to characteristics between the various asset classes.
There are various traditional asset allocation calculators available to help allocate the assets. Many of them only consider traditional assets – stocks, bonds, and cash – only. We’ll see in the upcoming section, why investors should also consider diversifying beyond these traditional assets.
Yale University’s Asset Allocation
Let us look at industry leaders when it comes to investment performance. We can look at enterprises with a good record of investment returns. Yale University is one of them. Yale University is known for its portfolio performance as it has performed better than many peers and many college endowments compare themselves to Yale’s endowment performance. Let us take a look at Yale’s portfolio below.
As we can see, Yale has allocated amongst many asset classes, some available to individual investors and some that aren’t (except for those with high net worth). Yale does invest in cash and fixed income, equities, and real estate that are available to individual investors. It also invests in private equity, venture capital, etc. that may not be available to individual investors.
California Pension Fund’s Asset Allocation
Let us look at another institution that manages many people’s money – Calpers. Calpers is California’s pension fund and manages the pension funds of its 1.9 million members. They are a leading institution when it comes to investment portfolio management. Let us take a look at Calpers portfolio below.
Essentially, Calpers has major allocation to cash equivalents (liquidity, inflation assets), fixed income, real estate and equities.
Looking at Yale and Calpers has given us an idea of how a couple of leading institutions are allocating between assets. We can draw some lessons for our personal portfolio from them though some asset classes may be out of reach for many individual investors.
Thinking through risk tolerance and portfolio asset allocation is a key pillar of investing. For a majority of us, the investment universe may just consist of cash and fixed income, equities, and real estate. The exact percentage allocation for your portfolio would be based on your risk tolerance and your goals. The traditional calculators and thinking behind asset allocation is undergoing a big change.
If you need more ideas on the % allocation, check out articles that address the various asset classes described above. We highly recommend you do this exercise on a regular basis. Here’s some advice from US SEC for investors.
If you understand your time horizon and risk tolerance – and have some investing experience – you may feel comfortable creating your own asset allocation model. “How to” books on investing often discuss general “rules of thumb,” and various online resources can help you with your decision.
For example, although the SEC cannot endorse any particular formula or methodology, the Iowa Public Employees Retirement System (www.ipers.org) offers an online asset allocation calculator. In the end, you’ll be making a very personal choice. There is no single asset allocation model that is right for every financial goal. You’ll need to use the one that is right for you.
Some financial experts believe that determining your asset allocation is the most important decision that you’ll make with respect to your investments – that it’s even more important than the individual investments you buy….
Source: US SEC’s Investor Beginner’s Guide
Coming up with a personal asset allocation model is the biggest decision an investor can make. An investor should devote significant time and attention to this effort and get trusted financial advice as needed. After taking a risk tolerance assessment and understanding your risk profile, the next step is to understand the major asset classes and allocate them amongst your portfolio.
We’ve seen some examples of leading institutional investors and how they invest in both traditional and alternative asset classes. Leverage calculators and modern thinking around asset allocation. Write down your asset allocation model and visit it on a periodic basis. This exercise is in itself worth your time in Gold.
We looked at how understanding our risk tolerance and setting goals is the first stage of investing in a previous post. What do we do once we understand our risk tolerance and the goals are set? The next step is to have a basic idea of the investing universe and determine the areas to put investment dollars to work.
Many individual investors have a typical journey when it comes to investing. We would have started with savings accounts or CDs and then moved to dabbling in stocks and bonds. It is also very likely that many were forced to manage our retirement portfolios when we started working and got introduced to mutual funds and index funds. Along the way, some may have got exposed to real estate, commodities, or derivatives.
In essence, many individual investors do not have the opportunity to look at their portfolio holistically. After all, most of our time is consumed with our daily job and family commitments. The purpose of this article is to provide a holistic picture of investing. We will go through the various investment options available for investors to put their assets to work. We’ll get some ideas from top institutional investors who have performed well in the long run.
An investor has a myriad of investments to choose from these days. We may have heard about many of these investments, but we may have just invested in one or two of them. It can sometimes be confusing and sometimes daunting.
Unfortunately, investing is not taught for many in school or college and hence we don’t have any structured approach or framework for investing to follow. Let us first understand the myriad of investment options available. In the financial world, the various investment options are also called asset classes.
