Real Estate Investing Online, Part IV: The Returns

Last post of this series was a little over two years ago. I figured it's about time to update the series with what really matters: the returns.

I posted in the very first post that the returns for that first year was around 4% but that over time I expected those same investments to yield around 12-15% annually. So, now that it's been over 4 years of investing, were my expectations realistic? 

Yes, pretty close, but a bit too optimistic.

My actual annual returns now (2017) from all of my investments, including many from 2017 that are just starting up, has already returned 12% this year. And the year is not over yet. So, I was right at that lower end of my expected returns, possibly a bit higher.

Let's see what contributes to the returns and how I compute these numbers.

Breaking it down

In year one I told you that my returns were right around 4%. Turns out that's a typical low-end over the last four years. In aggregate, over the last four years, I've consistently gotten around 6-8% from all deals open for one year (the average is 7.5%). This includes deals that are simple buy-and-rent and those which require remodeling.  6-8% is typical for year 1.

The full average returns by time since first investment is as follows:

Year      Average Returns

0           1.8%

1           7.5%

2           8.9%

3           20.7% 

Some observations about these returns:

1) As alluded before, year zero has low returns because many deals take a while to start returning and many others (e.g. rehabs, fix-and-flip) do not start returning until renovations/construction is complete.

2) Year 3 is particularly robust because many equity deals target a 3-year hold, returning all investment plus appreciation at the end.

3) My investment mix is not 100% equity (more on that later), so for some deals the points above do not mean as much.

4) Note that it's implicit in the numbers above that there were four year "zeros" and only one year "three" so far as I've been investing in these online deals for four years. 

Now, let's look at returns based on cash flows per year. This is different than the analysis above because I look at how much cash was returned from an outstanding capital invested in a given calendar year as opposed to bucketing everything based on their start time. Invested amounts (the denominator) carries over from one year to the next unless the deal exits.

Calendar Returns

Year    Returns

2014    4.6%

2015    5.1%

2016    6.5%

2017    11.9%

Here again we see the same trend: low returns early on and a jump on year 3. 

You may notice that 2017 is lower than year 3 in the previous table, even though there is only one year 3, which is 2017. That's because 2017 is year 3 for deals that began in 2014, but it's also years 0, 1 and 2 for more recent deals -- hence a weighted mix of returns (also, 2017 is not over yet). In other words, the calendar returns include cash flows from any deal that year, regardless of when they began.

So, going forward, I now expect returns to be more in the 11-14% range, assuming I keep adding new dollars and re-investing old dollars into new deals. If I were to stop investing, I'd expect returns to go up for 3 or so years and then trail off, eventually dropping to zero as they all exit.

Of course, we've been on a bull market and it will not continue forever. So, going forward, results could very well be much worse.

Investment Mix

I mentioned above that I have a mix of deals, not just equity investments. The mix has changed over time too. Here's the current snapshot by deal type, weighted by currently-invested dollar amounts.

I won't discuss the rationale for this particular mix right now. For a reminder of what each deal type entails, please see part II of this series. 

The point here is that equity is still the bulk of the investments and was the sole type of investment in the first few years, hence why we see a pronounced effect at around year 3. As of late I have made several debt deals because they offer immediate returns, which helps smooth out the lumpy returns achieved by equity deals. They're also more robust to downturns, which I expect will happen at some point in the future. Preferred equity is similar to debt in which they offer immediate yields, usually higher than debt, but also with more risk.

Min/Max

Another important pair of numbers to look at are the minimum and maximum returns so far. More the min than the max, I'd say. So far, no deal has gone negative. But I've had one deal return exactly zero -- I got my investment back and a tax headache to deal with, but no loss of principal (maybe a tiny loss due to how taxes are computed).

As for the current max, it was an equity deal that returned an annualized 30%.

So, there you have it, a detailed analysis of my returns so far.

If you want to start investing online, I'd look first at Realtyshares. I'm a fan of their platform and an early investor in them (I own shares of the company). My returns above are for investments done in their platform, plus a few others. Over 50% of my currently-invested dollars are with Realtyshares as of this writing.

Happy investing.

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.

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.

Real Estate Investing Online - Part I: The Basics

Over the past year and a half, I have been investing in many real estate deals online, via websites like RealtyShares.com and RealCrowd.com. I’ve done quite a few now -- over two dozen -- and I have learned a lot about investing in real estate online. I thought I’d share a few things with my dear readers.

