Investing in Private Real Estate | AWM Insights #113
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Episode Summary
In last week’s episode, Brandon and Justin started the discussion on real estate investing – hitting on topics like where and how to invest, public vs private, and types of properties. With the foundation now laid out, they dive deeper this week into how to actually go about investing and assessing whether you’re getting the returns you deserve.
They continue their conversation by focusing on private real estate investment and covering how to think through real estate investment deals, finding specialized help, and understanding the trade-offs between investing on your own or investing in a fund.
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Episode Highlights
(1:45) Refresher on the types of real estate investments
(3:48) Focusing on private real estate
(5:00) What does the due diligence process look like to vet deals?
(5:55) What stage is the property in?
(6:48) What’s your edge?
(7:43) Identifying value add properties – what improvements need to be done?
(9:20) The opportunities and tax implications of development projects
(11:06) Finding diversification through a fund
(12:08) Promoter carried interest and hurdle rates
(13:38) Understanding the costs of property and asset management
(15:29) Finding specialized help
(17:00) The importance of a good banking relationship
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Justin Dyer: LinkedIn
Brandon Averill: LinkedIn
+ Read the Transcript
Brandon Averill (00:03): Well, Justin we're back and we're talking a little real estate again. So everybody, hopefully our audience went up with last week's episode. But before we get started this week, I want to throw out the phone number at the beginning of the session. See if we can get some more text messages and more questions, but reminder, if maybe you haven't gotten to the end of these episodes, but we actually have a text line, text message comes right to my phone. I'll get back to you, but we'd love to hear your questions. So think of them as you're listening today, but that telephone number is (602) 704-5574. Just shoot us a message, we'd love to answer your questions. Love to stay in touch with you and potentially even send you some swag. But with that, let's jump back into real estate. We went over different things, different topics about real estate, where to invest, where not to invest, how you can invest, public markets, private markets, types of properties, et cetera.
Brandon Averill (01:00): And one thing that we got to towards the end of the session and started to realize is how do we, okay, that's great, now we know we can actually go invest in these things. How do we even start the process for understanding, are we actually getting what we deserve out of an investment and whether that's going directly to purchase a property on our own, how do we go about the due diligence there? Or even if we're outsourcing that we're going to go invest in a partnership or hire a manager to identify a property. So really broadly open ended, but maybe do a little revisit for us, Justin, of what are the different types of investments and then maybe even could filter from there, how do you access those investments in those couple different ways?
Justin Dyer (01:45): Sure. I'll start there. So repeating a lot of what we talked about last week, going into the different types, probably what's most familiar with folks is residential real estate. So residential, we all probably, hopefully anyone listening to this podcast is an inhabitant of residential real estate. Maybe it's a multi-family unit, an apartment building, a condo building in a city center somewhere or elsewhere, doesn't have to be that, or a single family home. Those are all versions of residential real estate. How you invest in those we'll get into, but those are versions of residential real estate. Then moving on down, think about commercial properties. So this building we're in would fall into the commercial property. Commercial property is generally housed. The tenants of commercial property are businesses of some way, shape or form. Maybe it's a service oriented business. Maybe it's a retail oriented business. Those are things more down on street level that are opening up their doors to the public walking by and trying to sell goods and maybe services there.
Justin Dyer (02:51): And then industrial. So think, industrial has become very, very popular, but a big example, a really good example of that is the Amazons of the world. So Amazon has become a very big tenant and owner of industrial real estate. Think the big warehouses they need to house all the millions of products that they have, not only do they have huge warehouses outside of city centers, but they have more localized warehouses that are smaller and more focused within city so they can get the goods to your door in a faster way. And that's not even to touch on, and we're not really going to get into farmland and more esoteric forms of real estate. That's beyond the scope of what we're trying to accomplish here. But residential, multi-family type is one area we'll spend a decent amount of time on, commercial, industrial, I think those are the big three areas of real estate that we're going to focus on.
