Real Estate Investing Online Part III: Tips, Tricks, Caveats and Final Considerations

Parts I and II of this series on online investing in real estate deals discussed the basics and what to look for in these deals. Now, let's talk about the little details that make all the difference and not obvious when one is just starting out.

K-1s and minimum investment size: opposing forces

In almost all cases when investing in real estate online, one will be a member of a partnership for tax purposes, as a limited partner. As such, you will receive a schedule K-1 at some point and you'll need to file that with your tax returns. Just like investing in MLPs or some commodities ETNs.

So far, so good, right? No big deal?

Except that if you use an accountant to file your taxes, many of them will charge you per form (or equivalently, per hour). That means that for every new RE deal you invest, you could be paying $50-$100 or more to file your taxes. And if your investment size is as small as say, $1000 on a deal that pays say 8% annually ($80 per year), you could be keeping just $30 of these $80, minus the tax you owe once you pay your accountant.

So, just keep in mind that very small investments sometimes are not worth the trouble at tax time. If you do taxes yourself, this is less of a concern, but still, it's one more form to file and it will take some of your time, which could be better spent doing something else other than tax.

Multiple States, Multiple Headaches

Online deals are great because one can diversify and invest in a state across the country from where one lives, thus hedging bets about local economies and the RE market across the US. However, this very diversification comes at a cost: tax preparation costs again.

Each state has a different requirement for when one should file, even if you're not a resident of that state. For example, Oregon has a low threshold of just $4,600 of income per year for married couples. If you earn money from an RE deal in Oregon, you will be liable to pay taxes there even if you never set foot on the state.

Filing tax in multiple states is not only a headache, but it's more cost too as a CPA will have to research that state's laws. Even if you use software like TurboTax, you will incur the cost of filing with a new state. So, keep that in mind when choosing to invest and when deciding the minimum amount of your investment.

Oh, and, of course, you're liable for the taxes due in that state. So, make sure you factor the state tax rate into your required returns before you invest.

Luckily, there are five happy states that won't require you to file anything because they do not tax personal income: NV, FL, WA, WY, and TX. But then again, check with your tax professional as things change and I'm not a tax specialist.

Finally, consider your tax consequences when you invest in national or regional funds. These are funds that invest all over the US or in a given broad region like mid-west or east coast.

Get familiar with capital calls and dilution terms

Many operators retain the right to make a capital call -- that is, request more money from investors in proportion to their original investments. Say, if a deal is underfunded or incurs losses or extra expenses not budgeted for, the general partner (GP) may tell the limited partners to pony up more money. And, as is often the case, those who do not put more money in will have their shares of the partnership diluted in some non-linear way.

The dilution can sometimes be 15-30% more than if you simply didn't add more money in subsequent rounds. For example, let's say there are 10 investors and they each put $1000 for a $10,000 deal, and there's a capital call later for another $1000 per investor. Normally, each investor would add $1000 and each would keep their 1/10th of a $20,000 deal. However, with some dilution clauses, if someone does not contribute the extra $1000, their share would not simply go down to 1/20th as you'd expect. It could become 1/25th, 1/30th or less, depending on the dilution penalty clause.

There is also the possibility that a non-contributing member could be automatically given a "loan" from another investor. In this case, some contracts specify that the "defaulting" (non-contributing) member needs to repay the lending member at a rate of interest of X%. This interest will be taken out of the member's distributions or even principal if the distributions are not enough to cover the implicit interest.

These dilutions terms are not very common, but I've seen quite a few of them. So search the documents of the deals for "dilution" and "capital call" and understand thoroughly what you're getting into. I've found that emailing the operator also works and most are willing to explain the terms in more details if you're having trouble with the legalese.

General Partners as Free Riders

Generally, the general partners will invest in the deal some percentage of what they're looking to raise. Obviously, the more they invest the more their interest is aligned with yours. And as I've explained in part II, investing alongside a GP who is also an investor, not simply a fee-taker operator, is a good thing.

Most GPs will invest some percentage. But whose money are they putting up? It could be your own money that they're co-investing with you -- so they're getting a free ride (and probably laughing at you at your own expense).

I explain.

Remember the acquisition fee we talked about in part II? Well, some GPs will openly declare that they will use that fee to make an equity investment in the deal. Meaning: they're charging you what I consider to be a borderline abusive fee to then turnaround and dilute your investment some, just so they can say they're co-investing in the deal. But in reality, they're taking no economic risk in doing so. These operators are just operators, not investors. Don't get me wrong: They might be great operators and they might generate great returns for their investors. I've invested in one such deal and it's working fine. But I strongly prefer when GPs are real investors in deals and are exposing their own money.

