All Forum Posts by: Jonathan S.

Quote from @Jonathan S.:

Hello Everyone, I am trying to understand what causes certain return targets to be placed by investors. For context, I am working on a passive investing platform with no cash-flow and emphasis on equity growth. While I know that return goals are different for each investor and their specific goals, it seems that a bad or low-performing deal for one person might be what another investor is looking for. 

Currently, my structure projects 8-12% IRR which stems solely from appreciation-based gains and has risks that differ from traditional REI or syndications. It allows for passive returns with increased control and diversification. The structure also allows for mitigated tenant and maintenance risk, but it has increased dependence on market movements due to being appreciation based. If anyone has more questions or interest in the specific structure, I am glad to share. However, my main question is how investors determine a reasonable target, especially since some investors with access to higher capital are able to target projects with higher returns than the easily accessible passive or traditional opportunities.

I appreciate any advice or insight.

Hey @Jonathan S. The returns that investors require is generally based on their perceived risk of the project and the investment period.

With my CFO clients who do real estate development, most LPs in the small-scale residential space (SFR & 2-4 MF) are investing for 3-5 years and are looking for a preferred return of 8% with an IRR of 16%-18% for turn-key and 18%-24% for value add. Hope that helps.

As such, I think you're going to find it difficult to attract investors with an 8%-12% IRR, which is what most investors can get by investing in the S&P 500.

Hi Jonathan! I am also a college student looking to learn more about real estate. I hope to buy my own property in the next 2-3 years (maybe sooner) so let me know if you want to connect!

Quote from @Jonathan S.:

Hi Everyone,

I am looking to develop passive real estate investment opportunities, but I am not sure if I completely understand what investors look for when investing in certain passive real estate investments, or real estate in general. Before finalizing anything, I wanted to get a better understanding of how to evaluate different real estate opportunities and what challenges might be posed. 

I would appreciate any comments on any of these questions:

1. What is the most important factors when considering passive (or even non-passive) real estate opportunities?

2. How do you determine a reasonable target return?

3. What are the challenges of passive investing as opposed to traditional real estate investing? 

I want to ensure that the structure of these investments I am working on correctly address key issues for investors. If anyone has any questions or is open to discussing further, please feel free to let me know!

Thank you!

Jonathan, you said:

What are the challenges of passive investing as opposed to traditional real estate investing?

I invest in both direct real estate (via residential rentals) and syndication/crowdfunding passive investments. In my opinion, both have their pros and cons and neither is 100% superior to the other. And I feel the ideal portfolio can benefit from the diversification of both.

I feel directly owned properties are great because they give me maximum control and the ability to tweak them exactly how I want. So for example I'm very conservative and don't want any debt on them because I feel this hardens them in case of a severe recession. That's unusual and it would be very difficult to find a passive investment like that.

Also direct control means I know exactly what's going on. And, for those people who have more time than money, they can put in sweat equity into directly owned real estate. This will increase the return above what can be obtained on a passive investment.

The flipside of having the power to control everything is that it can be alot of work (and a full-time job if a person is putting in sweat equity). Not everyone wants that or is willing to put up with that. It also requires gaining a level of sophistication and knowledge that not everyone has the time, inclination or ability to do. And someone jumping into this as a complete newbie can expect that they have a decent chance of making some expensive newbie mistakes.

On the other hand, I feel one of the main advantages of passive investments (via syndication/crowdfunding) is that I can hire a manager who has years more experience than I can ever hope to obtain myself. And once I finish the due diligence, my work is done: it's completely passive. Also, rather than taking a large amount of money and investing into one single directly owned property, I can split it up into much smaller chunks across many different passive investments. This gives much better diversification protection across geographies, asset types, strategies, investment subclasses etc. versus putting all the eggs into one basket.

The downside is that it's not for everyone, and a person has to be comfortable with turning over control to someone else. That means learning how to vet a manager. Not everyone has the time and ability to do that and not everyone feels comfortable turning over control. So I feel it's not a fit for everyone. Also there is a management fee to pay for all of the above. So someone who is looking purely to maximize potential return (and has unlimited time) is unlikely to find this a good fit.

 
How do you determine a reasonable target return?

This is going to vary widely depending on the strategy and real estate asset class. The more conservative, the lower projected return and vice versa.

You will need to look at multiple deals that are targeting your strategy and asset class, before you will intuitively "know" whether something is in line or not.

What is the most important factors when considering passive real estate opportunities?

When vetting a passive deal, every investor will do it differently because every investor has a different risk tolerance, comes from a different financial situation and has different financial goals. So a deal that look great to one investor will look horrible to another and vice versa.

I'm a very conservative investor and may look through a hundred deals a month, and at the end of the year only invest in 4-5. Here's how I do my due diligence:

1) Portfolio matching: (takes 30 seconds per deal)

a) Have an educated opinion on where I think we are in the real estate cycles (financial and physical market cycles)

b) Then and only then do I pick the strategies, capital stack, and specialized asset subclasses that make sense for that opinion. For example, I am a little concerned about some aspects of the business cycle recovery and a potential for a double-dip so I lean toward the safest part of capital stack which is debt (or low-debt equity). I won't go with the riskiest opportunistic strategies, and will stick to core and core plus mostly with some value-added. I won't be investing in the riskiest/most supportable asset subclasses such as hotels, and tilt my portfolio the ones that have historically been more stable such as multifamily and single-family housing. I also don't want refinancing risk, so any deals with only 3 to 5 year debt are out for me. For someone that's not as conservative, or a different view on the cycle, they might have a different opinion than me on all of this.

