Real Estate Investing 101 | White Coat Investor
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Do you find real estate investing confusing? You need Real Estate Investing 101. Today I’m going to assume you know nothing about real estate investing and discuss it “soup to nuts”.
Equity Real Estate Investing
Most investors are familiar with the concepts of equity (stock) and debt (bonds). These concepts carry over into the real estate world and mean essentially the same thing.
With equity real estate investing, you are the owner of the property. A property is really just a business and all profits from the business go to you. Any appreciation (increase in value) of the business (property) between the time it is bought and sold is also all yours, at least after you pay any taxes due.
If the business loses money in any given year, that’s your loss. If it decreases in value between the time it is bought and sold, that is also your loss.
This is the riskiest but generally, in the long run, the most rewarding way to invest. It is the equivalent of buying stock in a company. You can lose your entire investment and, depending on how much leverage you used, even more.
Debt Real Estate Investing
With debt real estate investing, you don’t own the property. You are loaning money to the owner.
Hard Money Loan
Typically, this is some type of a mortgage, often called a “hard money loan” when issued by a private investor for a short time period. You generally take “first lien position”, which means if the owner stops paying you every month, you can foreclose on the property and sell it to get your principal back (and maybe even some profit.) Even if you lose money, it is very rare to lose all of it because the property is still worth something even if the rental business it is a part of is a money loser.
Investments Bridging the Gap Between Equity and Debt
Mezzanine Debt or Preferred Equity
In the public markets, there are investments that sit between equity and debt, often called “preferred stock” or “convertible bonds.” There is a similar investment in real estate, called mezzanine debt or preferred equity. Risk and return are intermediate between equity and debt investments.
Mezzanine debt and preferred equity give the borrower or the sponsor of a deal leverage options in addition to common equity (the portion that the equity investors own of the property) and the hard money loan. You are generally paid a higher interest rate on mezzanine debt because you are not in first lien position. If the property must be foreclosed on, the person in first lien position must get all of their capital back before you get a penny. With preferred equity, you get paid before the common equity folks, but have a cap on how much you will be paid.
Capital Stack
There is a “capital stack” in a well-performing real estate deal. The bottom 65% or so of the property value is debt and earns returns such as 4-10%. The next 15% or so may be mezzanine debt or preferred equity and earn returns of 10-14%. The top 20% is common equity and may earn returns of 14-30% (or could lose everything.)
Ideally, a sponsor might love to simply borrow 100% of the property value. But no lender in their right mind is going to offer that large of a loan because it is too hard to get enough money out of the property through foreclosure to make it worthwhile. So the sponsor has to go elsewhere for additional funding and pay a higher price for it. So she offers mezzanine debt, preferred equity, and/or equity. Every deal has a slightly different looking capital stack, but you should know where you stand in the stack with your investment. Obviously, when things go bad, they are worst for the equity investor and best for the lender in first lien position.
Sources of Real Estate Investment Return
In a typical real estate investment, there are four sources of return:
#1 Rental Income and Expenses
Rental income is the most obvious. If you put enough money down (and I recommend you do), the property should be cash flow positive. That means it pays you more than it costs you.
Every property has expenses such as:
- insurance
- property taxes
- maintenance
- vacancies
- management costs.
A general rule of thumb is that these expenses add up to about 45% of the rent you can charge on a property. That leaves 55% of the rent that must cover any mortgage on the property. If it does not, you have a cash flow negative property that you must feed periodically from some other source of income or assets.
Most experienced real estate investors recommend avoiding this situation, especially in the long-term. You can turn a cash flow negative property into a cash flow positive property by:
- getting a lower interest rate on the loan
- getting a longer loan
- getting a smaller loan (by putting more money down)
- reducing your operating costs
- by charging more in rent, or
- by increasing non-rent income (parking, laundry etc).
#2 Appreciation
Appreciation is also an important source of return, especially in the long run. While the actual building generally decreases in value, the land it sits on generally increases in value. While there is no guarantee of appreciation because it is an inefficient market where location matters a great deal, it would not be unusual for a property to appreciate at about the general rate of inflation of 3-4% over the long run.