Thus, over the course of the next several weeks, I will write about my experience with these online marketplaces, the nuances of different types of real estate investments and the gotchas and pitfalls to watch out for.

Let’s start with some of the basics first: Why invest in real estate, how to invest online and the differences between two of the online investment sites I use.

Why invest in real estate

I’ve expounded on real estate investing before on this site. Basically, real estate investing has a few interesting properties:

1. Leverage. It’s easy and relatively cheap to use leverage to acquire properties, via a mortgage. Leverage will increase returns, if properly used.
2. Income. A property allows one to derive income from, via rents. This is not always true with say stocks, which may or may not pay dividends.
3. Control. Owning a property outright may allow you some wiggle room to control how much income you derive from it. One typical way of getting more income is by increasing rents when appropriate or by rehabbing the property to make it “worth” more to tenants, thus allowing for higher rents. Owning a dividend-paying stock or a REIT is great, but you ultimately have little control over the dividend.
4. Tangibility and simplicity. It’s relatively easy to “see” a property and value it through comparables and rental income. This is often not the case with large companies and their complex balance sheets and cash flow statements.
5. Tax and depreciation.  Oftentimes, the tax treatment on real estate can be constructed in beneficial ways, by taking deductions on the mortgage and depreciation and by using tax laws such as 1031 exchange.

All told, real estate often yields a solid stream of income with relatively low volatility. Of course, there are disadvantages too such as not having as much liquidity as with stocks and bonds and the added headaches of owning a physical structure that decays over time and needs maintenance.

How to invest online

Gone are the days one had to go see a realtor, stop at a bank and at a title company to buy real estate. Now this can all be done online, sometimes in a matter of a few seconds. Sites like RealtyShares and RealCrowd are making these investments very easy to make. Here are the US-based sites that I know of:

RealtyShares.com - Invest as little as $5000. Equity, debt.

RealCrowd.com - Deals starting at $25,000.

RealtyMogul.com - $10,000 minimums.

ProdigyNetwork.com - Manhattan only. $10,000 minimum.

FundRise.com

I have first hand experience with the first two, RealtyShares (in which I am also an investor) and RealCrowd. I will describe my experience with them. Both have many similarities, such as in how they present deals. They simplify the selection process by showing investors what they’re investing in. They show pictures and descriptions of the properties, financial terms (returns and fees), and the types of deals they are: preferred equity, equity, debt.

How online sites differ

Despite their similarities, RealtyShares and RealCrowd have big differences too. The biggest one I see is how they trade-off fees for ease of investing.

Fees

RealCrowd does not charge investors a fee to invest, while RealtyShares will typically charge 1% to administer the deals on behalf of investors. However, that cost comes with some benefits too, such as not having to deal with various operators and their individual preferences and quirks (see below).

Transparency and Complexity

Investors in RealtyShares don’t need to deal with operators (the companies that sponsor the deals). Everything is done through a separate entity -- an LLC -- for each deal. RealtyShares deals are investments in an LLC that pools money together and subsequently invests in the deals the operators promote. This means RealtyShares is responsible for collecting checks and providing investors with statements and their end-of-year tax documents (typically K-1s). In my experience so far, everything has been standardized with RealtyShares. They make it easy to see my returns with an integrated dashboard and they deposit payments directly to my bank account.

With RealCrowd, payments to the operators and distributions from them need to be dealt individually with each operator. RealCrowd does not track my returns for me. If you invest with only one or two operators, that’s not a big deal. But I have a dozen or so deals with RealCrowd and some operators pay by wire transfers or ACH and some send me checks in the mail. They each require a different way of funding their deals, which must be initiated by me. RealtyShares, on the other hand, will ACH the money to and from my chosen bank account automatically.

Operators on RealCrowd communicate with me directly, which is good for transparency, but it can also be messy as some prefer to call me on the phone, others send email and a few insist on sending me physical letters, making it more complicated to keep track of updates. Also, they each send their tax statements in different ways and at different times. I had three K-1s that were delayed and hence forced me to file for an extension on my tax returns. RealtyShares, on the other hand, sent me all the K-1s on-time and in one fell swoop.