An asset class is a grouping of investments that exhibit similar characteristics and are subject to the same laws and regulations.
https://www.investopedia.com/terms/a/assetclasses.asp
The major asset classes are depicted below. Historically, the popular asset classes have been stocks, bonds, cash-equivalent, commodities and real estate as depicted below. This misses some of the relatively newer investing options like private equity, hedge fund, derivatives and cryptocurrencies.
If you’re interested further in evaluating the various asset classes, nerdwallet has a detailed review of major asset classes.
Understanding asset classes provide a lay of the land or big picture that will help you chose the asset classes that you can invest in. Understanding various characteristics of the asset classes helps you diversify your assets (the often used “don’t put all your eggs in one basket”).
The key is to understand the characteristics of an asset class, whether you invest in it or not. For e.g. when one thinks of transportation, one intuitively understands the difference between various modes of transportation – cars, trucks, trains, buses, planes, etc, and their characteristics. Assets classes are similar when it comes to characteristics between the various asset classes.
There are various traditional asset allocation calculators available to help allocate the assets. Many of them only consider traditional assets – stocks, bonds, and cash – only. We’ll see in the upcoming section, why investors should also consider diversifying beyond these traditional assets.
Yale University’s Asset Allocation
Let us look at industry leaders when it comes to investment performance. We can look at enterprises with a good record of investment returns. Yale University is one of them. Yale University is known for its portfolio performance as it has performed better than many peers and many college endowments compare themselves to Yale’s endowment performance. Let us take a look at Yale’s portfolio below.
As we can see, Yale has allocated amongst many asset classes, some available to individual investors and some that aren’t (except for those with high net worth). Yale does invest in cash and fixed income, equities, and real estate that are available to individual investors. It also invests in private equity, venture capital, etc. that may not be available to individual investors.
California Pension Fund’s Asset Allocation
Let us look at another institution that manages many people’s money – Calpers. Calpers is California’s pension fund and manages the pension funds of its 1.9 million members. They are a leading institution when it comes to investment portfolio management. Let us take a look at Calpers portfolio below.
Essentially, Calpers has major allocation to cash equivalents (liquidity, inflation assets), fixed income, real estate and equities.
Looking at Yale and Calpers has given us an idea of how a couple of leading institutions are allocating between assets. We can draw some lessons for our personal portfolio from them though some asset classes may be out of reach for many individual investors.
Thinking through risk tolerance and portfolio asset allocation is a key pillar of investing. For a majority of us, the investment universe may just consist of cash and fixed income, equities, and real estate. The exact percentage allocation for your portfolio would be based on your risk tolerance and your goals. The traditional calculators and thinking behind asset allocation is undergoing a big change.
If you need more ideas on the % allocation, check out articles that address the various asset classes described above. We highly recommend you do this exercise on a regular basis. Here’s some advice from US SEC for investors.
If you understand your time horizon and risk tolerance – and have some investing experience – you may feel comfortable creating your own asset allocation model. “How to” books on investing often discuss general “rules of thumb,” and various online resources can help you with your decision.
For example, although the SEC cannot endorse any particular formula or methodology, the Iowa Public Employees Retirement System (www.ipers.org) offers an online asset allocation calculator. In the end, you’ll be making a very personal choice. There is no single asset allocation model that is right for every financial goal. You’ll need to use the one that is right for you.
Some financial experts believe that determining your asset allocation is the most important decision that you’ll make with respect to your investments – that it’s even more important than the individual investments you buy….
Source: US SEC’s Investor Beginner’s Guide
Coming up with a personal asset allocation model is the biggest decision an investor can make. An investor should devote significant time and attention to this effort and get trusted financial advice as needed. After taking a risk tolerance assessment and understanding your risk profile, the next step is to understand the major asset classes and allocate them amongst your portfolio.
We’ve seen some examples of leading institutional investors and how they invest in both traditional and alternative asset classes. Leverage calculators and modern thinking around asset allocation. Write down your asset allocation model and visit it on a periodic basis. This exercise is in itself worth your time in Gold.
There are beginner investors who can’t wait to invest or do a deal. They want to put capital to work right away and see the returns. On the other end of the spectrum, there are investors who hesitate to invest as they fear losing the money. And then there is a wide range of investors in between.
