I had an opportunity this past weekend to speak with an old friend I hadn’t seen for years. We had a lot of catching up to do; we talked about our wives, children, parents, and careers.
He actually had no idea that I was running some online businesses – including this blog – and he was extremely curious why I’ve invested so much time and effort into getting them up and running. After all, wasn't I doing okay financially as a physician?
So I went into the state of medicine and my desire to create financial freedom from it. I told him that at the end of the day, my goal was to use as much capital from my day job as well as these side hustles to create multiple passive income streams. The streams would produce cash flow that wouldn't be directly dependent on how much time I put in. That was how I was creating true financial freedom.
My friend works in a high-paying non-medical job, and after hearing about my personal financial goals, he eagerly stated that he was hoping to accomplish the same thing.
So, we discussed what his personal investing desires and goals were. He stated the following:
- He was interested in investing in real estate but absolutely did not want to own or manage it himself.
- He was hoping for something tax-efficient.
- He wanted to diversify outside of his current stock portfolio.
- He wanted something totally passive.
- He wasn’t interested in chasing super high returns for a large amount of risk.
So we discussed various opportunities to utilize real estate investing to achieve those goals. I told him that it seemed to make sense for him to look into real estate funds. He was an accredited investor and therefore would qualify to invest in these funds.
He was intrigued and asked how I came to make that suggestion in particular. Well I decided to share with him some of my goals, which were very much in line with his.
At the end of the day, I want my money working hard for me, creating more passive income. I want it to create a revenue stream that I can live on.
Sure, appreciation (the increase in price of an asset) is great, but that typically only matters when the asset is sold.
In actuality, I want cash flow to return to my pocket now so I have more choices in life. I can spend the cash, work less, or reinvest it to increase my returns.
I told my friend that when I evaluate real estate funds, I focus on the cash flow produced by paying special attention to something called “preferred returns.” These are the expected annual cash returns that are distributed first to investors before the company participates in any of the profits.
I look at projections for how the fund expects to produce that cash flow and how successful they've been in the past. I told him to remember above all else that if you have steady cash flow, you have flexibility and freedom.
My friend had a very valid concern when it came to taxes. As we all know, it’s not only what you make but what you keep that’s important. He works in a high paying job but stated that he pays “a ton in taxes.” He wanted an investment that kept more money in his pocket.
Personally, when I look at an investment, I also want to know if my returns are going to be tax-efficient in any way.
Just as if you were purchasing a rental property on your own, when a fund purchases an investment, they have the opportunity to take advantage of something known as depreciation which decreases the amount of taxes that need to be paid.
I look for funds that are mindful of tax efficient strategies like these and that these benefits are passed along to investor.
The bottom line is that a 6% return, if it’s tax-free, can be better than an 8-9% return with tax consequences. It’s important to look at what the strategy of the fund is and not just look at a simple number.
Taxes make a huge difference, and knowing how to take advantage of certain incentives and tax breaks can result in significantly better cash flow.
My friend was also looking for some added portfolio diversification, and that’s actually one of the major reasons I invest specifically in real estate funds.
When it comes to stocks, we all know that diversification is important. That's why many invest in diversified index funds. It helps smooth out returns as risk is spread across many assets.
The same can be said for real estate funds. For example, a syndication investment is often focused on a single building. So when you invest in it, everything rides or dies with that one property. Don’t get me wrong–when I find a good syndication deal, I jump all over it.
However, there is some comfort knowing that investing in real estate funds gives me instant diversification, kind of like a mutual fund of syndications.
This diversification is created by owning multiples assets in multiple parts of the country since weather, economic, and political factors can be highly localized. Funds also create diversification when it comes to market timing because they make purchases over time and at different periods in the market cycle.
It’s always nice to know that your risk is somewhat mitigated by this diversification.
I told my friend it’s extremely important to know how to vet these funds before investing in them, because once you do, you can consider your funds locked up for quite a while. Just how long depends on the nature of the fund, so that’s certainly something to consider.
When it comes to the vetting process, you have to identify the operators of the fund, their track record, and their goals. You need to know the type of assets they’re going to pursue, in which markets they're investing in, and how they're mitigating risk. This last factor is even more important now, considering we’ve been in a boom real estate cycle for quite a while and people are fearing some sort of upcoming recession.
The upfront time commitment to vetting these investments should be taken seriously, but once it’s done, the rest of the process is extremely passive.
Ultimately, real estate funds are very passive. You invest . . . and you wait for checks on a quarterly or semi-annual basis. That’s about it.
Returns across funds can vary greatly depending on the goals and strategy of the funds. You can find funds with returns anticipated at 25% or more, but often that comes with higher risk in this market.
For a portion of my portfolio, I chase slightly higher returns, while the majority of my portfolio is focused on steady returns. As I’ve reduced my time in medicine, I value the steady cash flow above all.
It only takes a simple a calculation to figure out what my expected monthly and yearly cash flow will be.
For example, if the fund states that they expect 6% cash returns on a yearly basis, if you invest 100,000, that 6% amounts to $6,000 a year or $500 monthly. So by knowing how much passive cash flow you need, you can figure out how much you need to invest to accomplish your goals
Also, don't forget that if the returns are for the most part tax-free, that makes a significant difference in how much passive income you need to create.
How to Find Funds to Invest In
After discussing all of this with with my friend, he naturally wanted to know where he should invest. I was hesitant to give him any straight advice.
Where you invest your money and with what company can depend on your goals.
There are funds that focus more on cash flow. There are other ones that look for more upside potential, such as development and heavy value add properties. There are ones that focus in the South, others that focus on the coasts.
There are funds that help you invest in other operators and funds for even more diversification.
The key is to figure out your goals, learn to do your own due diligence on passive real estate investments, then figure out which investments will help you get where you want to be.
Just know that most funds have a hold time of at least 3-5 years and often longer, so if you think you'll likely need immediate access to those funds, it’s probably not the right investment vehicle for you.
At the end of the day, my goal, and the clear new goal of my friend is to have investments that produce steady cash that we can live off of. Investing in real estate funds is one of my favorite ways to accomplish that goal.
What type of things are you looking for in your real estate investments?