Is THIS the Holy Grail of Real Estate Investing? - Passive Income

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Is THIS the Holy Grail of Real Estate Investing?

June 14, 2018 • 10 Min Read

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Does the perfect investment exist? Sometimes I feel like Indiana Jones, searching for the Holy Grail that is the “perfect investment.” I’ve spent time imagining what it would look like if it did exist. For me, the perfect investment would:

Have a High Return on Investment

I consider low-return investments to be anything that doesn’t beat inflation. Most financial institutions will use an average inflation of 3%-3.5%. If the return is any less than that, then you're not keeping up with inflation and it's slowly burning a hole in your pocket. I consider mid-level returns, then, to be anywhere between 3.5-10%, with high returns being anything over 10%.

Be Passive

This means that they don’t require much ongoing time or energy commitment. I’ve talked a lot about passive income, and I know that “passive” is a relative term. I believe that there is always something involved, whether it be time, energy, or money, particularly at the front end of the investment. However, the less of these things required, the better.

Be Low Risk

This one is also very personal, and it’s all relative to your goals. Do you consider low risk to mean a 10% loss rate? 5%? Or lower than that? Whatever “low risk” means to you, the ideal investment would be less than your tolerated risk.

The Quest

Whatever your Holy Grail of Investing looks like, we’re all on the quest to find it. You search to the ends of internet blog posts, online forums, and Facebook Groups, and pore over endless books. Some of us even try to follow gurus to find this perfect investment.

Well, I’m sorry to disappoint you so early in this post, but that perfect investment does not exist. Otherwise, that's all people would invest in and all these books, blogs, and financial institutions would be worthless. But stick with me, because I believe it’s possible to at least get pretty close.

Finding a Low-Risk Investment

What makes the search for the perfect investment so difficult is the concept of low risk in particular. Finding a high-return investment is easy by comparison; just ask anyone who rode the cryptocurrency wave the last few years or those who chased tech stocks in the late 90s.

But with those high returns often come the potential for a huge crash and burn. Ask anyone who enjoys gambling–sure, you can get phenomenal returns if you pick the right number on the roulette wheel, but the risk is commensurate with the payout. (For those wondering, it's a 35-1 payout for picking the right number on the wheel.)

Of course, what you consider to be low risk ultimately depends on your personal risk tolerance. I invest heavily in real estate and when it comes to this world, here is what I look for to help mitigate risk:

Collateralized Asset

One of the best parts about investing in real estate is that you are investing in a real underlying asset. Compare that to peer-to-peer lending where if the borrower decides to default, oh well, you're out of luck. Perhaps they get a credit score hit.

However, with real estate investing, like crowdfunding, the underlying asset (property) is there as collateral in case the borrower decides to default on the loan. In that case, you have the rights to take ownership of that asset.

Experienced Managers

Just like in any field, experience matters. Let’s be honest, everyone who’s invested in the stock or real estate markets in the last 8-9 years kind of looks like a genius. We’ve been on an unprecedented bull run in the stock market, and in terms of real estate, we’ve also been on a hot streak not seen since 2001-2008–and we all know how that ended.

So when I make investments with managers, I’m looking for people who have a longstanding history of navigating multiple down cycles.

Conservative Underwriting

What does conservative underwriting look like in real estate? Well, it usually has to do with leverage. Over-leverage and when vacancies increase, if you can’t handle covering the debt service or mortgage, the whole thing falls like a series of dominoes.

In this world, you’ll often see something called LTV or Loan to Value. If you’ve bought a house, the standard underwriting that a bank uses is typically an 80% LTV, and they ask you to bring in 20%. That builds in a buffer for the bank in case you default on the loan and they have to take over the property and sell it off.

When it comes to real estate investing, I look for conservative underwriting if possible where LTV is typically 70% or below.

Diversification – Property Type

What does diversification look like in real estate? Well, the real estate sector has a good number of property types that you can invest across, from residential (single and multi-family) to commercial (hotels, retail, offices) to industrial (warehouses) and land (vacant lots, farms).

