1. Is it safe?
The safety of your investment correlates directly with the process in which the fund manager secures the assets in which the fund invests. There are four primary factors:
- Investment strategy
- Diversification
- Deal underwriting criteria
- Downside protection
Investment Strategy — Examples of investment strategies include funding borrowers with hard-money or bridge loans, leveraged and unleveraged commercial property, residential flippers and more.
Market cycles also help determine which investment strategy is the best. Look for funds with investment strategies that make sense reflecting on the current economy and the condition of that investment strategy within the market cycle.
For instance, COVID-19 has created a number of opportunities for strong growth investing repositioning certain commercial real estate asset classes such as hospitality and retail.
Redevelopment of hotels to multifamily housing and conversion of retail to self-storage are a few examples of this strategy.
Diversification — Funds that diversify their real estate holdings among multiple dimensions such as asset class (residential/multifamily/self-storage/office/industrial/retail), geography, and sponsors or borrowers are less likely to be subject to the risks of funds that put all their eggs in the proverbial basket.
Deal Underwriting Criteria — Strong due diligence on the project sponsor, the subject property and the answer to a question as simple as “How will this project do under the stressed conditions?” are really the backbone of a prudent underwriting process.
Downside protection — How will the investment fare if things go wrong? What protects the principal of the investment?
Understanding and enhancing “safety” mechanisms is what creates downside protection. For example, investing in a note secured by the 1st lien mortgage at a low LTV (“loan to value”) ratio usually has downside protection.
On the fund level, it is a combination of many investments that fits this philosophy that makes the fund relatively well positioned with downside protection.
Takeaway: No fund or fund manager can ever guarantee the safety of an investment. Your research can go a long way to ensure that the necessary criteria listed above is being followed.
2. What is the Expected Return?
Like safety, returns are never “guaranteed.” Returns are projections or targets, based on the specific fund’s strategy, asset allocation model, risk management, and other factors.
Fund managers usually set a “target return” based on their mathematical projections. Prudent managers set expectations conservatively based on the “Risk Adjusted Return,” and work hard to outperform the projections. However, there are clever and unscrupulous people out there who promise high returns to attract investors without the “risk adjusted” underwriting in mind. They use the most optimistic and aggressive assumptions to come up with the highest possible theoretical returns to attract investors.
The lower the risk usually means the lower the projected payout; the higher the risk means the payout is usually greater. Finding the right balance between safety, risk, and payout is a hallmark of the best fund managers.
It is of paramount importance to focus on the “Risk Adjusted Return” instead of the top line target return.
One important comment about the Preferred Return (“Pref”): Pref is not guaranteed. Pref is simply a mechanism that gives investors seniority in the distributions before performance fees or performance split kicks in. If the investment works well, then full Pref gets paid, and the performance split kicks in. On the other hand, if the investment underperforms, then even the Pref might be underpaid.
Takeaway: Look for a fund that strikes the right balance between your risk tolerance and your desire for high returns. Many fund managers offer multiple funds from which you can find the one that meets your risk/reward criteria.
3. How am I paid?
There are two main ways funds pay investors:
- Distribute operating income on a periodic basis (e.g. quarterly), aka cash-flow
- Distribute capital gains and return capital upon sale or refinance of assets
Income focused funds usually deliver most of their return in the form of current income distributions.
Growth and income funds typically have some current distributions and some appreciation (“unrealized gains”) or future distributions upon sale or refinance of growth investments.
Growth funds normally have minimal initial distributions as most of their projects need to undergo “value-add” work and get sold or refinanced. At that time there are large distributions of capital gains and/or return of capital.
Fund Total Return = Income Return + Growth Return.
Some funds have very steady return streams, and some funds have “clumpy” returns. Most of the growth projects deliver these “clumpy” returns once the value-add strategy is fully executed and refi and/or sale event takes place.
If you are looking to invest into an income fund, history of distributions is helpful to predict future distributions, but market conditions may have an impact, e.g. “Yield Compression” environment may lower income in the future vs. the past.
If you are looking to invest into a growth fund, the history of distributions has little impact on the total return because most of the income comes on the back-end at the sale of asset(s). It is much more valuable to look at each asset of the growth fund, cost basis, value-add strategy, and the likely future value of these investments and project capital gains.
If you are considering a growth and income Fund, then you look at what portion of the fund investments are long-term value-add projects vs. current income generating deals.
