How to Vet a Real Estate Fund: Case Study (MLG Capital) Part 2 - Passive Income


How to Vet a Real Estate Fund: Case Study (MLG Capital) Part 2

July 19, 2018 • 13 Min Read

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Part 1 of this series on How to Vet a Real Estate Fund dealt with some questions to ask in order to get to know the operator of the fund itself. As I mentioned in that post, I think it's critical to know how to vet the operators just as much, if not more, than vetting the deal itself. So if you haven't read Part 1, please start there.

In Part 2, I'm asking questions that relate specifically to a current fund offering, MLG Capital Fund III. (MLG is a current sponsor of this site but I have no obligation to invest with them.) My thoughts are in [red]. Let's jump straight to it…

What are the expected returns for investors in Fund III and how will they be distributed?

Targeted returns are 13-15% NET of all fees and promotes. These returns are based on a combination of quarterly distributions (dividends) and appreciation (profit on sale). Although MLG cannot guarantee any returns, we’ve built in an investor-first model that legally prioritizes investor distributions and a return of the original investment prior to MLG sharing in any profit.

First, we accrue an 8% annual preferred return to our investors. This is a cumulative 8% return. Therefore, based on a $1M investment ($80,000/year), if we only return 7% ($70,000) in Year 1, the Fund OWES you 9% ($90,000) in Year 2 to net out a cumulative 8% annual return.

Only once we’re current on the 8% return do we then begin returning your capital and only once 100% of your original investment is returned, does MLG begin sharing in any profit. That profit sharing is split 70%/30% (Investor/MLG). Again, this split only occurs once you’ve received 8% plus 100% of your original investment is returned.

[In my opinion, this is an investor-friendly payout structure. MLG doesn't see a dime of the profit unless you've gotten your capital back plus an 8% return annually. It obviously incentivizes them to meet their return goals so they can start participating in the profit. Making sure that a good compensation structure where you, the investor, are at the top of the “capital stack” (with a preferred return in place) is an important part of any real estate fund or syndication deal.

To make it even more clear, you earn that 8% accrued return on your working capital. Meaning over time, as they return your capital, you get the rate on whatever is left of your original capital. Once your original capital is fully returned and you're playing with “house money,” the only payouts you'll receive are when the buildings are sold.]

When does that preferred return start to accrue?

The preferred return begins accruing on the date funds are due listed on the legal capital call notice from MLG Capital. An important distinction from other groups, MLG Capital does not begin assessing our asset management fee until your money is due. Many groups will begin assessing their asset management fee once you have subscribed. We don’t assess any fees until your money is accruing the 8%.

[The timing of fees and returns are details you should ask about.]

How often will distributions be received by investors along with updates?

Distributions are made quarterly and received along with our quarterly fund report. We also provide our investors with access to our web-based portal to monitor their investment and fund performance.

[Quarterly distributions means cash flow, which is a key component of what I'm looking for.]

When did you start the fund and what properties have already been acquired?

Fund III opened in September 2016. MLG’s Fund III property summary, which summarizes each deal acquired in Fund III, is shared with prospective investors.

[This is where you can begin to assess whether the fund is consistent with their stated objectives and values. For example, are they truly diversifying geographically like they stated? You can request the property summary here.] 

What types of properties are MLG targeting as part of the fund?

MLG prefers multifamily given consistent investor demand for the product type as well as the tax benefits associated with accelerated depreciation. We also prefer industrial product given its national demand as well as low(er) costs associated with capital expenditures, tenant improvements, and leasing commissions at times of tenant rollover.

MLG’s focus is on doing “smart” real estate deals, which means we believe the pro forma is realistic and achievable. However, we do have a bias toward multifamily and industrial. For retail and office acquisitions, we are described as a “merchant player,” making our investment strategy more opportunistic when acquiring those assets. If acquiring office or retail, we will have asset issues previously identified and look to cure as soon as possible. Once cured, we will subsequently look to exit as soon as possible.

As of 6/27/18, based on equity placed, Fund III’s complexion is 63% multifamily, 24% industrial, 12% retail and 1% office.