Deals on RealCrowd, however, are more transparent, as one gets to see the exact terms the operator is offering and read all the paperwork associated with deals first hand. Investors also get to communicate directly with operators and have their questions answered from the horse’s mouth. RealtyShares investors are investing in a proxy deal which RealtyShares itself operates, which in turn has terms similar to those originally offered by the operators.

The trade-off here is clear: one pays for standardization and ease of use.

Minimums

RealtyShares typically has deals starting from $5,000. Sometimes, a few deals can be found for as low as $1,000, especially when deals are near closing and there are only a few spots left.

RealCrowd deals are more expensive, starting at $25,000 and oftentimes minimums of $50k or $100k have been seen.

Deals on RealtyShares tend to close more quickly too which can be good and bad: good because you put your money to work faster. But bad because I’ve seen deals fly-by in a few hours, making it really hard to do my due diligence and read all the disclosures.

My experience so far

I have done about two dozen investments so far. A few more of my deals were on RealtyShares than on RealCrowd, but I invested slightly more money via RealCrowd, given their higher minimums.

I have not noticed any difference in quality of deals between the two sites so far. Deals on both sites have done mostly well and all are functional. No deal has defaulted in over a year that I’ve been investing in them. Most are already paying back regularly. But there are a few deals on both sites that have delayed their distributions more than they had anticipated. I’m not concerned though as complications are part of the process of investing in real estate and all operators have been open about their difficulties so far.

Partial Returns So Far

Total returns are hard to speak of as the exact accounting for depreciation, losses, fees and taxes play a role in computing them. Many deals offer 7-10% cash-on-cash with expected total return after the holding period of around 15-18%. But there are deals offering 12-14% fixed payment with little or no upside. And as I said, some deals are not yet paying, making it hard for me to know exactly what my real payoff will be.

So far, I have gotten about 3% return on all my disbursed dollars -- meaning, I got 3% back from what I’ve paid into deals in 2014, not accounting for any depreciation or tax breaks. That may not sound so great, but many deals that closed in the last 6 months have not yet paid a distribution. If I include only deals that closed in 2014, my partial returns on disbursed cash have been about 4%.

However, if I continue to invest in deals at this rate and they continue to offer the current mix of return -- cash distributions and expected returns upon sale of properties -- I roughly expect a steady stream of about 12-15% returns as some deals close out (sell appreciated properties) and others continue to return cash in the form of collected rents.

I will provide an update on returns by the end of this year to see where things stand.

In the next post, I will talk about things to look for and how I triage investments on these sites. And then after that, I will explain some of the pitfalls to avoid and things to look out for with these deals.

Disclosures: I’m a minority investor in RealtyShares. I’m not authorized to speak on behalf of the company. This is my own opinion as a real estate investor. I was not compensated in any way by any of the parties mentioned here.

3 Dividend Payers on Fire Sale

Here are three stock ideas for value and dividend investors. All three are cheap by most measures.

Cliffs Natural Resources (CLF)

Cliffs is an iron ore miner. Iron ore price is low due to low demand, especially from China, which for years has been the top buyer of iron ore. Cliffs is currently yielding north of 6%. They more than doubled their dividends back in April 2012. CLF is trading at close to book value of estimated available resources and a P/E of just 6.

Risks and Opportunities. Should demand for iron ore pick up again, CLF will benefit. However, prices can stay low for a long time, or even go lower. There's a ton of pessimism around miners in general and specifically around iron one. Prices are sensitive to China's economy as well as a global economic recovery. The silver lining is that China's own sources of iron ore are of very low quality and as such once China is back at building its infrastructure full steam, they will have to buy good quality iron ore from one of the global producers and so CLF's boat will be lifted with the high tide.

Investment Thesis. CLF is a risky bet, but one that could payoff handsomely for a patient investor. Meanwhile, should they continue to pay dividends, there's nothing to complain about the current yield. Demand has to pick up again, eventually. Timing is key though -- now could be early to invest and they could remain depressed for years and even trim the dividend. I recently started a position and am currently adding to it on pull backs. Look for prices below $36.


Intel (INTC)

Intel is a juggernaut in microprocessor and chipset manufacturing and a leader of its group. It's currently yielding 4.6% and has paid dividends for decades and raised it for the last 9 years. Its 9-year compounded annual return based solely on its dividend growth has been 27%. The stock price has not followed accordingly, but their earnings did just as well, with a compounded annualized return of 20% for the same period. With a historic low P/E of just 9, it's currently offering a juicy dividend on the cheap.