2) Sponsor quality check: (takes about 45 minutes per deal)

I believe that a great sponsor can take an average looking deal and make it great, and that in mediocre sponsor can take a fantastic looking deal and make it bad (especially if there is a severe recession). So I start with the sponsor first. Again, others might disagree.

a) Track Record: Get the entire track record for the strategy. As easy as this sounds, it's not simple and usually like pulling teeth. Many times they will claim it's wonderful and then try to hide their worst deals by only showing completed deals. Make sure to get unexited deals. Or if they are doing value-added multifamily, they will show you their hotel experience. That doesn't cut it for me. I want a specialist that's an expert, and not a jack of all trades and master of none. Also, in a mainstream asset class like value-added multifamily, I see no reason to take a risk on a sponsor that doesn't have full real estate cycle experience or that lost anything more than a small amount of money (and prefer no money lost). Again, other might feel differently here.

b) Skin in the game: as a conservative investor, I understand that the dirty secret of industries that the waterfall compensation is in the line with me and incentivizes sponsors to take more risk. So I require skin in the game (average is 5% to 15%) to offset this. Contrary to popular belief, this is not set because I believe it will give me a higher return. I believe it tends to give me a slightly lower return, because the sponsor is going to be more careful, and if there is a severe downturn will prevent me from taking catastrophic losses. Someone that is more aggressive, may want lesser even though skin in the game. Also, if the sponsor is new, I am fine with less skin in the game as long as it is significant to their net worth. On the other hand if they are a sponsor that is experienced in stopping a skin in the game, that's a huge red flag for me.

c) how open to scrutiny are they? I always discuss investments with others in an investor club because other people might think of things that I might miss. And even though virtually every sponsor agreement allows me to share investment information with others who might be advising me on it (especially when club members are bound by an NDA), I still ask the sponsor if I can share it, because it's a test. Most are fine with that, but a few will have problems with it and claim there are legal issues, etc.. That's a red flag for me.

d) death by Google: I Google everything I can about the sponsor. I check the SEC, FINRA, ratings websites for inside information on the principals in the company. I also look for lawsuits and see what happened in them. Many times it's an easy red flag. Sometimes it's ambiguous, but even then, why should I bother with the company that has numerous unresolved lawsuits, versus another company that is virtually the same but has none. Again, others might feel differently here.

3) property level due diligence: (takes seconds to weeks per deal): here is where I drill in with the low-level details.

a) pro forma popping: I examine all the assumptions, and see if they are overoptimistic or not. I look at every single item in the pro forma and imagine that it is complete BS, and see if I can challenge it. If there's a hole, it may be a red flag.

b) sensitivity analysis: I examine all the assumptions, and make sure I can live with the worst case scenarios.

c) "Stall and see": if they are getting money over multiple years, and there is no penalty for investing later, I would usually wait so I get some real performance data, versus having to look at theoretical pro forma information.

d) Recession stress test: I will not invest in anything, until I subject it to recession level stress and see if I can live with the result. And I take the worst recession I can find in the recent past. Sometimes there is only great recession data, and that recession was pretty mild on some asset classes, versus previous recessions. So I will usually 1.5x or 2.0x the stress. If the deal collapses and I would lose everything, I'm out. Others might be fine with taking risk, but least by doing this a person can get an idea of what might go wrong.

e) Legal document analysis: it will usually take a few days to go through the legal document properly, as almost inevitably there are tons of gotchas that either have to be explained, or mitigated with a side letter.

That is the very short summary of what I do. If you want more information, p.m. me and I can give you a lot more details.

@Jonathan S. REI is pretty unique and comes in many flavors. Instead of asking questions about passive or active you need to ask yourself what sacrifices can I make to get started. If were talking about a group of investors they need to bring value to the table. 

There is no passive REI. Lets make that clear. From SFH BRRRR, flip, or complex syndication apartment deal they all require effort. At a minimum they require babysitting (response to a PM company), research, and educated decision making (accredited investor status). Few people get into REI and find out it's totally hands off. If you want hands off get into the stock market and buy bonds, and S&P 500 index funds.

The challenge for passive investing is you have little control. If the stock market goes on a roller coaster ride you have no control. With REI we have ALL the control. I created my lease from scratch and dictate what happens in our properties. I control rent (income) and manage maintenance (expenses). A small amount of effort yields a good long term ROI.

Targeting returns with REI is based on market analysis. You run the numbers on targeted properties in specific neighborhoods, repeat a bunch of times, and something finally sticks. Every house can be a deal if the numbers make sense. Every strategy targets a different ROI and each come with varying levels of effort and risk. You have to value your time, leverage your skills, and execute a long or short term play.