Justin Dyer (03:48): And then just to add to it, this discussion today, and I'm getting into the access piece of it a little bit, but this discussion today is going to be heavily focused more on the private market side of things, as opposed to the public market side, everything we're talking about generally can be repeated, or is replicable on either side of the market. But the big focus here is private real estate.
Brandon Averill (04:12): Yeah. And I think that's a good point, because at least our philosophy still holds, in the public markets, you're still going to have information that's pretty efficient. You're going to know a lot about the different investments there, probably competitive advantage does not exist, but we move over to the private side. I just had a client shoot over a property this morning. I didn't know about that property. If I went to go get information on that property, probably not as easy to go get information on that property. Maybe I get slightly different information. So I think that's where the advantage starts to come in, but also the pitfalls. So let's start to talk now a little bit about, okay, this property came over, it's a 10 unit complex, it's selling for five and a half million dollars.
Brandon Averill (05:00): How do I start that process for even understanding, hey, yeah, okay, that's great. It all sounds good. Of course the real estate agent that's pitching it to me is telling me that somebody's going to rent each of the units for three grand a month, but how do I start? Do I just take their word for that? Facetious question there, but how do you actually go through this process and what qualifies somebody individually to do that? And I think that'll ultimately lead to where a lot of people turn and that's to the fund management side where maybe you go hire a manager to actually identify properties, run the property, run the asset management piece of it and maybe some of the pitfalls or things to look for in those.
Justin Dyer (05:46): Yeah. Well I would start, and this is a little deviation, but I would start almost, I want to hit on this as well. I think it's important and it does dovetail in your question, start with the stage.
Brandon Averill (05:55): Yeah.
Justin Dyer (05:55): So, what stage you participate in really dictates your risk return profile. Are you buying raw land and you're going to build something and then sell that property? That's more of a capital appreciation type play, but there's a lot of risk let's call it outright there, you have to have a way different skill set than you do to just manage and maintain a more, what's called stabilized asset that has 98%, what's the word I'm looking for? 98% tenant rate, if you will, and versus a more value add type property where you're trying to, you're coming and it's like a hybrid, you're coming to the table and you're like, oh wait, I'm going to improve these different office spaces and then jack up the rent on people, and get a little bit more appreciation from that point.
Justin Dyer (06:50): So think about this stage that's really, really important and where your potential expertise is, or the fund manager to getting to your point, Brandon, what the fund manager's expertise is here. The critical question to ask is, what's your edge? So using your example here is, is this a space in the market that I understand, or am I going up against, if this is an individual property, are we going up against a bunch of institutional investors that really are doing this as a full time job, not just as a one off hobby to fill your time. Those guys, they're going to have incredibly robust models and experience on how to figure out what is the right price to pay. And what's the risk they're willing to accept to make this a viable investment for them to participate in.
Justin Dyer (07:43): Another kind of example just to bring it to real life is, we know some folks up in the San Francisco Bay Area that participate in real estate quite a bit. I was talking to one of them, and maybe I mentioned this last week even, around a property that was a big value add property. What I mean by that is the asset itself, the building itself, was a little bit run down and needed a lot of actual environmental of bringing things up to environmental code, whether that be improving the rain runoff, or how water was dispersed throughout the property, et cetera, et cetera. It was a heavy lift and would require a substantial upfront investment.
Justin Dyer (08:25): How well do you know that? Have you seen something like that before? These are all really, really important questions because something like that you're like, oh wait, the price of this is really, really attractive as it should be, because it has some risk to it. But the question then becomes, well, how comfortable am I improving the property to bring it up to all these new code requirements? Do I have a high confidence in what that amount of investment will be? Do I know the people that I can get on site as fast as possible to bring it up to code, et cetera? There's so many just different aspects to it, but really, and this is a really long-winded way of getting to your answer, but it comes down to the modeling and the experience, and we'll touch on that in a little bit greater detail.