Risks and Opportunities. Intel has missed the mobile wave so far as most cell phones and tablets out in the market do not use Intel's technology. This trend is dangerous for Intel, but I believe fears are exaggerated for a couple of reasons. 1) Intel has always caught up to competition even when it wasn't the leader. Almost a decade ago, AMD had better performing, lower cost and lower power chips than Intel, but Intel managed to catch up and dominate again. It's highly dubious Intel won't produce an ARM-like chip for cellphones and tablets. 2) Tablets and cellphones are becoming more compute-hungry and that brings the market closer to Intel's turf. 3) It's misguided to think that mobile computers replace big computers. That might be true at home and office, with tablets replacing desktops, but for every few cellphones and tablets a big server must exist in the cloud somewhere. Datacenters are the playground of Intel and these are constantly growing. Demand will not go away for big and powerful chips.

Investment Thesis. Intel is a clear winner. It has traded for a large premium for a very long time. Its best days are still ahead of it and current low prices are bound to disappear. I recently started a position and am still adding to it, mostly via at-the-money naked put options. Prices below $20-21 offer the greatest returns and yield.


Entergy Corporation (ETR)

Entergy is an electric and gas utility in the northeast and midwest. Entergy has paid dividends for decades, raised it most years and bought back its own stock at various times in the past years. It's currently yielding 5.3% and has a P/E of 16. It has grown dividends a compounded annual rate of 9% over the last 10 years and its earnings have appreciated by a similar amount.

Risks and Opportunities. With the global slowdown, ETR has suffered too. Demand for energy has weakened, especially in the industry-heavy midwest. However, growth and energy are synonymous -- as one cannot happen sustainably without the other. Once growth returns, ETR will continue to prosper. It's currently the cheapest it's been in many years, approaching levels not seen since 2004 and some brief moments during the 2008-2009 crisis.

Investment Thesis. I have been following ETR for years and have never made a move due to its relatively rich valuation. I believe this current weakness is temporary (a mere reflection of the poor state of the world's economy) and its fundamentals have not changed. I've started a position at around $63 and am looking to add more at this level or below.


Final words

CLF is the riskiest of the three, but also offers the most potential upside. Invest carefully and with a long-term view. INTC and ETR offer the most down side protection, especially ETR, which is as stable as utilities come. INTC offers good down side protection, but as with all technology leaders, watching for new developments is crucial. Should it fail miserably to make inroads into mobile devices or see its lead in the server market erode, things could turn south fast. I put the odds of that happening at low, though.

Disclaimers: This is not intended as financial advice. Do your own homework and consult your financial adviser. I own all three stocks mentioned above.

Novartis Looks Cheap. But...

Pharmaceutical company Novartis (NVS) looks attractive right now from some financial angles. But is Novartis a great company to own going forward? Judging from its history of earnings and dividends, it seems to either lack good management or a defensible business moat. But I'm getting ahead of myself. First, let's look at why it might be cheap.

Why NVS might be cheap: Dividend Growth Model

For the last 12 years (the most data I have available), NVS increased its dividend an annualized 16%. That's an amazing track record!

However, one should be skeptical of this record being achieved in the future -- especially because its earnings have only grown an annualized 7% during this period.

Still, let's assume the current dividend can grow at a 6% clip going forward. If we require a 10% return on our investment, that means that a fair price for NVS is around $62. Given its market price is currently $52, that's a nice discount.

If we instead insist on an 11% return, then the fair price drops to $49. So, the current price is no longer a bargain, but it's close.

Dividend growth model. Source: S&P

Why NVS might be cheap: P/E analysis

Assuming NVS is neither growing nor shrinking, we can assume it will continue to earn what it has earned on average in the last five years.

Averaging the last 5 years earnings we get $3.62 per share. Now apply a P/E multiple of 15x, which is approximately NVS' historical average and the industry's average and also the current market average, then we get a fair price of $54.  Not too far off its current price -- about a 4% discount.

Now, to consider an investment, one must look at how long time shareholders have fared and whether the company has shown good results.

Why NVS may not be such a great company

Let's apply the Buffett test. I attribute this test to Buffett because I first heard this from him, but Ben Graham has written about it on his various books too. The test is very simple: has the stock price of the company shown $1 or more in return for every $1 retained (and not distributed to shareholders)?

