Real Estate Investing 101 with Real Growth Capital

Topic: BASIC KNOWLEDGE • By: Michael Lewis • 12-30-2018

Group investing (sometimes called “syndication”) simply means pooling resources.  A group of people pool their money to buy a real estate asset together.  They can buy a bigger asset with their pooled money, and each investor can face less risk.

Let’s say you’ve got $50,000 to invest.  You could put a down payment on a rental property–maybe a single family home or a condo depending on the market.  That would require you to find the property, underwrite the deal, perform diligence, find tenants, and manage the property.

Lots of real estate investors do this.

But it’s a lot of work, the returns might not be great considering the investment of time and capital, and it’s fairly risky.  Remember that a single rental property provides all-or-nothing revenue.  When you budget for one month’s vacancy and suffer two months without a tenant, your annual gross revenue is (at least) 8% below your projections.  That’s probably the difference between making and losing money in a given year.

Group investing is an alternative to finding, buying, and managing a real estate asset yourself.

You are still investing directly in real estate.  The difference is that you pool your money with other investors to buy a bigger asset.  Maybe you invest $50,000 on a particular project.  Someone else invests $100,000, and so on, until $2 million has been invested.

Now, the investor group can buy an asset worth $2 million with cash or around $8 million with bank financing.

You still get the profits and tax benefits that flow from your ownership of the asset.  But, you don’t have to do any day-to-day operation of the asset.  A professional property manager will do that.

Who Is Investing In These Assets?

Group real estate investing is popular among high net worth individuals because of the relative security and high risk-adjusted returns.

Generally, there are two groups of people who come together to make a deal work.

Group #1: Sponsors (also called general partners or GPs)

These are the people who find the deal, underwrite it, conduct diligence, obtain financing, and create the business plan.  They put the deal together and manage the asset–like you would be doing if you bought a single family home as an investment.

Group #2: Passive Investors (also called limited partners or LPs)

These are people who invest money into the deal but have no active responsibilities to manage the asset.  *Note that a sponsor can (and often does) invest alongside investors in a project.

Together, Sponsors and Passive Investors create an LLC that buys, holds, manages, and (sometimes) sells the asset.  Because an LLC is a pass-through-entity, you get the tax benefits of direct ownership.

What is a practical example?

Let’s say Michael and Scott work to find an apartment community in Charleston, South Carolina.  Michael is an attorney, real estate broker, and developer.  Scott is a real estate developer with a background in finance and construction.  After searching for months, they find a property that meets their investment criteria.  It’s in a great location, but some deferred maintenance and poor management are holding rent revenues below market value.

Michael and Scott conduct extensive underwriting to make sure the deal will be profitable.  They determine that the project could add a lot of value to the apartment complex.  The asking price is $10 million; and they project a sale price of $13 million after modest renovations and management changes.

Because Michael and Scott don’t have $10 million to purchase the property themselves, they put together a group investment offering.  They create a detailed business plan and summary of the opportunity for investors.  They work with securities lawyers and accountants to organize and structure the formal investment offering.

Then, they look for investors who want to join in the project.  Michael and Scott invest $100,000 each in the deal.  Investors contribute the remainder until they’ve raised enough to cover the down payment, renovations, and cash reserve account.

After the deal closes, the LLC owns the property.  Michael works with the existing property management team to reorganize workflows and modernize systems.  Scott works with the contractors handling renovations.  They both handle all the actual management of the asset and send out updates so that passive investors can see how the deal is progressing.

Renovations are completed as leases end, so it takes a year to completely renovate and raise rents to market levels.  Passive investors are paid quarterly during year one, but the big returns are yet to come.

After renovations are complete and the asset is stabilized, Michael and Scott see that multifamily asset values are rising because of a general downturn in the economy and other factors.  This is what they originally projected, so they decide to stick with their original plan and hold the asset for two more years before selling.  Investors receive favorable quarterly payments for two years.

After two years, Michael and Scott determine that it’s a good time to sell.  They sell the property for $13 million (as initially projected).  The investors get their original capital back, the bank loan is paid, and they split the profits from the sale 70/30 in favor of the investors.

What types of properties are purchased with groups of investors?

Every type of real estate asset can be purchased with group investing.  There are groups that acquire agricultural land, vineyards, golf courses, storage units, mobile home parks, shopping centers, restaurants, gas stations, hotels, warehouses, and all variety of commercial spaces.  Some groups build, others renovate, and some just buy and hold for steady cash flow and tax benefits.

Real Growth Capital focuses on value-add multifamily deals that are small enough (relatively) to avoid being purchased by big private equity funds (because big funds usually overpay).  Value-add means that the properties are performing acceptably; but with a little polish, they can really shine.  For example, maybe the complex has terrible management and loads of negative reviews online.  As a consequence, occupancy rates are below market norms.  A change of ownership and redirecting the management team may improve occupancy, increase revenue, and subsequently boost apartment value.

What returns can I expect?

This is the most important aspect of any investment and the key to building wealth.  Our library has several articles about returns, but for our purposes here, I will keep things simple.

Returns typically come in two phases:

First, investors receive a return of cash flow as the business makes money.  They get paid cash as the business earns cash.  This can start one month after the investment is acquired or take longer to begin depending on the particulars of the project.

Second, investors receive a split of profits upon sale of the asset.  This depends on how a particular deal is structured.

Our general investment criteria is a target AAR of 10-15% for investors in value-add properties. 

In newer assets (less value-add potential) in strong submarkets, an ARR of 10% is a solid risk-adjusted return as we head towards the end of our current growth cycle.  Generally, projected returns are 6-10% per year while held plus 30% or more upon sale.  Every deal is different, but that’s the typical formula to provide our targeted returns.  Average annual returns will typically be a couple points higher than IRR in value-add investments because of the substantial profit upon sale.  In our current economic climate, an AAR of 15% would be a very strong targeted return.

