At The Motley Fool, our primary investing focus is on individual stocks -- which we view as the most powerful tool out there for long-term wealth building. But there are other options, and one that's long been popular is real estate. For those looking to branch out from Wall Street to something near the corner of Elm Street and Summit Avenue, Motley Fool Answers co-hosts Alison Southwick and Robert Brokamp have invited a special guest to join them for this podcast: Thomas Castelli, a tax strategist with The Real Estate CPA, who will take them and their listeners on an exploratory ramble through the world of real estate investing.
In this segment, they discuss the various types of passive vs. active real estate investing, turnkey vs. syndication, as well as flipping -- which you really shouldn't view as investing in the first place.
A full transcript follows the video.
This video was recorded on March 5, 2019.
Alison Southwick: So when most people think about investing in real estate -- at least here in the D.C. area for a little person like me who doesn't have some massive real estate empire or come from a world like that -- when you think about investing in real estate you think about investing in a house and maybe flipping it like a single property. Or investing in a property and then renting it out. And it is very active, because you have to go and physically either pound nails into the wall, yourself, and paint the place. Let's talk a little bit about that form of real estate investing, because it's broken up into "active" and "passive", correct?
Thomas Castelli: Correct. When you're flipping a house, it's not really a form of investing, necessarily. You're considered a dealer, in most cases, so you're actually in the business of buying and selling houses. It's really no different than buying and selling cars. No different than buying and selling shoes in a shoe store. It just happens to be that the asset is very expensive that you're buying and selling. That's more of an active business. It just gets misclassified as investing by real estate investors.
Really the active form of investing would be you're building a rental portfolio, buy-and-hold real estate. That would mean you're identifying a market that has favorable fundamentals. The population is going to be growing. Job growth is there. A diversified economy. There's other factors that may make that area desirable.
You're going to identify properties. Most of the time people want to identify properties you can get at a discount. Maybe the buyer has a motivation to sell. Maybe they're getting divorced. Maybe they can't afford it. Maybe they're facing foreclosure. Or in other cases the property has deferred maintenance and needs a lot of work, so you buy it, fix it up, raise the value of the property, rent it out, and then later on sell it down the line.
That's the active side of it and you're going to be responsible at the end of the day for finding that market, finding that property, putting down the down payment, getting that financing, and then managing the property after the fact. Are you going to hire a property manager or are you going to manage it yourself?
All that comes into play when you're on the active side of the business. In the beginning, especially when you're first starting out, that's going to be quite hefty. It's going to be quite a hefty load for you to carry to get your first one or two properties. And then after that it might be easier for you to scale going forward. That's kind of the active side for most individual investors. You'll be buying single-family homes. Maybe two to four units. Maybe smaller apartment buildings. That's the type of thing you'd expect.
Southwick: Now let's talk about passive investing. We're going to talk about two different kinds -- "turnkey" and "syndication." Let's start with turnkey. What is that?
Castelli: Turnkey investing is when a lot of that work that I just mentioned is done for you. A turnkey company will find a property that has deferred maintenance or buy from a motivated seller. They will go in and fix that property up, put a tenant in that property, and then sell you that end product. You, as the investor, will buy a property. It's already fixed up, it already has a tenant in it, and generally the turnkey company will remain on as the property manager. You still own the property, but it becomes very passive for you, and that's why they call it turnkey, because it's almost like you're just buying the property and letting it go.
However, when it comes to turnkey you are still, at the end of the day, going to be responsible. If a boiler breaks, you're going to be the one paying for it, not the turnkey company. That's something to keep in mind. But at the same time you still have that access and control. You still own the property so unless there's some kind of contractual obligation, you can fire the property manager and manage it yourself or hire someone else. So for people who are looking to get in on a passive side on more scale and still have that access and control, turnkey is an option for them.
Southwick: Then the next one we're going to talk about is syndicate investing in real estate. If I understand it correctly, this is something that's really taken off recently because of the Jobs Act. Is that correct?
Castelli: Syndication has been around for a long time. People were doing syndicates back in the 1980s. It's been around, but it became more popular with crowdfunding. Then with the Tax Cuts and Jobs Act with the introduction of opportunity funds, we're definitely going to see a rise in that type of business model on the syndication side.