[Different funds have different focuses so it's important to know what they're investing in. I appreciate the fact that they're diversifying across various property classes. I have some experience in the multifamily space so being part of a mostly multifamily fund is something I'm comfortable with.]

Any difference if I invest now vs earlier when the fund was created?

There are a few differences:

Investing early in a fund

You will receive more accrued/paid distributions at the 8% preferred return rate, although it may initially lag. We have many investors who will always invest early in the fund knowing that they are accruing the 8% return.

From a tax perspective, MLG also differs from most groups; we pass 100% of any depreciation and other taxable losses onto our investors. By investing early, you are more likely to benefit from the potential depreciation and taxable losses associated with early acquisitions. For example, as of 12/31/17, Fund III has generated $1.366M of cash flow while realizing a $4.55M ordinary loss.

[As I've mentioned, there are multiple ways to make money in owning real estate, and the tax benefits can be tremendous. The most notable of those tax benefits is depreciation. It's great to know that investors are participating in those tax benefits.]

Investing late in a fund

The main benefit is that you have clear visibility into the fund; an investor coming into Fund III today will have ±75% visibility into the fund. Additionally, since inception (9/2016), MLG has been actively executing its business plans on many of the assets within the fund. With a primary investment strategy of growing operating income, this potentially leads to value enhancement at many properties within the fund.

We believe timing is very much dependent upon the individual investor and their respective investor goals/desires.

[So to sum it up, the advantage to investing early is that you accrue more interest and hence returns, although you don't get to see what investments are already purchased by the fund. The opposite is true for investing late.

Which is better? Well if you trust the operator and know you're going to invest with them anyways, it might make sense to invest earlier. However, if you want to see the hand in front of you and are willing to give up some returns for that, then it might be better to invest later on. For this fund, in particular, we're at the end of the fundraising cycle so there's really no choice when I want to participate in it.]

Upon all sales, do you return all capital to investors or do you ever reinvest it?

Prior to (5) years since inception, MLG has the right to return capital, reinvest into new assets, or do both. It all depends on what we feel is best for the investor group, at that time of disposition. Earlier in a fund, it may be best to further diversify the investor groups' portfolio. Later in a fund, we may opt to return capital or return capital and reinvest. It depends on available opportunities at that moment in time.

After (5) years since inception, MLG MUST distribute 100% of all proceeds to the investor group for the preferred return and/or return of capital.

Understanding our investment model is critical when discussing this topic. Keep in mind, MLG is incentivized to become current on the 8% return and return 100% of our investor’s capital as soon as possible. After that occurs, we can then share in the profit. However, we’ll often opt to reinvest proceeds as that’s what’s best for the investor group, in our opinion, at that moment in time.

[Hopefully this is clear. They will opt to do what they deem best upon the sale of a property (return capital vs. reinvest in another property) for the portfolio before the fund is 5 years old, but after that point, they have to simply return that capital to investors when a property is sold.]

What is the minimum investment and do I have to invest all at once?

Although we don’t possess a legal minimum, our lowest accepted investment is $50,000. Our desired minimum is $200,000 – $250,000 as it correlates to approximately a $10,000 investment per deal as we strive to acquire 20-25 deals per fund. That said, we see many investors start at $50,000 – $100,000 and subsequently choose to reinvest.

At the time an investor makes their commitment to invest in the fund, does the capital get called immediately? You touched on it briefly, but at what point exactly does preferred return actually accrue?

Great question. No, capital does not get called immediately. MLG Capital is different than some funds as we raise and deploy capital simultaneously. At the time a prospective investor calls MLG Capital and indicates they’d like to invest, we will request some information to prefill their subscription documents. Upon execution of the subscription agreement, we require a 10% down payment of the subscribed investment amount (think of this as earnest money), which will be held in an escrow account.

When investor equity is needed for a deal, investors will receive a written “Capital Call Due Date” notice requiring the balance (remaining 90%) of the subscription amount. Legally, MLG Capital cannot give less than five (5) days’ notice to receive the balance, however, we do attempt to give much greater than five (5) days’ notice. In addition to the legal written capital call notice, we do our best to follow up with all investors slated for the capital call with a personal phone call notifying them of the upcoming legal notice.