Every market and submarket is different; and each deal has different projections for hold period and sale price.  This is an important caveat because return potential is analogous to risk potential.  The number one rule of real estate investing is “never lose money.”  We’re not afraid of investing; but we conservatively underwrite our deals and aim to over-deliver on our projected returns.

Here’s an example: an investment of $100,000 might pay $8,000 each year for three years, then $150,000 upon sale in year 4.  That’s an IRR of 16.26% and Equity Multiple of 1.74x.  Meaning, for every dollar invested, the investment pays a return of $1.74.  Average Annual Return is 18.5%.

That level of return is absolutely possible with strong underwriting and the right asset.

If you’re not familiar with these terms, here’s an article explaining their practical use.

To put that into perspective, Berkshire Hathaway stock has generated a 20.8% average annual return since Warren Buffett took control in 1964.  It’s Class B (BRKB) stock fell 32% in 2008.

Group real estate investing can generate very favorable returns without the volatility of the markets.

How much do I need to invest?

Typically, we ask for a minimum of $50,000 for our projects; but that varies.  We can also be flexible to meet our investors’ individual needs because of our firm’s small size.

How long will the deal last?

This is an important question because your money is illiquid until the property is sold.  While each investment offering is different, we typically search for projects with a holding period of 3-5 years for value add projects.  Tax favorable projects in economic opportunity zones, for example, might be held for considerably longer.

Can I invest?

Most group real estate investments are available only to accredited investors.  We do not verify accreditation status until you decide to invest in an offering, but that may vary depending on the offering sponsor.  The term “accredited investor” is used by the U.S. Securities and Exchange Commission in Section 501 of Regulation D.  To qualify, an investor must meet one of the following criteria:

1. Earn an individual income of more than $200,000 per year, or a joint spousal income of more than $300,000 per year, in each of the last two years and expect to reasonably maintain the same level of income;
2. Have a net worth exceeding $1 million, either individually or jointly with his or her spouse (excluding the primary residence);
3. Be a bank, insurance company, registered investment company, business development company, or small business investment company;
4. Be a general partner, executive officer, director or a related combination thereof for the issuer of a security being offered; or
5. Be a business in which all the equity owners are accredited investors. Be an employee benefit plan, a trust, charitable organization, partnership, or company with total assets in excess of $5 million.

How do I invest?

We do not have an exhaustive list of current opportunities because we are highly-selective in our investments.  When we have an new opportunity, we share it through our email list.  If you want to invest in a particular property, the email discussing the opportunity will contain a link to view detailed information about the offering and instructions how to invest.  If you choose to invest, we will contact you with instructions on how to verify your accreditation, sign legal documents, and fund the investment.  You can also speak directly with Scott or Michael about a particular opportunity to make sure that you understand the details.  Transparency is important to us.

What fees are involved?

This varies depending on the sponsor.  At Real Growth Capital, we structure deals to earn the bulk of our fee based on performance then invest alongside our investors.  This keeps everyone in the same boat.  A performance fee means that a sponsor might contribute 10% of the capital to a project; then receive a range of 10% to 30% of the profits depending on investment performance (how much the investors make).

Generally, there are three common types of non-performance fees that a group investment sponsor might charge depending on the work required.  These are typical of private equity offerings and are generally intended to compensate the sponsor where he does work that the investment group would otherwise pay an outside professional or firm to do:

Acquisition Fee (1-3% of the purchase price).  This is paid upon the deal closing to compensate the sponsor for the work of putting together the deal, underwriting the project, performing diligence, assembling the project team (potentially accountants, bankers, property managers, lawyers, brokers, and contractors), and acquiring the property.

Asset Management Fee (1-3% of gross revenue).  This is a monthly expense of the business to compensate the sponsor for the ongoing work of managing the asset.  This is earned for the sponsor’s efforts and expertise actually running the business.

Construction Fee (varies).  This is an expense during construction to compensate the sponsor for oversight and management of construction.  This is earned when a sponsor has particular knowledge and expertise which allows him to do the work a project supervisor or other professional would otherwise be hired to do.

Do the investors pay these fees?

No.  They are simply treated like any other business expense as the business operates–which makes sense because the sponsor is performing work that the business would otherwise pay a third-party to do.

Are those fees counted before you forecast an investor’s return?

Absolutely.  Transparency is what separates Real Growth Capital offerings from other types of investments.  The offering circular and private placement memorandum, which accompany each offering, detail specifically when all fees will be taken, their amounts, when investors will be paid, and the amounts they will be paid.  If an offering projects an ARR of 18.5% and Equity Multiple of 1.74x, we project the deal will pay each investor $1.74 for every dollar invested.  That’s after all expenses.

Our investments are designed to be a win-win.

We buy assets where we can create value for ourselves and our investors.  We actually invest alongside our investors.  There is no better indication that we believe wholeheartedly in the strength of our opportunities and the equitable distributions of our profits among sponsor and investor.

Passive group investing is a great way to invest in real estate without having to deal with the hassles of being a landlord.  It’s usually less risky than being a landlord because revenue and expense fluctuations of a 100-unit apartment complex are statistically more predictable than one single family home.  The tax benefits flow through the LLC to investors.  Returns are typically quite good.

Investors must be accredited, and investments are illiquid until maturity.

The investments and fees are generally much simpler than an employee-sponsored 401K.  The difference is that an investor can actually understand what they’re purchasing with their capital and how that capital will be increased.

By reading this article and the several I have cited herein, you will have the knowledge to understand how group real estate investing works.