So far, all my newsletters have been targeted at real estate investors who want to do all the work as an operator but after checking out my readership, I’ve found that a good chunk of folks are the “set it and forget it” types. They are interested in investing in real estate, but they rather let someone else do all the work while they just kick back and enjoy the cash flow from rental income.
Here is a fact: Passive real estate investments make up over 40% of the market!
Honestly, I wanted to do the same thing as well, but I hit some snags that forced me to go all in.
So today I thought I’d share some things to consider if you’re thinking about investing in real estate and especially passively. That way, you’ll be able to make an informed decision from every angle.
Let’s dive right in.
The good of real estate
Real estate has a few interesting benefits:
Unlike stocks, you benefit from 4 different types of returns
- The biggest benefit is consistent cash flow.
- Principal Paydown
- Asset Appreciation
- Tax breaks
Diversification and upside potential
In the right market, real estate has inherent potential energy for extreme upside while offering diversification to minimize downside: the best-performing assets can 20+% annual return in a 5-7 year period. This is the nature of the right acquisition strategy + efficient operations: some assets get big and skewed returns.
- Compare this to investing in a stock index fund: you get diversification, but you neutralize the potential for massive, outlier returns.
- And compare this to individual stocks: you get the potential for huge returns (although not often 20+% annual avg. in 6-10 years) but not diversification. Plus, you have to stomach the recursive volatility of trader sentiment.
You are compounding deal flow and relationships
If you’re investing directly with a competitive GP, you can build on the relationship for future deals. This deal flow access can become a flywheel leading to a competitive advantage. In RE, relationships matter more than everything else.
Reduced stress due to less-perceptible volatility
Some investors find real estate less stressful than stocks or crypto—and every other asset with a high frequency of performance fluctuations. If you’re an investor who factors the cost of stress into your investments, you can “set it and forget it” with RE and not worry about looking at Robinhood or crypto-token prices every morning. This seems like a small benefit, but it’s meaningful for many.
Learn about RE
Some investors want access to the return profiles of an asset—and nothing more. That’s great! Others, however, want to learn about the RE landscape, which makes this asset class extra interesting: it’s a means to learn. For example, if you invest in a fund (which makes you a “Limited Partner” or “LP” in the fund), the proper fund’s partners will often socialize thoughtful summaries of their learnings as investors. The benefit of quick, high-signal learning—if that’s your goal—may be reason alone to write the smallest check possible. Read their LP updates, identify patterns across them, and empower yourself to make better direct investments in the future.
The not so good of RE
Long lock up.
Most often, real estate dollars are illiquid for 5-7 years—and usually on the longer end of that.
- In some cases, as a direct investor in a syndicate, you can attain liquidity early by re-selling your equity before the asset itself becomes liquid. This happens most commonly with breakout assets when other investors badly want in but can’t get access to invest directly.
Most real estate groups investors will have access to will be non-hot. Meaning these are groups who need to surface their fundraiser widely to fill their round. This doesn’t mean they’re bad groups, but it might mean they’re not among the best groups. In contrast, the hottest groups are ones you’ll never hear about until their round has closed. They already have a reputation and a pipeline of returning investors. This is one reason why it may be better to invest time in finding the right group.
- So what should you do? I recommend looking for high-potential ex-corporate partner led funds (discussed shortly).
Higher minimum investment
Unlike stocks, index funds, the minimum investment most groups would require is 40-50k (25k in rare cases). This is even greater than angel investing, where you can write smaller checks ~ $1k
If you are not getting into a partnership with close friends. You need to be an “accredited investor” to access the majority of RE deals. There are several ways to qualify as an accredited investor (the following is not legal advice!):
- “A natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year.”
- “A natural person who has an individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase, excluding the value of the primary residence of such person.”
- “Individuals holding Series 7, Series 65, and Series 82 licenses are now included as accredited investors.”
- “Individuals who are ‘knowledgeable employees’ of a private fund.”