It’s easy to think of real estate as a whole going up and down together as the market fluctuates, but those in the industry know that’s not the case. Just like everything in finance, the different property types go through different cycles. While one is hot, the others may be seeing a downturn and vice versa. In real estate, you can lower risk simply by investing in different categories at the same time.

Geographic Diversification

While there are global and national economic factors that affect the country as a whole (we saw this in 2008), not all parts of the country are always affected the same. In 2008, some saw larger dips, some recovered faster, some are still recovering, while others are at all-time highs. The effects of natural disasters, for example, are usually pretty localized, and local economies differ from town to town.

For these reasons, investing in different parts of the country is a good strategy for diversification. Even though one part of the country might be affected by an economic downturn or natural disaster, it’s possible that your other investments won’t be affected.

Introducing Private Real Estate Funds

A few years ago, I was introduced to something called a private real estate fund, after I had made a couple of investments in syndications.

Quick review: what is a syndication? Imagine that there’s a 105 unit apartment building in Texas worth $4.5 million. A management group will pool funds from investors to purchase this property, arrange financing, manage rehab, and ultimately change the revenue of the business. The goal is to typically sell the property after 5-7 years and realize a profit that gets returned in a predetermined split between management and investors. Distributions are usually paid along the way to shareholders as well.

Well, if you think of a syndication as a stock, a real estate fund can be thought of as a mutual fund. It is a pool of funds that are used to purchase multiple properties, giving the investor diversification over a larger pool of properties. This seems to satisfy the diversification method of mitigating risk and in my opinion, it's even better if they invest in different parts of the country.

Private real estate funds are typically handled by experienced managers who guide the use of those funds. It’s important to note that who this manager is can make all the difference. You need to look at their level of experience, as well as what criteria they use to purchase properties. As a fund investor, you’re usually not privy to what property they’re targeting or adding to a fund until it’s already added, so there’s a level of trust required as well.

What kind of returns can you expect? It varies widely, but when I look to invest in funds, I look for returns in the 12-16% range. Of course, I’d prefer something like 20%, but any fund that advertises that they expect returns of >20% typically makes me wonder what risks they’re taking or what underwriting standards they’re using to realize this return. I have invested in syndications that have promised and realized higher returns, but when I’m investing in more broadly diversified sets of properties, the expectation is that the return won’t necessarily be as aggressive. The flip side is that there is (hopefully) less risk involved.

So where can you find funds like these? Well, in the past, the only way to find them was to primarily hear about them through word of mouth. SEC guidelines can be very restrictive about marketing. But now, with the advent of the Internet, there are several websites that allow much easier access. Certain crowdfunding sites may actually present funds once in a while.

Late to the Party but Making Up for Lost Time

Now, the whole point of this blog is to let you in on what I’m learning and what I’m doing, and so I’ll tell you that my next sizable investment will be in a private real estate fund. I’ve been fortunate to make a little cash flow through this blog, and instead of spending it on something I consider wasteful, I want to create more passive income from it.

It's not as if real estate funds are a new thing. They've been around forever, but they're relatively new to me. So I'm trying to make up for lost time and trying to understand everything I can about them.

I’ve been vetting a fund for several months by MLG Capital (which has since become a sponsor of this site), and I’ll share my vetting process in a future post. Suffice it to say, I first heard about them as part of an investor group I’m part of.

Through my process of finding out more about them and talking with them, MLG decided to become a sponsor of my site because they believe in my mission of helping people achieve financial freedom through passive income. I have no obligation to invest, and I’m still in the process of considering the factors mentioned above, but so far, they’re looking good.

So Is There a Perfect Investment?

The short answer is no. Unfortunately, every investment comes with risk. I’m okay with that. After all, the lifestyle I’m looking to maintain and continue to improve upon isn’t possible without risk. In fact, I mentioned, fear of inaction is what drives me, not the fear of risk.

Real estate funds may not be the holy grail, but I believe they could be a major player in helping me to achieve my goal of financial freedom through passive income.

At the end of the day, I’m looking for diversification, risk mitigation, and cash flow. I’m currently invested in single family, multifamily, and crowdfunding (both debt and equity), and I can safely say that the next investment will be in a real estate fund.

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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