In NVS' case this is a big no. Let's look at the numbers, summarized by the table below.

Retained Earnings. Source: Morningstar.

In the last five years, NVS has had about $66B in free cash flows (operating earnings minus capital expenditures). Over the same time, it paid out about $26B in dividends, thus retaining about $40B in earnings. However, what has happened to these $40 billion? They were mostly spent on acquisitions. Have the acquisitions been successful?

Well, let's see: the stock price in the last five years should have grown by 40/2.42 (billion shares outstanding) = $17 per share.

And yet, the stock market doesn't show that growth. In fact, the stock has gone nowhere in the last five years. From 2007 to 2011 the stock went from $59 to $57. Not only that, but NVS also blew most of the $4.6B it had on hand in the beginning of 2007.

But perhaps the market is mispricing the stock now, you ask?

Well, if you believe our analysis above, the current fair price is between $62 and $49. Nowhere close to the implied price of $76 ($59 -- stock price in 2007, five years ago -- plus the $17 it retained).

So what's wrong? Perhaps management is not that capable. Perhaps the acquisitions haven't paid off yet but may in the future. Or maybe the company's business model is just not great.

Maybe the industry is at fault?

Well, maybe. It's a highly competitive industry and highly unpredictable, given the various status of pipelines, patent expiration and generics. Take JNJ for example, which is in the same industry. Its numbers aren't much better: JNJ's stock price hasn't gone anywhere in the last five years, but our calculation would suggest it should have grown by $11 during during these five years (for JNJ, at least, the balance sheet is in better shape and a lot of the retained earnings show up as cash).

Why didn't NVS's number materialize, I can't say. But at a first glance, it signifies either poorly-timed (or poorly-priced) acquisitions or inefficient management, possibly combined with a tough environment for pharmaceutical companies.

Conclusions

NVS looks cheap at these prices and could reward shareholders looking for a growing dividend income. But given its lackluster past in share price growth and poor track record of creating value for each dollar retained, shareholders should not expect significant price increases in the near future. Current shareholders should consider pressing management to increase the dividend, instead of using the cash on malinvestments.

Disclaimers: I own NVS at the time of writing.

Berkshire Hathaway's Shareholders Meeting

This past weekend Warren Buffett and Charlie Munger fielded some four dozen questions from shareholders, analysts and reporters on things as diverse as the shares buyback, how to become a successful investor and the notorious "Buffett rule".

Prostate cancer

I expected that this year the main topic would be Buffett's heatlh, given that he recently announced he's got prostate cancer. But it was barely mentioned during the meeting, except for when Andrew Sorkin asked him how he was feeling. Buffett said he was great. Munger took issue with so much concern about Buffett and not much about him. Munger claimed he probably had prostate cancer too, but he wouldn't let anyone test him. That made the crowds laugh.


How to be a successful investor

In two separate questions, shareholders asked Buffett what he would do if he were starting today, what to buy and what to avoid. His advice for someone starting now would be to start early, build up a very good history of returns quickly and raise money to buy entire companies. He said he would have started earlier and sped up his early career to achieve what he has achieved later with Berkshire. The later part of his career he wouldn't change.

He again referred to chapters 8 and 20 of the Intelligent Investor by Ben Graham as the two most important chapters one should read to be good investors. His ideal MBA course would teach students how to value companies and how to think about markets, which are exactly the topics of these chapters.

As for what to avoid, he mentioned again one should steer clear from IPOs, since those tend to be done at the best time for the company and not the investor and they are typically hyped by media and analysts due to the fees associated with their sale. "Special promotions and commissions almost guarantee prices won't be cheapest", said Buffett.

Buffett would also avoid buying medium or long-term sovereign bonds from any country, including the US, right now.

BRK buyback and dividend

As is already usual, a shareholder asked why a buyback instead of a dividend and Buffett again explained that a dividend is not as tax efficient for shareholders as a buyback.

He's willing to buyback stock in unlimited amounts, so long the stock remains at or below 110% of price-to-book ratio, which significantly undervalues it, and that he keep at least $20 billion of working capital -- that's Berkshire's safety net.