So, with this wide range of investors, where does one start? We’ll argue in this article that the first step to start investing is to understand risk, our tolerance to risk, and our goals. Understanding ourselves, our motives, and behavior is probably the hardest and most time consuming for many beginner and intermediate investors. In this post, we’ll share key steps with some resources for investors to assess their personal risk tolerance and create investing goals.
Remember the first time you built a hobby? It probably happened over months or years. You tried a few things, liked that particular activity, and started doing more and more of it. Consciously, you may not have even taken the time to observe our actions. But, but you enjoyed it and continued it. Though many won’t consider investing as a hobby, the journey is similar. There is a lot of learning involved – technical and behavioral – and it is a very long journey to get better at investing. What is the first step in this journey? It comes down to understanding risk and our tolerance for risk. In the first place, what is risk?
In simple terms, risk is the possibility of something bad happening……
Risk involves uncertainty about the effects/implications of an activity with respect to something that humans value…such as health, well-being, wealth, property, or the environment…. often focusing on negative, undesirable consequences.
Source: https://en.wikipedia.org/wiki/Risk
It is easy to get carried away in this day and age as most of us are exposed, sometimes overexposed, to finance and investing from general and financial media? We maybe seduced to get stock tips from our favorite financial media or guru and act on it. We need to be careful. Investing is not speculation and is for the long-term, and patience and learning are key. A good investor learns the basics and continues to learn every day!
Understanding and having an appreciation for risk is at the heart of finance and investing. Reward or returns is a by-product of risk. Many of us focus on rewards without appreciating the underlying risk. We’re always enticed by the higher return. But, we need to start with understanding our risk tolerance as explained below.
We take risks on a daily basis though we may not see it as such. We make decisions based on risk all the time. Every time we cross a road we assess and take the risk of safely crossing the road. We select a college and course after weighing the risks and rewards. Will this college help me secure a job? We may not see it as such but some of the major life decisions are also risk-based decisions:
Given the importance of risk in finance and our daily lives, understanding our individual risk tolerance is of paramount importance. This will save months and years of worry and regrets.
Let us take an example. Say, you’ve $1000 to invest and are looking for ways to invest. You have done your research and narrowed it down to 3 options. The first option will give $10 after a year, but $1000 most likely not get affected. The second option will give you $100, but you could also lose $100 and end up with $900. i.e. Option 2 is riskier than Option 1. Some may prefer Option 1 and some may prefer Option 2. There is no universal single correct answer. It depends on the individual. It is important to understand which option you prefer i.e. what is your risk tolerance.
FinYork recommends taking an Investment Risk Tolerance Assessment, as the first step in assessing investment risk tolerance. The one below from the University of Missouri is popular. It is worth every minute of your time as this will set the stage for your investment planning.
Once you finish answering all the questions, you’ll be given an assessment of your risk tolerance. You can use this as the basis of your investments or discuss it with your financial advisor. You may have seen your brokerage’s investor profile questionnaire which is another tool for individual risk tolerance assessment. The whole purpose of this exercise is to evaluate your individual risk tolerance and even confront your fears upfront.
The survey gives a risk tolerance score at the end as shown below. The score will indicate whether you have a HIGH, MEDIUM or LOW risk tolerance. Your investment strategy has to follow your risk tolerance level. For e.g. someone with a LOW risk tolerance should go with a conservative investing strategy and invest in less risky asset classes. We’ll cover this in detail in upcoming articles.
We have so far looked at evaluating our risk profile and risk tolerance. Once we have an idea of our personal risk tolerance, what do we do next? The next step is to set up investing goals which will form the basis of our personal investing approach. If you already have investing goals and approach to meet those goals, that is great. If you don’t, please take the time to write them down. You need to make sure that you don’t stop at personal finance and budgeting but also think about your net worth and investing goals with a long-term view. You’ll find it beneficial to evaluate where you’re today in terms of personal finance (income/expenses) and net worth.
Investment Goals will differ by age and personal situation
Investment goals for people in their 20s are quite likely different from people in their 40s or 60s. Similarly, goals for people with families are going to be different for singles or couples. More importantly, they are going to be different based on your risk tolerance and personal financial situation. Please take note of your work situation, financial cash flows when coming up with goals. It is best for goals to follow the SMART method of setting goals. For further reading, please visit Corporate Finance Institute’s site on setting up SMART goals.