#3 Debt Paydown
Debt paydown is also a significant source of return. In a cash flow positive property, the rent is covering all of the non-mortgage expenses, the interest on the mortgage, the principal on the mortgage, and putting some money in your pocket. The expenses and interest are just throwing money away, but that principal pay down is increasing your wealth each month and eventually will pay off the mortgage and dramatically improve its cash flow.
#4 Tax Benefits
Finally, there are significant tax benefits to real estate ownership. I’m not just talking about writing off the expenses of the business. Any business can do that. But with real estate, most of the value of the business is the house or building sitting on the property. Tax laws allow you to depreciate that building.
Depreciation
Depreciation is a tricky concept to wrap your mind around, but the basic idea behind it is that the building and everything in it will eventually need to be replaced. In order to compensate you for that fact, the IRS lets you take a deduction each year for the depreciation of the building. Even though you are maintaining it and even upgrading it, you still get to take this deduction. In a well-structured real estate business, the depreciation “covers” most or even all of the income from the property. This has a tax-deferral aspect to it which is very useful, especially if you are in your peak earnings years.
Bonus Depreciation
Bonus depreciation lets you take even more depreciation than you used to be able to. It applies to the capital expenses of all kinds of businesses, including real estate businesses. In fact, you can take a massive chunk of the depreciation on the property in the very first year. An example might be that one might be able to take a $300,000 bonus depreciation deduction in the first year after buying a $1 Million property. You might have only put $300,000 down on that property, and in return you got a deduction that was the exact same size!
When you sell the property, all depreciation has to be “recaptured” (i.e. the deduction has to be paid back to the IRS), but it is only recaptured at up to 25%. If that deduction was worth 37% to you when you took it, paying it back at 25% is a pretty great deal.
But guess what? If you die before selling the property, or simply exchange one property for another instead of selling it, that depreciation is not recaptured at all. You may also find some other valuable tax benefits to property ownership such as writing off trips to go check on it or work on it.
Different Methods to Invest in Real Estate
There are a plethora of ways to invest in real estate. Lots of people don’t want to invest in real estate because they don’t want to get “3 am toilet calls”. Most methods of real estate investing don’t involve getting calls like that or even dealing with tenants at all.
On the most passive end of the spectrum, you can simply invest in an index mutual fund of publicly traded real estate stocks called REITs (Real Estate Investment Trusts).
On the most active end of the spectrum, you personally own and manage a single-family home down the street from yours. This allows you the most control (and tax benefits) from the investment, but also requires the most work and the provides the least diversification.
In between these two options are private real estate funds, REITs, syndications, and turnkey properties where somebody else is doing all of the work after your initial investment. They obviously charge fees for doing that (and sometimes A LOT of fees), but it does allow you to put your limited time to its best use.
The Benefits of Real Estate Investing
There are five main benefits of real estate investing:
#1 Low Correlation
Real estate generally has low correlations to more traditional stock and bond investments. When stocks do poorly, real estate may do well and vice versa. This diversification benefit allows for steadier growth, which results in better long term portfolio returns, at least when asset classes have similar long-term returns.
#2 High Returns
Equity real estate returns are generally stock-like. There are lots of alternative asset classes out there, but many of them only keep up with inflation in the long run. Equity real estate provides high returns. In fact, they are high enough that some real estate investors don’t bother investing in stocks at all. For the record, I think this is a mistake and gives up valuable diversification.
#3 Leverage
While a stock or bond portfolio can be leveraged, it is simply easier to do with a real estate portfolio. You are generally limited to 50% leverage in a stock margin account but can go much higher with real estate. 65-75% real estate leverage is actually pretty justifiable most of the time, although there won’t be much cash flow at those amounts. With stock investing, margin accounts offer variable rates and can be called when the market drops, but most real estate loans cannot be called and are often fixed.
You cannot leverage up stocks in a retirement account at all, but leveraged equity real estate can be placed into self-directed IRAs (not recommended) or self-directed individual 401(k)s (better due to no Unrelated Business Income Tax, but I still don’t recommend it.) This leverage generally results in higher returns in the long run.
#4 Depreciation and 1031 Exchanges
Depreciation, as discussed above, is a major benefit to real estate and is the reason I generally do not place equity real estate into a tax-protected account. I don’t really understand why one is allowed to 1031 exchange one real estate property for another without recapturing depreciation or paying capital gains taxes but cannot do the same for a stock or mutual fund, but that is the way the laws are written.