Brandon Averill (09:10): Yeah. And I think also, what your goal is because that could change things quite a bit, because those stages matter, they're often taxed differently.
Justin Dyer (09:19): Yep.
Brandon Averill (09:20): Tax all the same, but the different speed with which they're taxed, or different stage which they're taxed. If you're most real estate investors, and this is a very broad statement, but are looking for income. If you're an investor that's willing to forego some of that income and rely more on capital appreciation. Now some of those value add or development projects, they open up a whole world of opportunity. And so I think that's exciting thing about real estate investing in real estate is very exciting if you understand the goals that you're trying to get to and you can find that unique edge. For a lot of our clients, if you're in the highest tax bracket, the last thing you want is income, unless you need that to live on, but hopefully not. You may have a greater opportunity to go do one of these development projects. And yes, it's a little bit higher risk, but if we're making sure we're getting compensated for that on an after tax basis, you could be setting yourself up fantastically.
Brandon Averill (10:20): But this ties a little bit into, you have a lot more control, you go buy your own property. So in that earlier example, I mentioned, client sends over a 10 unit building, him and his wife are the only ones buying that building. They have all the control in the world so they can make those decisions, make decisions for their personal tax situation. And not that this makes it a negative, but when you start to go into a fund, now you're all of a sudden you're in there probably as a limited partner with a bunch of other limited partners. And it becomes less specific if you don't need the income. But the majority investor, really the anchor there would prefer the income, or would prefer to sell on a timing, there's potential impacts around that.
Justin Dyer (11:06): There is, but the trade-off there is diversification, well, diversification and expert management. So you're, instead of you individually buying a 10 unit building where, hey, if one tenant decides to leave, you have to go through the whole process of getting that unit filled. And there's work. That's hard. That's not the easiest thing. Markets don't always go up into the right. We're starting to see that right now. And so that is on you to refill that 10% tenant, or that 10% piece of the property, whereas when you're in a fund, things are well diversified, it's professionally managed. If it's a fund that holds a hundred units and one person leaves, that's a far lower impact. Now the trade-off there, and let's go through the economics of a fund structure somewhat. The trade-offs are you generally pay for that. But the argument is a good manager should earn what you're paying of their services.
Justin Dyer (12:08): Some terms within the real estate fund are very, very similar to the private equity world in general, venture capital, specifically, there's something called promote. So that is a new term, but it's essentially the exact same thing as what's called carried interest in the private equity space. So promote is what, the amount of profits or the amount of appreciation over and above the initial investment generally, sometimes there's a hurdle rate there as well, that the general partner, or the manager of the real estate fund, gets to keep. So let's say after all water marks or hurdle rates are met, there's a $10 million total gain, generally speaking there's a 20% promoter carried interest. Again, very similar to what happens in the private equity and venture capital space. So of that $10 million of total appreciation, the general partner is getting 20% of that or $2 million.
Justin Dyer (13:02): Some other critical things to think about within the fund structure, the economics of fund structure, like I said, hurdle rate, what does that mean? Well, if it's more of an income oriented type asset, so generally speaking, a common hurdle rate in the industry is an 8% hurdle rate. The general partner is not going to participate until the limited partner earns at least that 8% rate. So they get a hundred percent of the income as an example, up to that hurdle rate, up to that 8%. Again, using common industry levels.
Justin Dyer (13:38): Some other cost that show up are property management and asset management, two similar sounding terms, but they are different, they're related, but different. Property management is the day to day. So who's on site to turn the internet back on, as an example, in an office building? Who's that property manager dealing with the sink bursting in the bathroom, as an example? Versus the asset manager is thinking a little bit more strategically long term, if you're buying a piece of property that's value add, and you need to redo 20% of the units to bring them up to more modern standards. Well, they're planning through all of that and they're saying, okay, well, we need X amount of capital to make those improvements. We'll do these two units today, and we'll do these two units six months from now, and really map out that strategic game plan.