Write down Investing Goals
Before we get into the how of investing, particularly real estate investing, it is very important to assess your risk tolerance and have clear investing goals. Please take the time to write down the investing goals even if it takes a few hours a day. Above all, investing is a habit. You need to be committed and keep practicing it consistently to get better at it. Your investing goals may consist of the following or more:
In this article, we understand the basics of risk and risk tolerance and why understanding our risk tolerance is so important. Risk and our tolerance of risk is in itself not a good or bad thing. We just need to understand our risk tolerance as this will define our investing strategy. Having a true appreciation of our risk-taking will define our investing strategy. It will lead to the kind of investments – stocks, real estate, etc. we chose. We hope we’ve convinced you as an investor to evaluate your risk tolerance before making your first investment as it will save a lot of headaches.
Complete the above-referenced questionnaire, evaluate your risk tolerance, and keep it for your reference. In addition, take the time to think through and write your Investment Goals. We suggest doing this exercise on a regular basis (say, year-end every year) as that will inform us of our risk tolerance and come up with an appropriate investment strategy to manage risk. This will be the topic of upcoming articles.
Airbnb has been a disruptor in the hotel industry though many may view it as just another technology marketplace or platform company like Uber. We’ll argue in this article why Airbnb is a disruptor not just in the hotel industry, but the overall commercial real estate (CRE) industry. Airbnb’s business model has ramifications that can echo past hotels and disrupt other property types in CRE in the years to come. As investors, we need to watch out for the Airbnb effect and how the industry responds.
Airbnb probably needs no introduction to many, but let us level set and review Airbnb’s summary from Wikipedia. The key points we will review are highlighted in orange.
Airbnb… is an American vacation rental online marketplace company… Airbnb maintains and hosts a marketplace, accessible to consumers on its website or via an app. Through the service, users can arrange lodging, primarily homestays, and tourism experiences or list their properties for rental. Airbnb does not own any of the listed properties; instead, it profits by receiving commission from each booking.
Source: Wikipedia
Let us also look at the numbers to get an idea of the reach of Airbnb. As of 2020, Airbnb had grown to 4 million hosts and 800 million guests in 100,000 cities in almost every country and region across the globe. The reach of Airbnb blows away the reach of traditional hotel companies like Marriott. After all, Airbnb can operate anywhere there is a house with a room to spare.
We can use two lenses to look at Airbnb as a company and its place in the markets. The first lens is that of a technology company and the second lens is that of a real estate company. Airbnb can be viewed as a high flying technology company that went public in 2020. In and of itself, there are probably tens of other technology companies in the platform or marketplace category. Notably, Airbnb can be seen as the Uber for guest stays. In essence, just viewed as a technology company Airbnb may not come across as a significant disrupter. Here is an opinion from 2013 during the early years of Airbnb.
Please hear me loud and clear when I say the following: disruptive innovation does not exist or apply as far as the real estate business is concerned, and it will not in the future, either. Not even in the case of Airbnb (explained below). Real estate product and its consumption are fundamentally different from non-real estate product and its consumption, and at this point in history, real estate markets are no longer likely to be disrupted.
Source: https://www.getrefm.com/disruptive-innovation-in-real-estate-there-is-no-such-thing/
The significance of the disruption and further potential comes into play when one looks at Airbnb from a hotel or real estate lens. How big is the disruption? Let us look at the chart below from Professor Galloway at NYU Stern School of Business. As of October 2020, around the time Airbnb went public, the projected market cap exceeded those of FIVE major hotel chains and THREE major airlines combined. The battered hotel and airlines have recovered since October 2020, but you get the idea – Airbnb is worth many major hotel chains combined.
In the previous section, we looked at valuations and reach and saw how Airbnb easily surpasses the valuation and reach of the largest hotel chains. In this section, we will look at exactly how Airbnb has disrupted the hotel industry business model and turned it on its head.
Asset light and Risk light
Airbnb is a marketplace platform and does not hold real estate assets. Hotels on the other hand hold the hotel’s real assets. What this means is that hotels (or their franchisees or partners) are responsible for buying, building, and running the hotel property. In Airbnb’s case, the hosts are responsible for buying and running the assets. This leads to Airbnb being asset-light which is a huge advantage. How come? The hotels hold the real estate risk whereas the hosts (not Airbnb) hold the real estate risks. In an ironic way, Airbnb is disrupting CRE without holding ANY real estate assets. This is similar to Uber which disrupted the car ride industry without holding any cars.
