2015-06-29

Real Estate Investing Online Part II: Triaging Deals Online

Last time, we talked about some of the basics of real estate investing online and how I’ve been using online platforms for over a year to generate an income-focused portfolio.


This time, let’s talk about some of the things to look for and be aware of when investing in real estate online.


How investors earn money from real estate deals


Real estate deals online have several dimensions. First, one needs to understand the difference between a loan (debt) versus equity.


Equity vs loan (debt)


Most often, I see deals that are equity deals. This means you’re investing in buying the property advertised. If it’s a rental property (commercial or residential), you can expect to get some income from rents. For rehabs (fix-and-flip), you’ll likely see returns after the property has been sold. Same thing if it’s a new construction. Typically, equity deals have some upside in the end, even if they pay a distribution (say, from rent).


Equity deals also have a downside: if the property fails to generate enough income, you may not get your distribution. And if something bad were to happen and the operator defaults on the bank loan (most equity deals still take out loans with banks to buy the properties), then you likely would not get your investment back.


Debt, on the other hand, is a loan to the entity buying the property that pays a fixed interest but with no upside upon sale of the property. Loans typically offer a higher annual payout than equity investments. Loans also are often structured in a way such that the investor would get his/her money back first in case of default, before the operator and equity investors. Note, however, when making a loan investment, be sure it has a first-lien on the property, before any bank or other investors. Otherwise, you’d be running an even greater risk of loss of principal, which needs to be matched by a higher payout or other risk-mitigating factors.


Bottom line: I tend to prefer to have upside and thus invest in equity deals primarily, but I do invest in debt when it offers a solid return with a decent risk profile -- I avoid debt to buy a single family home for example, but find it more acceptable when doing so as part of a fund or a multi-tenant property.


IRR vs Cash Flow (or Cash-on-Cash)


Internal Rate of Return (IRR) is the annualized return one gets after the property has been held for a few years and then sold. For example, if your share of a property is bought for $1000 and it pays $100 per year in rent for 5 years and is then sold at the end of the 5 years for $1500, the IRR to the investor is the $500 collected in rents (5 years x $100), plus the $500 appreciation ($1500 - $1000), plus the principal back ($1000), annualized over 5 years, for that original $1000 investment. Thus, this means an IRR of 2000/1000^(⅕) = 14.9%


But note that for the first 5 years, the investor did not get these 14.9% every year. So, IRR does not mean money in your pocket every year, even though it’s an annualized rate.


Cash-on-cash is the money in your pocket every year. These are the $100 per year you’d get in the example. This translates to a cash-on-cash return of 100/1000 = 10% per year.


When looking at deals, it’s important to look at both numbers. IRR will tell you what your average return will be. It’s important for it to be a high number, certainly higher than what you could get out of stocks or bonds. I personally look for 15-18% in most cases.


One needs to be aware that a lot of the IRR is due to property appreciation, which is very hard to predict, specially for long hold periods, say over 5 years. So one needs to balance a high IRR with an equally healthy cash-on-cash return. I like to see the two numbers being closer together rather than farther apart, for a balanced deal without a lot of my return coming from hypothetical appreciation. It’s easier to predict cash flow from rents than price appreciation -- though, neither one is guaranteed, of course.


I typically look for cash-on-cash of at least 8% and currently I’ve been looking for even higher returns, given that interest rates are expected to go up soon, which means that in a few years a return of 8% is likely not to be as attractive as it is now that “safe” rates are very low.


But it’s all a balance, of course. A very high and realistic IRR might make up for a relatively low cash-on-cash.


A quick note on another metric, the equity multiple: that is simply your overall return after the hold period and sale of property all combined into one big multiplier of your initial investment. In the example above, it’s 2x, because one would get out $2000 for an investment of $1000 after the hold period. It’s essentially the same information one gets from the IRR, but compounded over time. I’ve trained myself to understand the compounding effect of IRR, so equity multiple does not give me any new information. But it does put things in perspective a little bit. For example, if the equity multiple is 1.2x for a hold period of 10 years, that’s a terrible investment, as one would be getting a total gain of 20% after 10 years. Likewise, the IRR on such a deal would be 1.8%. So, looking at the IRR usually suffices for me.


Bottom line: I typically look for cash-on-cash of upwards of 8% and a believable IRR of 15% or more. These required numbers will go up when interest rates go up.


How deals are structured


Commonly, real estate deals online have a “waterfall” structure of returns. A deal might be structured such that investors get 80% of the returns and the sponsor of the deal (the operator) gets 20%, beyond their own investment.


More commonly though, investors will get 100% up to some preferred return or “hurdle” rate. A typical structure might look like this:



Hurdle Rate
Investors
Operator
Preferred return
8%
100%
0%
Thereafter

80%
20%


It’s also common for deals to differentiate between cash flows and capital events (i.e. sale of property, cash out refinance, etc).


And sometimes there are multiple tiers of returns, such as this (real) example below:



Hurdle Rate
Investors
Operator
Preferred return
7.5%
100%
0%
Tier 1
18%
75%
25%
Thereafter

50%
50%


The example above is interesting because it gives the operator an extra incentive to go beyond that 18% hurdle rate and thus collect a larger fraction of the money to themselves. I don’t mind that, because it means a higher return for me too. Just beware of 50-50 splits right after a low hurdle rate. I’ve seen these deals too.


In real estate lingo, the operator’s split is commonly called the promote. It’s similar to what hedge funds call performance fee. A good return structure is crucial to align investors and sponsors.


Fees


If there’s one guiding tenet in all I do when investing and consuming is this: minimize paying fees. Fees not only eat into returns, they potentially create a misalignment of interests between investors and the operators. But not all fees are bad. Let’s discuss them in turn.