Southwick: I know a bit about the Jobs Act and how it has opened up investing like this for more people because of the Motley Fool Ventures Fund. Like before the Jobs Act, it probably would not have been possible for The Motley Fool to open up a venture fund and have 800 limited partners. In a similar way, the Jobs Act opened it up so that accredited investors have more opportunity to invest in commercial real estate?
Castelli: The Jobs Act definitely opened it up to more people -- allowing more people to invest -- and you don't necessarily have to be an accredited investor.
Southwick: To be an accredited investor, you have to...
Castelli: To be an accredited investor as a single individual, you have to make $200,000 or more for the last two years with the anticipation of making that same amount or more in the third year. If you're married, that's going to be $300,000. Or you have to have a net worth of $1 million or more excluding the value of your primary residence. That's whether you're married or single. Those are the two different ways you can qualify as an accredited investor. There's certain offerings that are made to "sophisticated investors."
Southwick: I love that! Everyone thinks they're a good driver, has a great sense of humor, and are also a sophisticated investor.
Castelli: There's definitely different levels of sophistication, but basically there's something called a 506(b) rule. It's a regulation under Regulation D that allows sponsors, or people who are going to raise the money for a deal, to allow up to 35 non-accredited investors into the deal as long as they're "sophisticated."
That's really going to be determined by the sponsors, themselves, and how much risk they're willing to take on. They have to understand this person's sophistication, so they have to measure that in some way. Maybe this person works in real estate. Maybe they have a finance or accounting background, or a business background. They might not be accredited, but they're still sophisticated enough to understand what they're investing in.
Southwick: Let's get into it. How does it work?
Castelli: Syndication is when multiple people pool their money together to buy an asset that they wouldn't maybe be able to buy individually. There's two parts of the syndicate. There's going to be the "general partnership" side, also called the sponsors, and there's going to be the "limited partners" or the passive investors.
The sponsors are responsible for everything in the deal. Making sure that it happens. Making sure that they're identifying the market. Identifying the property. Identifying the business plan. There's something called value-add -- a strategy -- where they go into a property that has that deferred maintenance or is otherwise undervalued. They're going to renovate that property over a few years and rate that property's value and then later on sell it.
They're responsible for identifying the asset, making sure it's in a good market, coming up with a business plan to renovate that property. They're going to be responsible for raising the financing, both from the debt side, whether that be from a bank or another institutional lender, and then the equity side is going to be usually from passive investors to be used for the down payment and renovation budget of the property.
Then they're going to usually use third-party property management to manage the property and make sure that renovation goes as planned, ultimately selling the property. These things usually happen anywhere from three to seven years. It's the traditional time frame of a syndication from purchase to end. It just depends on a number of factors. Market conditions. How long it takes to get the renovation done. That's how that works.
Southwick: And does it end when they determine they're going to sell the property to someone else? What determines the end? I assume your money is locked up there.
Southwick: How do you get paid?
Castelli: It depends on the structure of the deal. There's all different types of structures on how it can be done. Sometimes there's cash flow that comes out. During ownership of the property you get distributions. Then there is also the capital gain at the end of the sale. So when the property is sold it's usually when the syndication will end. That's two profit models -- two different ways to make money on the syndication.
Depending on who you're investing with and how they structure it, usually you'll see anywhere from a 6%-10% pref, preferred return, which means that the investors will get paid out anywhere from that 6%-10% annually before the sponsors get to touch any of the money, before they get any profits.
Then usually there's a target of 15%-20% or more internal rate of return. This is the kind of returns you expect on these deals. Now, depending on what type of asset class you're investing in it can vary and these days a lot of people are investing in multifamily. We're starting to see those kinds of rates decrease, slightly, because there's a lot of money chasing a little bit, amount, of assets. Supply and demand is going to push the price of those assets up, and when you have to purchase that asset for a higher price, the return, the yield is going to be, of course, lower.
So returns vary, and I'd have to say that if you're going to be investing in one of these things, the biggest part, as a passive investor to look at, is the sponsor themselves. What track record do they have? Do they have a track record of success in that asset class -- for instance, multifamily or self-storage? What do other investors say about them? Who are their partners? Who are they using as their lender? Their attorney? Their accountants? All this comes into play when you're determining whether or not you want to put your money with it, and it really comes down to, like Warren Buffett always says, the management team. You invest in a company with good management. It's no different here.