#5 Inefficient Markets
Inefficient markets can be a positive or a negative when it comes to real estate. All real estate is local and there are far fewer potential purchasers for a given property than there are for a publicly-traded, blue-chip stock. There are a lot fewer buyers, sellers, operators, and analysts in the market. Most real estate is also not publicly traded. This inefficiency allows a talented investor to take advantage of less talented investors and earn “alpha” for their ability. Obviously, the opposite is true for less talented investors, who are providing that alpha.
Real Estate Asset Classes
There are a lot of different real estate asset classes including single-family homes, duplexes, triplexes, and apartment buildings (multi-family), industrial, retail, student housing, senior housing, storage, and mobile homes to name a few. Each of these has its own risks and benefits. Most real estate investors tend to specialize in their preferred area.
Lots of people talk about NNN or “triple-net” properties as well. These aren’t really a separate asset class, but merely a way to structure the rental agreement. In a NNN agreement, the tenant is responsible for paying the property taxes, insurance, and maintenance/repairs. So your rent is already “net” those expenses. Obviously this means you can’t charge as much for rent, but it does make your cash flow a bit more predictable by putting the risk of those expenses increasing on the tenant. These deals generally fall in the industrial and retail asset classes.
Real Estate Strategies
There are a lot of different strategies used by real estate investors.
Flipping
“Flipping” has been made popular by numerous TV shows. The idea here is to buy a property (hopefully from a distressed seller for much less than it is worth), improve it rapidly, and sell it to another buyer. Most people would describe this as a job or a side hustle rather than an investment because the workload is so high in such a short time period and must be continually repeated.
Speculation
Speculation is also an occasionally used strategy. Empty land is a good example. If a property does not produce any rent or other form of income, you are entirely reliant on appreciation to achieve your return. Investors purchasing cash flow negative property could also be said to be speculating, at least until such time as they can turn the cash flow positive. There is a lot of risk in this method.
Private Real Estate and Syndication Strategies
Private real estate funds and syndications generally follow one of four strategies, listed in order from lowest risk/return to highest:
#1 Core
A core strategy uses lower leverage (0-30%) and has stable, predictable cash flows. These properties are fully leased to “high-credit” tenants. They are often “Class A” properties (more on that below) in gateway cities. They require little in the way of improvements. They are the most liquid of real estate investments (although still dramatically less liquid than publicly traded stocks, bonds, and REITs). They are appropriate for those looking for capital preservation and long holding periods.
#2 Core Plus
A core-plus strategy uses more leverage (30-50%). Tenants and properties aren’t quite as good and will likely require a bit more work. Risk is higher in exchange for higher returns. Think of it as a core strategy with additional leverage.
#3 Value Add
A value-add strategy is medium to high risk and return. It often involves “Class B” or “Class C” properties. These properties need work, so the investor comes in, buys the property, makes some improvements, increases the rent, leases it up, and then sells it. These properties have management/operational problems, capital constraints, or often physical problems that need to be fixed or upgraded. Once the problems have been fixed, the property is worth a lot more and so it is sold for a significant gain. These investments are typically held for 3-7 years. They generally provide some cash flow to investors with significant upside potential. Leverage is generally 40-75%.
#4 Opportunistic
An opportunistic strategy is value-add on steroids. It needs a lot of work. This might involve developing raw land or a niche property. Leverage is high and risk of loss is high if the business plan is poorly created or executed. Borrowing terms are not generally favorable. Done well and in favorable conditions, the potential returns here are the highest.
Property Classes
You will often hear properties described as “Class A” or “Class C” properties. There is no precise definition of what these terms mean, but the following general descriptions may be helpful:
Class A
These are the highest quality, professionally-managed buildings in an area. They have the best amenities and were built in the last 10 years. They generally have the highest income tenants, the least maintenance issues, and charge the most in rent. Despite that, cash flow is generally the lowest here due to higher purchase prices. These are the “easiest” properties to own.
Class B
These are older buildings with lower income tenants and may not be professionally managed. Rental income is lower and there may be some deferred maintenance or management issues. These are often targets of “value-add” strategies to bring them up to Class B+ or even Class A. They were generally built in the last 10-30 years.
