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September 16, 2020

Investing in Real Estate – The Basics

Introduction

This is the second article in a 4-part series about getting started as a real estate investor.

In the first article, I discussed why real estate is a good addition to a portfolio that has a high allocation of stocks and bonds. It’s also good for diversification if you have invested in a lot of high risk assets — like startups. 

In this article, we’ll discussion real estate asset allocation as a part of your portfolio and cover some real estate basics. In the next article, we’ll dive into the different ways that you can invest in real estate.

Real Estate Portfolio Plan

In our discussion of startup investing, we talked about the importance of creating a portfolio plan. You should go through a similar exercise when adding real estate (or any other major asset class) to your portfolio.

  • Total capital (money) commitment in terms of dollars and percentage of your investable assets
  • Standard investment amount per real estate investment
  • Total number of properties needed to achieve diversification

Guidelines for real estate asset allocation are more varied than for startups. They range from 5% to 30% of your investable assets. The “right” allocation depends on your goals and needs (growth, income, liquidity, time horizon), the risk-return profile of the real estate investments you plan to make, and the composition of the rest of your portfolio. While startups are nearly always high risk, illiquid, and deliver returns through capital appreciation, real estate is entirely different. Real estate investments have a range of risk levels, may be liquid or illiquid, and can provide returns through dividends as well as capital appreciation.

Real estate assets are confined to a specific location, so we need to consider both geographic diversification and having a minimum number of properties. With startups one investment = one company. But with real estate a single investment could be deployed in one property or hundreds of properties through a Real Estate Investment Trust (REIT) — similar to an ETF or mutual fund. So, if you want exposure to a minimum of 25 properties, that can be achieved with 1 investment in a broad-market REIT, 25 individual properties investments, or any combination in between.

Real Estate Sectors

Like technology, real estate is an industry with many sub-sectors. Real estate is involved in how and where we live, work, and play because different activities require different buildings and infrastructure. Real estate isn’t just about homes and apartment buildings. There are real estate sectors that focus on properties used by other industries, such as retail, office buildings, apartment buildings, warehouses, healthcare facilities, and even communications infrastructure. See this link for a list of real estate sectors.

Considering various real estate sectors gives you the option of developing a real estate investment thesis. You could focus your investments on the specific sectors that you think provide the best risk-return profile. I say “option” because you also have the opportunity to take an index investing approach with publicly-traded real estate ETFs or broad-market private REITs.

Real Estate Investment Basics

Let’s go over some real estate basics to familiarize you with some industry terms and common investment considerations.

Real Estate Investment Trusts (REITs)

I mentioned REITs above, but I’ll explain a little more about them here. At the highest level, a REIT is an entity that is designed to own and operate income-producing real estate properties.

A REIT may take the form of a trust, partnership, limited liability company (LLC), or corporation. Most publicly traded REITs are corporations, while many private REITs are LLCs. What differentiates a REIT from a typical C-corp or LLC is meeting a set of qualifications that makes the entity eligible for favorable tax treatment. To qualify as a REIT:

  • 75% of assets must be in real estate
  • 75% of income must be produced from real estate
  • 90% of income must be distributed as dividends

If an entity qualifies as a REIT, it is treated as a pass-through entity. That means the entity pays no business taxes on its net income, avoiding double taxation on the dividends paid to investors.

The REIT structure is so popular that it has become synonymous with real estate investments in general and publicly-traded REITs specifically. Just as you would ask a series of due diligence questions in order to understand the business a startup is engaged in, you should feel comfortable asking questions to fully understand the strategy and activities of a REIT.

Development phase of a property

A standard way of categorizing properties is by their development phase, which reflects the work and capital required by a property as well as its risk-return profile.

  • Stabilized — A stabilized property is one that has already been built, does not require major capital investment for upgrades or renovations, and is already occupied by tenants. For these properties, you are essentially collecting rent and doing regular maintenance. These properties are operating at their maximum cashflow and profitability, which makes them low-risk and great income investments.
  • Value-add — A value-add property is one that has already been built but is in need of upgrades or renovations. The need for these improvements is keeping rents below market or limiting occupancy. Capital investment is needed to complete the upgrades. The property is typically producing cashflow from current tenants, but rental revenue is expected to increase after the upgrades. Value-add properties tend to provide a combination of growth and income potential.
  • Development — A development property is often a new construction project. It requires the most capital and time to complete. It also carries the risk of construction overruns and lease-up risk of finding tenants and negotiating rent. Development properties are the highest risk, but provide the most growth potential.

Hold period

Startup investors know they may not see a return for 7-10 years, but in reality there is no guaranteed end date. With real estate, investments often have a stated “hold period” that ranges from 3 to 10 years. Others may state that they are an “evergreen” fund that has no end date — like an ETF or mutual fund — but allows investors to request redemptions (withdrawals) on a quarterly basis after a minimum hold period (and possibly other limitations).

Debt or equity

When you invest in a startup you are typically investing in the equity of the company. With real estate an investment could be in debt, equity, or possibly both. REITs are often equity investments, but that is not always the case.

Just as there are different types of equity securities used to invest in a startup (common, preferred equity, convertible notes, SAFE notes), there can be different securities used to execute a real estate deal. Be sure to confirm exactly what security is being issued and the rights it provides to investors.

  • REITs often issue common stock, preferred stock, or membership units (if an LLC)
  • In order to provide new ways of investing in real estate, crowd investing sites may offer unique securities specific to that site.

Expected returns

Compared to startups, real estate investments have a higher success rate in delivering positive returns. There is still risk and you can lose money, but a real estate investment is less likely to experience a complete loss of capital, as often occurs with startups.

Real estate returns also tend to occur in a narrower range. Best of all, it is feasible for an experienced real estate management team to forecast the return potential of a property before you invest (it’s a red flag if they don’t). This is because many of the variables are known or can be reasonably estimated based on similar properties. For instance, the cost to acquire or build a property, total occupancy of a property, market rents, and expected maintenance and operating costs can all be modeled ahead of time to get to a “target return” range.

You can compare the target return between investments, taking into account the different strategies, risks, and unique factors of each. To help you understand what a reasonable return expectation is — fully caveated by the fact that nothing is guaranteed with any investment ever — below are a few round numbers and ranges.

  • The total “cash-on-cash” return multiple can range from 1.5x to 3x. This metric is heavily influenced by the hold period of an investment and whether it is a debt or equity investment.
  • Total annualized return is typically 8% to 10% — however, the range can be as wide as 5% to 20%.
  • Cash dividends typically range from 3% to 6% and may contribute anywhere from one-third to two-thirds of the total return. This is heavily influenced by the development stage of the properties, type of property, and whether it is a debt or equity investment.

Hopefully, this gives you some good information to start thinking about whether real estate is a good asset class for you, and some of the factors you need to think through when considering real estate investments. In the next article, we’ll dive into the different real estate investment vehicles that are available to investors.


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About: Mike Cozart

Mike is a Director of Product Management and part-time start-up investor. Mike started his career as an investment banking analyst and venture capital associate before taking on general management and product management roles with Amazon and Axon Enterprise. He earned an MBA from Columbia Business School in New York City, a BA in Economics from The University of Texas at Austin, and a BS in Geographic Information Science from Texas A&M University at Corpus Christi.

View Mike Cozart's articles

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