6 Things to Consider When Investing in Private Real Estate
Steve Horstmann, CFP®, MSPFP, is a Wealth Advisor at BlueSky Wealth Advisors.
When navigating the waters of investing, it’s crucial to avoid falling prey to “shiny new object syndrome”, that is, the lure of a new, trendy investment prospect. Investing should be boring, consistent, not exciting. In the words of Shakespeare, “all that glitters is not gold”. Evidence of this is all around us; just look at the GameStop craze. Sure, a few people hit the jackpot, but many lost their shirts. Buying GameStop, AMC, and the like is not an investment; it is speculating. It’s crucial to differentiate and define the two.
Speculating is just betting that the price is going to continue to rise after your purchase and that someone else will be left holding the bag when you sell for a profit. The intrinsic value and fundamentals of the company are of no concern. Alternatively, an investment operation, as defined by Benjamin Graham, “is one which, upon thorough analysis, promises safety of principal and a satisfactory return.” So, bearing this crucial distinction in mind, the next question becomes, what types of assets do I invest in? For that answer, we can look back a few thousand years to an excerpt from the ancient text, the Talmud: “Let every man divide his money into three parts, and invest a third in land, a third in business and a third let him keep by him in reserve.” Some of the best investment advice is not the newest and flashiest, but rather that which has stood the test of time.
You could certainly make a case that exactly one-third in each asset class is too much of a generalization, but the asset classes themselves are what is important. Roger Gibson uses this quote on the first page of the very first chapter of his book Asset Allocation: Balancing Financial Risk. You can think of “reserve” as bonds, “business” as stocks, and “land” as real estate investments. Each asset class plays an important role in your overall portfolio, but today I want to focus on the “land”.
One of the great things about real estate is that there is a limited supply. The property or business type may change throughout the years, but the space that it takes up is finite. Most people that own real estate in their portfolio own it through publicly-traded REITs (real estate investment trusts). These REITs trade on the stock exchanges and can be purchased, like public stock, on any number of brokerages. It is important to note that when you purchase a share of a REIT, you technically own a share of the REIT company, not the underlying property. This is indirect real estate investing, and a great way to get broad exposure to real estate markets.
If you’ve read Invest in Your Life, you may remember that you can think of real estate investing on a spectrum. On one end, you have the publicly traded REITs; on the other is owning a rental home directly, lock-and-key. Now, the direct investment may be a headache, with the management & landlord responsibilities, expenses, mortgage liability, and tenant negotiations, but they can be strong income generators and carry immense tax benefits.
However, also on that real estate investing spectrum, delightfully balancing risk and return, is private real estate. As an investor in private real estate, you become a direct owner of the real estate property itself, usually through an LLC, alongside other investors. This allows you to get the tax benefits you would get if you were to own a lock-and-key rental property, but without all the work, liability, expenses, and other management responsibilities. As with REITs, there is a plethora of different types of investable private real estate. As with the stock market, it’s prudent to differentiate a real estate investment from a real estate speculation. I like to look for income-generating real estate with a solid expected rate of return over the holding period.
What is private real estate?
Private real estate is an alternative investment class that offers the opportunity to invest in a specific property or properties. Private real estate firms will target properties according to their own unique business strategy and desired property type and then raise the necessary capital from investors. Many firms have a specific market niche, where they know they can deploy the capital effectively. The types of properties offered can range from raw land, development, and conversion (more speculative, not income-generating) to retail, multifamily, and industrial/flex space. For investors seeking income from real estate, the latter three property types are superior because they have tenants paying rent. A good private real estate firm will purchase, improve the property, and enjoy the cash flow, and those returns will flow through to the investor.
6 things to consider when investing in private real estate
1. I’m already invested in publicly-traded REITs. Should I have exposure to private real estate markets as well?
As is the case with many financial planning and investment questions, the answer is maybe. Public REITs and private real estate alike offer investors exposure to the “land” portion of the Talmud’s simple but shrewd ancient asset allocation triumvirate, referenced earlier. Real estate, both public and private, is so attractive to investors for a myriad of reasons: it’s income-generating, it’s not strongly correlated with other asset classes, and it can lessen the impact of inflation (inflation ticks up, rent prices tick up, returns tick up).