Class C
These properties are 30+ years old and the tenants are generally working class or on government subsidies due to the lower rents. Expect numerous repairs and ongoing maintenance. The purchase price is lower so cash flow is generally quite good, as long as it doesn’t get eaten up by the expenses.
Class D
These properties are in the bad part of town. They are as old as Class C properties but not as well maintained.
It has been said that you would live in a Class A property, you could live in a Class B property, you might visit a Class C property, and you would rather camp than live in a Class D property.
Fee Structure and Waterfalls
When you own a property all on your own, there is no fee structure or waterfalls. All of the profit and all of the expense are yours. But when you move into property syndications (where dozens or hundreds of investors pool money to buy a large property, hire management, and benefit from economies of scale) or private real estate funds, you will find the fee structures to be much more like a hedge fund than an individual property or even a typical mutual fund. You’re doing well if you can get the fees down below the “standard 2 and 20” (meaning 2% a year plus 20% of any profits.)
A typical project is purchased by a Limited Liability Company (LLC) paying taxes as a partnership. There is a General Partner (GP) who buys, manages, and sells the property. You are generally a Limited Partner (LP) who has little control over the investment, but also limited liability. Your potential loss is limited to the amount of money you invested. The “waterfall” just explains who gets money when.
A typical waterfall looks like this, from first person paid to last person paid.
#1 Management Fees Paid to the GP
May include an acquisition or set up fee of 1-3%, plus an annual fee of 1-2%
#2 The Mortgage
Next, the debt is paid off. This includes the “first lien” mortgage as well as any mezzanine debt or preferred equity
#3 Return of Principal
Now all of the common equity investors including the LP and GP get their money invested back
#4 The Preferred Return
This goes to the LPs (including the GP if they put money into the deal as you would hope) and often ranges from 6-10%. The purpose of the preferred return is to prioritize and thank the LPs for investing as well as to motivate the GP to exceed this return (because she doesn’t get paid until she does.)
#5 The Promote
This is where the GP makes most of their money in a deal that goes really well. Theoretically, the management fees are supposed to just cover their expenses and the preferred return is simply paying them for the use of their capital. The purpose of the promote is to incentivize the GP to choose a really great deal and execute it well. After the preferred return is paid, the remainder of any return on the project is split between the LPs and the GPS 80/20, although that can range from 70/30 to 90/10. Pay attention to whether there is a “catch-up” for the GP or not on the preferred return, i.e. if the preferred return is 8% and the project makes 10%, is the promote 2% or 0.4? About half the time there is a catch-up and half the time there isn’t.
Obviously these fees are dramatically higher than the expense ratios of a mutual fund. You should not pay them if you can get the same risk-adjusted returns without paying them. But most real estate investors consider that an apples to oranges comparison.
First, these investments are all actively managed, unlike an index fund (which is a good thing given the inefficiency of the market.)
Second, the size of these investments does not allow for the same economies of scale you’ll see in a Vanguard index fund. A syndicated apartment complex might cost $10 Million of which only $3 Million is equity. A big mutual fund might have $100 Billion in it but a large private real estate fund might only have $100 Million in it.
Third, all of the companies in a mutual fund have expenses that are not included in the mutual fund expense ratio, including the compensation to their executives. You see that more directly in a private real estate investment.
Fourth, while low expenses are the best predictor of future mutual fund performance, that doesn’t necessarily apply to a private real estate investment. What you really care about isn’t the expenses, but rather the after-expense return on your money. That said, the same basic principle of investing applies–the more you pay in expenses, the less you keep in return. All else being equal, lower expenses are better.
The Bottom Line
Real estate is a great asset class. Katie and I put 20% of our portfolio into it (5% publicly-traded REITs, 10% equity, 5% debt). It is not a mandatory asset class for physicians to be financially successful, but the majority of the most successful ones have invested in real estate in some form with some portion of their portfolio. It is easy to overweight publicly traded REITS in your portfolio by adding a REIT Index Fund to a mix of stock and bond index mutual funds. Anything else is going to take more work and expertise to do effectively, but in my opinion, you are likely to be rewarded for your efforts there.
If you would like to be introduced to private real estate opportunities (including some that I invest in myself), be sure to sign up for our FREE Real Estate Opportunities Mailing List by clicking on the appropriate link at the bottom of any email I send you.
What do you think? What else should be included in a real estate 101 post? How do you invest in real estate and why? Comment below!
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