Keep in mind you are the Limited Partner

This is common to all deals: you're the limited partner and you have little to no say in how the asset is managed and operated. That's great when things are going well, but it's useful to always think of worst-case scenarios and how you'll recover your money if something goes bad.

Imagine, for example, that a debt deal goes bad. If you have first lien on the property, you may think you're covered: "I take my part of the asset and sell it". Right? However, first lien debt is not exactly like a bank mortgage. First, you don't control the terms. Second, you can't threaten to ruin the borrower's credit score. And most importantly, you're one of many investors so even in cases where you may vote (typically, in case of default you have some limited rights), you still need to reach consensus with other borrowers. So, imagine what other investors will think when the borrower decided to negotiate a 50% haircut. Maybe you don't agree with it, but you may not have final say.

There's not much you can do as an LP. So, choose the operators wisely and don't settle for mediocre returns. There's a reason they need to offer you more than what they would pay a bank for a "normal" mortgage. Make sure this margin is not too thin, because you have limited recourse in case something goes bad.

The sites that offer these deals are not in the business of foreclosing or negotiating with operators when things go south. These platforms may or may not help you, but that's not their business. So make sure you build your own defenses as much as possible in terms of due diligence and margin of safety.

Debt: Repeat borrowers, good or bad?

Many sites offer debt deals these days. You may see borrowers asking for as little as $200k to rehab a house and flip or to buy one or two properties, improve them and rent out.

Many of these operators have been doing this for a long time. Experience is great. But it also could spell trouble: how can you be sure these operators are not over-leveraging themselves and borrowing more than they can handle?

It's true that each deal has its own terms and guarantees. But can a bad deal somewhere else in their portfolio cascade to yours? Typically they're separate legal entities, so you might be protected that way. But often times these debt deals come with a personal guarantee from the borrower -- a line of credit if you will. But this guarantee is often the same one for all deals of an operator. So it's not much of a safety net if many deals go wrong.

Just something to consider. Look at the history of each operator on your platform of choice to have an idea of how much they're borrowing and what they offer as guarantee and whether you think that guarantee is enough of a safety net for all the deals they've listed. More deals is not always better. It can be, but don't just assume it is.

Payment In-kind

This is not a big deal, but some operators reserve the right to pay you "in-kind". Meaning, they will give you the asset(s) instead of cash. One such operator I contacted said it is rare they need to do this, but they reserve the right in case the market is not conducive to a sale.

In most cases, I'd just prefer that the time frame for the deal gets extended instead of receiving the asset directly. But it's a choice the operator will make for you. Again, as the LP, you won't have much say and you'll need to deal with other investors if you're given the asset directly. Just make sure you're okay dealing with it.

Be wary of indirect language, unnecessary complexity and general sneakiness

Most operators are straightforward and most deals are reasonably easy to read if you've read a few of them -- even for someone not versed in legalese like me.

But then there are deals that have hundreds of pages and things that are defined in addendums, appendices or left unspecified or unclear. For example, I've seen deals where there's a hurdle rate for investors, after which there's a catch-up phase for the operator. But the catch-up amount was not specified until later in an appendix. This may be because these deals use template documents or for whatever reason. But I generally prefer a straightforward document that is easy to read and has everything spelled out nicely and up-front. Not in footnotes or appendices.

Another tell tale sign of potentially too much ass-covering language: if the word "fee" appears as many times or more than there are pages in the document.

I can't list all of the things I've seen nor give an exact formula for what unnecessary complexity and sneakiness means. This is something one needs to learn by reading multiple deals. And sneakiness and complexity are subjective and personal things.

Try searching the documents for words that matter to you as an investor: "fee", "dilution", "guarantee", "capital call", etc and read around these sections. Sometimes you'll be surprised by what you find out lurking in subscription documents.

That's all for now. Happy investing.

1 comment:

  1. Thanks you sir!!! This was your best post yet!! I learned tons.

    "General Partners as Free Riders" really blew my mind!!

    You should do a Part 4 about the new tax structures Reality Shares is setting up. I think that is pretty interesting.

    I think you did a great job of highlighting the major thing to consider when doing these Real Estate deals. They are great on the surface but you need to have a plan. With K1s and filing in other states you need to invest a fair amount to make it worth it (I would say a 10k min is smart). But since you don't have much control you need to invest in many deals to ensure one deal does not destroy your returns. So maybe a 10 - 20 deal min. So bottomline is you gots to be rich. Willing to put 100 - 200k into these deals.

    Thanks for the great blog post!