Once the written legal notice is received, it will indicate the day the capital will begin accruing (e.g. if the Capital Call Notice Due Date is 7/19/18, that is when the capital will begin accruing). This notice may be received before, but not after 7/14/18, with a 7/19/18 Capital Call Notice Due Date.

[Different funds run their capital calls differently. Some of them ask for 100% of the funds up front. That may not be a bad thing if you're looking to start accruing a preferred return right away. In this case, they ask for 10% up front, but it's my opinion you should have the remainder of the funds readily available for when the capital call does come.]

Can I invest using retirement funds (SDIRA or Solo 401k)?

SD-IRAs are acceptable; however, they do come with additional paperwork. We will need approval from the custodian that services the SD-IRA. That said, in all cases regarding an SD-IRA, we recommend speaking with your CPA regarding UBTI (Unrelated Business Taxable Income) as the income may be subject to tax.

[I know plenty of people who opt to invest using retirement funds because they want to diversify from investing their whole retirement portfolio in the stock market. Not everyone has the choice depending on their current retirement plans. I'd advise asking your CPA to see what your best options are.]

What is the expected fund term?

We advise our investors to be comfortable with illiquidity for approximately 6-8 years. Our goal is 6-8 years, however, there is no guarantee on the timing of the return of capital as it is predominantly dependent on the sale of assets.

In Fund III, the fundraising period closes 2 years from fund inception (9/30/2018) and the acquisition period closes (5) years from fund inception (September 2021). Within that (5) years, should the fund exit early (sell) an asset, we have the right to reinvest those proceeds (this keeps the fund diversified with the potential of creating more value). However, (5) years after inception (September 2021), we must distribute 100% of all cash and sales proceeds to the investor group.

[So at this point, we're 2 years into the fund. Important to know because it means they can continue to acquire for 3 more years they will start returning all proceeds from sales to investors.]

Can I liquidate prior to the term?

No, which is why we genuinely want to ensure our investors are comfortable with the illiquidity period otherwise we’d recommend not investing with MLG Capital. Although it is allowable to sell your interest to a 3rd party with Fund approval or negotiate a sale of interest with the Fund.

[If liquidity is your primary concern, you probably shouldn't be investing in funds or longer-term syndications.]

What are the states that you plan to invest in and do investors have to file their own taxes in all those states?

We are market agnostic in that we chase opportunities rather than geography. However, our targeted markets create a geographic triangle from Minnesota, southeast to Florida, west to Arizona and back up.

We will prepare K1s on behalf of our investors, which can be provided to any accountant preparing your return. We also have an in-house tax director as a resource for our investors and their accountants regarding questions with the K1s.

MLG Capital (in Fund III) currently owns in Wisconsin, Texas, Florida, Minnesota, Arizona, Missouri & Colorado.

[Important to know that there is geographic diversification as is one of the stated goals of the fund. You should ask your CPA about this, but my CPA told me it's easy to handle with the K1s already prepared.]

When do you expect to close the fund?

Fund III will officially close 9/30/18 for new subscriptions. Fund IV will open October 1, 2018. Fund IV information will become available within the next few months.

Does the fund get audited by an outside party?

Yes. Fund III is audited by Deloitte and will be made available to investors upon completion.

[Always good to know that the fund paperwork is being audited by an outside, respected agency.]

I hope this series was helpful both to understand some of the inner workings of a fund and what questions are necessary to properly vet a fund. The next step is to actually verify what they say is true by looking over their Private Placement Memorandum (you can request it here), by looking over their portfolio and performance from previous funds, and by noting the properties that are currently in Fund III.

I'm committed to investing in a fund for my next large investment as part of my overall diversification strategy. The more I talk to various funds to find out how they works, the easier it gets to vet them. Obviously, this doesn't guarantee success but I get a better idea of where to put my money for the best chance of a nice return. The goal as always is to create more passive income streams, which equates to financial freedom in my book.

If you want to verify MLG Fund III info on your own, check them out here.

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Disclaimer: The topic presented in this article is provided as general information and for educational purposes. It is not a substitute for professional advice. Accordingly, before taking action, consult with your team of professionals.

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