The above-mentioned asset and risk light nature of Airbnb vs Hotels have major implications for investors. The investor who invests in Airbnb stock takes limited or no real estate risk whereas an equity investor in a hotel asset takes the real estate risk. As it happened during COVID-19, the hotels faced a deep loss of revenue when stays come to a screeching halt. The hotels still had real estate expenses and loan obligations to run minimum operations. Airbnb stays also came to a screeching halt, but it didn’t have any real estate expenses or loan obligations. Its hosts had.
Agile, Lean and easily scalable
As we saw previously, Airbnb has no real estate obligations to build or maintain the asset, raise capital or get a loan. But, Airbnb has a powerful technology platform and spends most of its money on R&D and improving the platform. This makes Airbnb agile and lean. Airbnb can also scale up or down its business in little time as it has no real assets.
When the COVID-19 pandemic started, both Airbnb and hotels took a big hit. But, Airbnb was able to recover way faster. More so, Airbnb was even able to go to the public markets with an IPO. Airbnb has disrupted the hotel business model to such an extent that hotels are now providing Airbnb-like platforms i.e. the hotels just act as intermediaries but provide some basic branding and consistent service. The table below summarizes salient features of Airbnb and Hotels business models we reviewed.
Disrupting hotels which is a major CRE property type is one thing, but disrupting the whole CRE is at a different level altogether. In our opinion, Airbnb has the potential to disrupt the rest of CRE as well. COVID-19 and Airbnb’s potential should be a cause for concern for many players in CRE. The CRE industry, particularly office and retail, is facing a big crisis with the pandemic. Will it provide an opening for disruptors like Airbnb or other players? It will be a mistake for the CRE industry to treat Airbnb as just a hotel company for the reasons mentioned below.
From hotel to other property types
We’ve argued so far how Airbnb has already disrupted the hotel industry. Why can’t it do the same for offices or retail or for that matter any property type? COVID-19 has actually accelerated the importance of homes. Which real estate player is better positioned to leverage the home as an asset than Airbnb? Let us take a few scenarios which may seem a stretch but quite possible:
Who can create and capitalize on these trends? Startups or established players like Airbnb that have a platform. The above will reduce the need for a traditional office or retail property type and increase the need for a technology platform that can facilitate the above. Let us take a couple of different scenarios:
There is nothing stopping Airbnb from providing the conventional marketplace for office, retail, and other property types? In essence, it can become the Shopify equivalent for the CRE Amazons of the world.
Shorter Leases
Another key differentiator for Airbnb is that it provides a way for shorter leases or stays to guests across millions of assets. At the surface, this may not appear to be a big deal. So what? Most of Commercial Real Estate is built around leases that run into years. For e.g. you may have signed an annual lease for your apartment. Retail, industrial and office leases run into many many years. The penalty for breaking the leases are so high that many tenants hesitate to break the leases.
With this background, Airbnb provides pretty much provides short leases to tenants. Yes, hotels also provide short stays but their model has not been transferred to other property types because the business model cannot work. Airbnb can make that business model work for other property types like an office. For e.g. similar to WeWork Airbnb has the platform to provide shorter office leases to office goers. Airbnb has thus built a transferable platform to further disrupt CRE.
In this article, we’ve looked at Airbnb as a marketplace platform and how it has disrupted the hotel industry by being asset-light and easily scalable. We also looked at how Airbnb has the platform and potential to disrupt the rest of the CRE industry property types as well. As a real estate investor, one has to closely watch Airbnb’s entry into other property types as well as newer behavior and trends that are arising, accelerated by the pandemic. It may not be enough for an investor to just look at the numbers and evaluate deals. They also need to answer the question – Can Airbnb or a similar player disrupt this space to affect my bottomline?
One of the most common questions we get from beginner individual investors: should they invest in real estate rentals? Some want to take their first step in investing beyond stocks and bonds. Some see rentals as a source of passive income, in addition to their primary source of income. Some rent out their existing house when they buy a new house. Some are very much interested in real estate and want to take their first step. Reasons are varied and many.
Even though there is a lot of interest, real estate investing comes across as daunting for many. The reasons are again varied and many – high capital needs, time commitment, etc. The purpose of this article is to lay out three major ways to invest in real estate, including rentals. We will look into the characteristics of the different investment options and provide an approach to answer the question. The investor can then evaluate the pros and cons and decide whether rentals make sense.