Property management fees


Normally, operators charge a property management fee. They are fees paid to a third company or sometimes the operator directly, for making sure rents are collected, the property’s conditions are kept in shape (toilets unclogged, gardens landscaped, etc). Those are necessary, so don’t mind them.


In fact, most operators I’ve studied charge a very reasonable property management fee, between 4 and 5% of rents collected. This is actually why I prefer to join a professionally managed deal online than buy my own property and hire a property manager -- they would cost me 8-10% typically. But seasoned operators have scale and thus their fees are quite reasonable.


Bottom line: Make sure to look for property management fees around 4-5%.


Asset management fees


Now, asset management fees are the ones I don’t like. These are fees for keeping my money, like mutual fund and ETF expenses. I often see them in the 1-2% of assets range. Some operators will charge less and a few don’t charge them at all and at least one I've seen charges a fixed rate.


The reason these fees turn me off (besides eating 1-2% of my returns) is because the operators get paid even when the deal goes south, which is the misalignment of incentives I was talking about. A flat fixed fee is okay, as they need to pay for accountants and office staff. But the work does not become more expensive with extra money. It might be proportional to the number of investors, but not with the number of dollars necessarily. I would not be opposed to a fee on  a sliding scale, where it goes down with higher amounts invested -- which is similar to a flat fee anyway.


Another reason why an asset management is bad is because it is typically beyond paying for the accountants, lawyers and secretaries. Most deals, if you read the fine print, say that the company investing in the property -- most commonly a separate entity than the sponsor itself -- is responsible for all reasonable expenses. So, my understanding is that all the overhead of running the deal is paid by all investors already. This makes an asset management fee just an extra way to compensate the operators regardless of how the investment performs.


Bottom line: Avoid asset management fees like the plague.


One-time fees


Many deals have an acquisition and/or a disposition fee, oftentimes around 0.5 to 1%. These are justified in some cases because these fees are paid to brokers and other companies employed in finding the properties in the first place. However, one needs to inquire operators about these fees, as they’re not always meant to reimburse third parties, but instead are an “incentive” for themselves -- sort of a self-congratulatory high-five for putting the deal in place.


In some cases, these fees are used to fund the operator’s part of the equity in the deal. This means that the operator does not need to put up its own money into the deal. They instead charge an acquisition fee to fund their portion. Think about it: they take your money to fund their participation in the deal, as an equal partner to you, plus their promote. Seems unfair, no? It is.


I believe that the bulk of an operator’s returns should come from their equity investment alongside you, the investor, and in part from their promote. It should not come from auxiliary fees or asset management fees. I don’t expect them to work for free, obviously. But in many cases the entity formed to operate the deal is paying all incurred expenses directly anyway and the sponsor will get its performance fee (the promote) as compensation for working on the deal. A fixed-amount asset fee on top is not unreasonable. This structure of compensation is what I would want for me if our roles were reversed and I was operating one of these deals. Anything else seems greedy and unfair. Several operators follow this approach. Some don’t even charge a promote and instead are equal partners to you. Our incentives are truly aligned, as they should be. Long and prosperous lives to them.

Bottom line: Inquire about the use of acquisition and disposition fees and avoid them if you can. Prefer operators that are investors themselves and are getting their returns from their investments mostly and not from selling you deals in which they have little or nothing at stake.

3 comments:

  1. Thanks for the write up!!! As you know I recently just took my life savings and invested into my first Realty Shares deal. If all goes well I can retire! If it goes to hell......any chance your hiring?? :)

    I wish I had this write up when I made my first deal. It really nicely highlights the key things to look at. It can be confusing at first glance to figure out how the money flows when you invest in a deal.

    I enjoyed your break down of fees. My guess is the market will reduce fees over time (it always does). For me the fees are not bad. I have spent sometime in the hard money lending world and the fees you find on sites like Realty Shares are way less.

    Also, with fees. Yeah. Maybe they are a "high five" but cash flow is king in Real Estate. Many operators throw money into deals (skin in the game). Operators tend to have a lot of Real Estate all in the same area. If things don't go well even just appreciating a few percent less than predicted they can be high and dry. People do crazy things when things don't work out. I don't want operators to get rich on fees. But I want to make sure their families are taken care of. They are living a good life. You don't want operators checking out, doing stupid things, selling properties just to get out of them. They are making decisions on behalf of the fund. Their personal comfort is going to factor in (even tho it should not).

    One question. Lots of deals have a preferred rate. Often operators are throwing money into the deal as equity. Is their money preferred as well for the shares they own?

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    Replies
    1. Hi Spicer,

      It sounds like you've been reading my blog consistently and learned well the concept of diversification and managing risk. :-)

      Yes, fees ensure the survivability of the operators. However, as I alluded in the post, there are different types of operators: those that are also investors and are looking for *partners* and those who prefer to just put deals in place for other people to take risks while they take little of their own. There's nothing wrong with the latter. But they are more in the administration business than sheer investing. I prefer to invest along operators who are also heavily invested, rather than plan administrators who sometimes also have small positions in the deals. Of course, I also invest with the professional administrators who have a good track record of ensuring deal success and obtaining good returns for their investors.

      However, I see your point. It is a counter-argument to my point above: if an operator is not heavily invested in the deal and they're paid mostly by fees rather than investment returns, there's more emotional detachment from the deal and therefore they may be more able to make rational decisions in case something goes bad. But emotional detachment can be had with investor-operators too, especially the experienced ones.

      As I said, I prefer to be aligned with operators as much as possible. This is a personal thing but also a cost reduction issue.

      Thanks

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