Justin Dyer (14:32): But they all cost something, they're not going to work for free. Property management costs something, and generally it's a percentage of the overall income from a property management standpoint, an asset management standpoint, can be pretty varied. And then if you're buying a property on your own, you have to make the decision, hey, do you want asset management manage this yourself, or are you going to pay somebody? Do you want to get on a plane and go see a piece of property you own in Denver, if you happen to live in Phoenix as an example. These are all costs that really come into play.
Brandon Averill (15:04): Yeah. And I think those costs a lot of times would get ignored. It's like, you don't think about the flight cost. I just looked at a flight to Boston, it's going to cost a thousand dollars to fly out there. You start to think about these variable expenses. And they all go into your robust model, whether you're evaluating a single property, or you're evaluating the fund, like you said. So I think there are trade-offs on both sides. Neither one of them is a slam dunk, yes or no. Justin Dyer (15:29): No.
Brandon Averill (15:29): There's probably room for both in your portfolio. It's just figuring out exactly what your goals are, what your priorities are and tying it all together with that. And I think when you, the last thing I'll say around the manager due diligence, like anything else, there are specialties. You're going to go to people, if you're getting your elbow fixed, you're going to a couple people, you're getting your knee fixed, you're going probably a couple different people. So, it's just the same in real estate. If you're trying to purchase a property in Texas, there are probably people that know Texas better than the person that's up in Washington and you're purchasing a property in Washington. So there's local to it. There's different, we went through the different types of property. There are people that specialize in industrial.
Brandon Averill (16:15): We were just with a really successful real estate investor this last week. And he talked about, he spent the last, however many years really focused on industrial and feels like that market might be changing. So now he's got to reinvent himself. So I think there are real niche specialties within those that we all have to pay attention to. And then there's the power of leverage. Well, let's just touch on this really quickly before we wrap up. And if we get more questions, we can bring another episode to fruition, but how the leverage gets dealt with is so important as well. Making sure you have the right banking relationships so that you can get the best terms possible. And then at the end of the day, we also know leverage makes the real estate investment sing to an extent.
Justin Dyer (17:00): Oh yeah. Most definitely. And what type of leverage too? So you mentioned your banking relationship, getting the best rate possible. Do you get a variable rate, or is that all they'll give you? At what point in time can you get a fixed rate? These are all critical, and how much will they loan to the purchase price? The loan to value ratio is incredibly important and various banks will look at various investors and various properties differently. And those are really, really powerful variables within this overall equation.
Brandon Averill (17:32): Yeah. So I hope that takeaway from today is, real estate's a fantastic investment to be able to build your wealth if done in the right way. So, I think when you guys, or even gals are walking away from this, I think the question you have to answer is, it's natural, it's human nature for us to fall in love with one specific asset class. And that's what real estate is, but to take a step back and think about it. Hey, my goal really here is to meet my priorities, the things that I've identified are really important to me, what's the best way to do that? And let's try to take some of the emotion out and evaluate, hey, if I can find a real estate project that gives me what I can deserve more so than let's say, private equity or the public equity markets, then by all means that's where you should be investing your dollars. But let's be really honest and make sure that we're actually achieving that.
Brandon Averill (18:26): So that's the question you should be asking yourself, that's the big takeaway. And then rely on your advisors. This is something that people like us should be helping you work your way through. If your advisor's not doing that for you, I think that's a whole other issue, but this is a big part of your wealth. And if you want it to be a part of your financial structure, then just make sure you're doing it the right way.
Justin Dyer (18:48): Yep.
Brandon Averill (18:48): But we'll close out. We've rambled on a little bit here.
Justin Dyer (18:52): That's real estate
Brandon Averill (18:53): Yeah, I know, that's real estate. But we would love to hear from you, like I mentioned at the top, so (602) 704-5574 is that number, you can shoot me a text, get right back to you. Would love to know the follow-up questions see if we need to go another episode, my guess is real estate will probably revisit here at least in the near future, but until next time, own your wealth, make an impact and always be a pro.