Takeaway: Investing for growth strategy usually sacrifices current income to receive a greater return upon the sale of the investments. Investing for income typically is more of a “steady-eddie” strategy and historic returns may help predict future performance. Your investment capital objectives should match the fund strategy in order to be a good match.
4. What are My Tax Consequences?
Real Estate is the most tax-advantaged asset class. Some of the major benefits are:
- Depreciation
- Appreciation
- Amortization
- Cashflow
Different investments generate different type of income:
- Passive income (Collected rents minus operating expenses, minus depreciation)
- Interest Income (Interest collected on loans, e.g. fix-n-flip loans)
- Capital Gains (Sale proceeds minus cost basis)
Qualified money (IRA/401K) investors usually like interest income and capital gains, and don’t really care about the benefits of depreciation (or accelerated depreciation). Non-qualified money (non-IRA/401K) typically enjoys the depreciation benefits as they reduce taxable income.
Real estate professionals may greatly benefit from investments with accelerated depreciation as they can deduct “passive losses” against their current income. Non-real estate professionals too might enjoy “passive losses” if they have “passive gains” from current income generating investments or sale of appreciated assets generating capital gains.
Broadly diversified funds may combine many assets that generate different types of income, while some other funds have a focused investment strategy generating only a single type of income. Generally speaking, having a good real estate CPA will make a big difference in helping you make the right investment decisions.
Takeaway: If this section sounds vague, it is — purposely. The point is to always talk to your CPA about the tax consequences of any investment. Most funds managers are not CPAs and should not give you tax advice. They should be able to explain to your CPA what assets the fund invests in and the likely tax consequences, but your CPA should be the best source of tax advice.
5. How Liquid is my Investment?
Most open-ended funds have a lock-in period during which any funds you invest cannot be withdrawn except for specific emergencies. The lock-in period for many real estate investment funds is at least two years. Some are shorter, and some are longer. Redemption may or may not be available even after the end of the lock-in period if there are adverse market conditions impacting the fund (e.g. COVID-19) cause liquidity to dry up.
Most close-ended funds have no redemption mechanism and so there is no liquidity until the fund completes its investments strategy and exits its assets. Normally, the fund manager will communicate the target investment time and projected exit time, say 5 to 7 years. Some assets may exit sooner, and some may take longer to sell. Market conditions could play a big role, obviously.
Fund liquidity is usually a function of the assets in which the fund invests. So, once the lock-in period has expired the liquidity of your investment — your ability to withdraw it — is tied to the liquidity of the funds. With funds that have short investment cycles, like lending on the short-term fix and flips, many times you can withdraw your investment fairly quickly. With funds that have longer-term investments, the process of withdrawing your investment can be longer.
Either way, when you request to pull out some or all of your investment, and the lock-in period has expired, if cash is not readily available from the fund, you are placed in a queue and your money is withdrawn when it becomes available.
With a close-ended fund, you may ask the fund manager to find another investor to “step into your shoes” if you need the liquidity. However, the new investor may or may not be willing to pay you the full value of your investment plus accumulated preferred return. Assuming there is a willing investor to take your position in the fund, it becomes a negotiation and typically requires fund manager’s approval as well.
Takeaway: Know the lock-in period (open-ended fund) or fund life-cycle time (close-ended fund) for your investment, and be comfortable that the types of investments made by the fund coincide with your future cash needs should you need to pull some or all of your investment.
Reach out to me at Mike@TempoFunding.com or by phone at 917-806-5029 if you want to learn more about investing with us. You can also schedule a time to chat via bigmikecall.com.
Also, be sure to check out my latest podcast episodes:
Ep 070: The Points of Interaction with Multi-Family Acquisitions
071: The Stigma of Section 8 and Government Checks With Fuquan Bilal
Thanks for reading,
Mike Zlotnik
CEO, TF Management Group LLC
This newsletter and its contents are not an attempt to sell securities, nor to sell anything at all, nor provide legal, nor tax accounting, nor any other advice. The presenter is a private lending and real estate fund management business, and the information represented herein are purely for educational purposes and represents the opinions of the presented. Prior to making any investment or legal decision you should seek professional opinions from a licensed attorney, and a financial advisor.
TF Management Group LLC (TFMG) is an investment fund management company that specializes in both short-term debt financing for real estate “fix and flip” projects, and long-term “value-add” equity deals.