- “SEC- and state-registered investment advisers.”
Should you passively invest in RE?
I’d treat any base capital you put into real estate as money you don’t see for 5-7 years. However, historically, this is unlikely to happen when investing at the fund level—with diversification across many assets and refi cycles after value-added operations.
Here is my take: You should consider real estate if you want to diversify, you don’t mind many years of illiquidity, and you know how to identify a top operator.
If illiquidity and initial capital requirement is a concern, then you can consider re-purposing your old IRA into a self-directed IRA or a solo 401k.
I think real estate is the best asset class for its cash flow benefits, especially if you can get in with a top-tier partnership. Top-performing operators can outperform other asset classes, plus they have a shot at much more prominent, outlier returns.
Now here’s the flipside: I wouldn’t invest in real estate if I lacked discretionary capital or if I wanted something more liquid. (If you’re unsure of whether you’ll need the money in the next 3+ years, then you should invest in an asset class with a shorter time to liquidity.)
I also recommend you avoid real estate if you don’t have the patience to diligence the best funds/vehicles to put your money into. Perhaps stick with an asset class that requires less diligence—like an index fund—than risk choosing the wrong operator to bet on.
Also, if you’re making a binary decision between investing in real estate through an operator or investing in yourself (e.g., starting your own real estate journey), personally, I’d always use that capital to bet on myself than investing in the top-tier operators out there, which is what I have done.
- Don’t over-index on the social proof. I think hot operators—who don’t announce their rounds—will outperform non-hot groups on average. They don’t solicit capital subscriptions publicly, which is probably well-correlated with success because, most likely, the existing investors re-subscribe. But that doesn’t mean you should go with a hot operator at the expense of your intuition. Many hot deals will, of course, implode. So, if you don’t think an idea makes sense, don’t go in because others are. You need to earn the right to have conviction by doing the research and learning, or you need to stick to your and say no.
- Early on, collaborate with someone you trust. The right profile is “a bird dog with past big-tech or corporate experience.” Real estate is brimmed with pattern followers but also passionate hustlers. It’s hard to beat extreme hard work unless you can also work hard and strategize, automate and use technology to disrupt the traditionally archaic real estate industry. Most current operators lack the latter putting them at a disadvantage when folks with cross-industry experience hard pivot into RE investing.
How are deals typically structured?
The most common model includes a preferred return and a pre-determined split on the operating return and exit events with a hurdle rate.
Example - an 8% preferred return with 70/30 LP/GP split up to 13% ARR. When the LPs reach 13% ARR, the split changes to 50/50.
Preferred return is paid out from the operating profits, and the most common distribution schedule for the cash yield is either monthly or quarterly.
In case the annual operating return is below 8%, then all of it will go to the LPs.
If it’s over 8%, it would be split 70/30, with 70% going to LPs.
When the property is refied or sold, the below payouts also initiate in addition to the operating profit payouts.
What happens when you do a cash-out refinance?
If you refinance, any capital pulled out will go back to LPs till all their initial investment is paid out.
- The remaining will go to LPs till they have the preferred return threshold met.
- Any remaining balance is divided in a pre-determined profit split as stated above- eg, 70/30
- If the ARR hurdle is met, the remaining profit is divided 50/50.
What happens at the sale of the asset
- All the initial investment goes back to the LPs first.
- Total return to LPs is calculated until this point, including preferred return + any return from refinancing event.
- If LPs haven’t their pref return of, let’s say, 8 %, then they get all that before GPs get anything.
- Any remaining balance is divided up until the LPs receive a total of x% ARR.
- The remaining balance is then divided as 50/50
These structures are limited only by the creativity of the sponsor and their lawyers and the relationship between the GPs and LPs. I am in the process of writing a comprehensive playbook explaining the most common models in use out there and a bespoke model I use to make more deals work. Hope to share it in a couple of months.
That’s a wrap. I hope it helps.