2. So, why should I consider private real estate if the REITs in my portfolio can accomplish most of the same things? (Hint: it’s the tax benefits)
When you own a public REIT you own shares of that particular REIT company, you don’t own the brick-and-mortar properties themselves. With private real estate, you become an owner (in proportion to your investment amount) of the actual underlying property. This fact is why private real estate is considered the most tax-efficient and advantageous investments. As a direct owner, you can take advantage of the plethora of tax benefits, chief among them being depreciation deductions. Tax law allows owners of investment real estate to annually deduct an amount equal to the portion of the property that can be considered to have depreciated that year due to its age, and normal wear and tear. That’s a mouthful, but what does this actually mean for the investor? It means that the cash distributions that you receive can be offset by depreciation deductions. It’s common to see a tax loss on paper, while still receiving annual cash distributions.
Another huge benefit of real estate ownership is the ability to defer taxes due on any profit when the property is sold. Usually, when you sell an asset, such as an investment property, you have to pay capital gains tax on the difference between what you paid for it and what it sold for. If you sell before having owned it for a full year, it’s short-term capital gain, which is taxed at your ordinary-income tax rate. If held for more than a year, it’s taxed at the lower capital gains tax rates. However, with investment properties, you can do what’s called a 1031 like-kind exchange. Rather than selling out of your position after a given number of years and paying capital gains tax on the profit, you essentially reinvest your proceeds (without ever having constructive receipt of the sale value) into a similar investment property, allowing you to defer potential taxes due.
3. What is my overall strategy with investing in real estate?
As with every investment you make, there should be a smart, purposeful strategy in place with private real estate investing. One of the best things about private real estate is its income generation. Similarly to how a stock pays a dividend, usually quarterly, many private real estate syndications and funds pay out a quarterly cash distribution to the investors. REITs also pay out dividends, but they’re frequently taxed as ordinary income. Contrarily, distributions from private real estate syndications are generally not taxable. The investor is taxed on their share of the profit/loss of the property, and losses can work to your advantage.
Two of the most common ways to invest in private real estate are through real estate syndications and funds. With a syndication, you invest alongside others in a specific property, say an apartment complex, usually through an LLC. With a fund, the tax benefits and cash flow tend to remain the same, but a $100,000 investment may be spread over multiple targeted properties as opposed to just one. In either case, a sound real estate portfolio should be diversified.
4. What funds should I use to make the investment?
As attractive as private real estate is, it’s not suitable for every investor. If you don’t have a solid diversified portfolio of stocks and bonds or a large cash balance already, it is probably wise to focus on building that before going into alternative investments. If you do already have a sizeable portfolio, the next question becomes what types of accounts do you have, and which is the best to fund a private real estate investment? Generally, only taxable money should be used. Or perhaps you’re a business owner generating heaps of cash and are in need of diversifying beyond a stock and bond portfolio. Every person and family has different circumstances, so bear in mind that these are generalizations, and not to be interpreted as specific recommendations. What’s right for the Smiths may not be right for the Jones.
5. Am I able to forego liquidity for 5-7 years?
Another aspect to consider is your time horizon. Do you have large expenses planned in the next few years? If you don’t have enough liquidity in the rest of your portfolio, then it’s probably not prudent to invest in private real estate yet.
6. Which firms should I work with?
It’s important to work with the right firm. Just like choosing the right financial advisor to work with, finding who to partner with when investing in private real estate requires proper vetting.
In this day and age of investing, it can be beneficial to one’s overall investment strategy to have exposure to alternative markets. Studies have shown that holding private real estate in conjunction with a more traditional portfolio of stocks, bonds, and REITs can be more optimal from a risk and return standpoint than having just private real estate or just REITs. That being said, it’s not an appropriate investment for everyone. No two investors are alike, even if they appear to be similar. Before pulling the trigger on a new investment, alternative or traditional, it’s important to do your homework (or have your advisor do it for you). It’s important to be diligent when investing. Keep your eyes on the prize and don’t be distracted by the latest trend. That’s the thing about private real estate - you’ve likely passed by investment properties on your way to work without even knowing it. They may not have glittered, but they very well may have been “gold”.
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