When asked about the buyback and why he implied the stock was undervalued but he never let shareholders know when the stock is overvalued, Buffett explained that it would make for a very awkward moment if he were to publicly announce when Berkshire stock was overvalued. Makes sense.

He also answered a question on why the BRK was undervalued now and whether it was due to the "Buffett rule" he proposed. He didn't speculate on why it was so, but just said these are things that happen in the stock market.

Another shareholder asked him whether a dividend would help stabilize the stock price and reduce volatility by setting a floor for the stock and Buffett vaguely replied that in fact it wouldn't, that volatility happens for dividend payers too and that a dividend could also help increase volatility, but he didn't elaborate.

Gold

I sent journalists a question about gold, but they didn't ask it. Luckily, a shareholder asked a related question pointing out that gold has outpaced the return of BRK stock in the last 10 years.

Buffett, always with numbers on top of his head, replied that the price of gold and BRK 47 years ago where $15 a share and $20 per ounce, respectively and that now BRK/A trades for $120,000 while gold is at $1600. The problem, he explained, is that people look at short periods of when a  security or asset had a strong return and try to extrapolate from it. (Granted, 10 years is not exactly a short period, but Buffett is a very long-term investor.) Both Munger and him emphasized again that productive assets are better than inert ones -- and they are more fulfilling and rewarding to hold, because one can see them grow and produce wealth, while inert things like gold remain the same forever.

This is a very controversial point and I will just add that the distinction does not need to be black and white. Buffett is a businessman and likes to invest in companies. In  the long run, an investment in well-managed companies at the right price should outpace the return of gold. But gold has its place in a well-diversified portfolio, especially because it's so hard to pick well-managed companies and buy them for the right price. So, sometimes a return of zero (after inflation), which is what gold offers, might be a good thing, when the economy is in trouble.

Buffett's personal account

When asked why he owned JP Morgan Chase for his personal account but Wells Fargo for Berkshire's account, Buffett explained that securities laws would see a purchase of the same stock in both accounts as a conflict of interest. He likes Wells Fargo more than Chase, but he is not allowed to buy Wells Fargo for his personal account, so he buys his second-best idea instead. He said he reserves his best ideas for Berkshire, always.

Purchase of a newspaper

A shareholder asked why he bought the Omaha World-Herald paper if he had said a while back that newspapers are a dying industry. The shareholder insinuated that Buffett might be self-indulgent by buying his home town's paper. Buffett then explained that he bought it because that particular newspaper has a very tight local community around it and local newspapers are still a reasonable business. No one buys a newspaper for looking up national news, stock quotes or classifieds anymore. But for local news, obituaries and other local information, they can be useful. Another good local paper is the one he already owns, in Buffalo, New York.

Google and Apple

Asked about technology, Buffett explained that both Apple and Google are incredibly profitable companies with large margins and they will probably do well 5 to 10 years from now. They are hard for competitors to dislodge. But he wouldn't buy either because he doesn't have any edge on studying them. He wouldn't short them either. Charlie said they have a reverse edge in analyzing deeply technological companies such as these giants.

How fast will the economy grow

While not a fan of predicting the future, Buffett entertained a question about how to get a 4% return per year. He said that GDP tends to grow with the population (my note: plus changes in efficiency typically due to technology) and so anything more than a 1% real (i.e. after-inflation) return would be already a wonderful result for such a mature economy as the american one. Charlie agreed. At this rate, they added, the economy would double every 72 years or so and with inflation an indexing portfolio should double every generation.

The "Buffett" rule

Buffett clarified that his proposed tax rule is meant to correct a deviation that has been increasing in the recent years. Currently, out of the top 400 highest individual earners in the country, a full 131 of them pay a tax rate below 15%. Years ago this number was only 16. This shift has been made possible by various loopholes and tax breaks given to the rich. He suggests a way to fix that so that he himself should be taxed at a higher rate than his secretary, Debbie.

Energy policy and foreign oil

Munger was vocal about people thinking about "energy independence" the wrong way. He thinks we should use foreign oil first and conserve our own oil for later. Most people get this backwards and think of energy independence as extracting our own oil to avoid buying foreign oil.

In summary, it was again a very useful trip. Every year I learn something new, though, the main tenets of his investment methodology are repeated every year. But since repetition leads to solidification, that's not a bad thing.

Disclosures: I own BRK at the time of writing and I will probably own even more by this time next year. :-)

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