Real estate investors these days have a variety of options to start investing in real estate. Many of these were not easily available to a lot of individual investors even a few years back. The major options include investing in REITs, private placements, and directly investing in rentals. The good news is that there are so many ways to invest in real estate and get started that you don’t need to have a large amount of capital which used to be a big roadblock.
We’ll look at all three investment options through the lens of an investor, not necessarily as someone who wants to build a career in real estate. There are many ways for investors to get started with investing in real estate. Basically, it comes down to investing in the following three major ways illustrated and explained below.
Direct Ownership of Rentals
Direct ownership of rentals needs no introduction. Buying a rental property has been an “old school” way to invest in real estate for decades and even centuries. Almost everyone can identify with buying a rental property and having full control over the property. People buy a rental home and are responsible for everything – buying the home and managing it themselves.
Syndication or Crowdfunding Platforms
Investing through syndication or crowdfunding platforms has become very popular over the past few years. Someone you know may have done it through crowdfunding platforms like Fundrise, RealCrowd or CrowdStreet. The terms maybe confusing to beginners, but think of syndicates as capital pooled from tens or hundreds of investors. The property is bought, managed and sold by the sponsor. In essence, sponsor is the active landlord and you’ll be the passive investor as a limited partner.
REITs and Stocks
Real Estate Investment Trusts (REITs) are real estate securities that trade like stocks. REITs are run by large institutions and they typically manage a property type (e.g. office or multifamily) across a large geographic region. Some of the popular REITs are Equity Residential for Multifamily or Prologis for Industrial property types. In addition to REITs, investors can also invest in housing stocks or real estate mutual funds.
Now that we have an understanding of the major options to invest in real estate, let us look at the characteristics of each of them. We’ll look into the four key characteristics of the real estate investing options available – Ownership, Liability, Control, and Finances. The key characteristics are summarized in the illustration below:
Ownership, Control and Responsibility
When an investor invests in a rental property she will be the sole owner or one of the few owners. The investor is in full control. This is the storied mom and pop landlord that many of us are familiar with. The investor will be the sole responsible party as the landlord and she is responsible for all aspects of buying the property, getting a loan on the property, managing the property, and eventually selling it.
For private placements, the investor will most likely be a limited partner – one amongst tens or hundreds – in a given property. The investor will share the ownership with tens and possibly hundreds of other investors depending on the capital contributed. The investor will have limited or no responsibility, but she will have access to the sponsor and will get periodic distributions (usually quarterly or monthly) and reports.
From an ownership perspective, the investor will be one of the thousands of shareholders in REITs, funds, and housing stocks. The investor will hardly have any control over the property or management. The investor’s experience is the same as buying the shares of a public company in any other sector.
Liability and Financial Worst Case Scenario
When someone buys a rental property directly, they are fully liable as their name is on the title and all the documents. If a tenant sues the landlord because she hurt herself, the landlord will be fully liable and responsible. The investor also needs to get the debt (i.e. loan) and guarantee it. If things go south, the investor will lose her equity in the property and in addition, will need to pay off the debt as well. This is very important to understand.
For private placements, the investors will usually be a limited partner i.e. someone with very limited or no liability. The sponsor will be the general partner and will be responsible for all liability. The investor doesn’t even have to worry about debt financing, as the sponsor will be responsible for the loan. So, if things go terribly wrong, the worst thing that could happen is the investor will lose all their investment, but not more.
For REITs, the company management will be liable and the investor has NO liability at all. In the worst-case scenario, if the REIT does a poor job the investor loses all her money invested, but she won’t be responsible for the debt.
We have looked into the major ways to invest in real estate and their characteristics. Now, let us come to the key question – Should you consider investing in rentals? Investors have different personal objectives, motivations, and situations. There is no one answer that fits all. We’ve seen the characteristics of the major investment options. Which one do you find appealing? The following questions will help you personalize the decision to your objectives and situation:
Once you have understood the characteristics of the major investment options discussed earlier and answered the above questions, the choice will start crystallizing. Are you looking for passive income with minimal time commitment and headaches? Then, the options are REITs or private placements. Do you enjoy real estate or want to be more active in real estate? Then direct ownership in rentals may make more sense. After all, you know yourself the best.
