ARTICLE
28 August 2021

How To Invest In Real Estate If You Know Nothing About Real Estate

DS
Duval & Stachenfeld

Contributor

Duval & Stachenfeld
One of the things going on today is that many investors would like exposure to real estate but – being honest with themselves – don't know how to determine where to invest or how to assess risk and reward.
United States Finance and Banking

One of the things going on today is that many investors would like exposure to real estate but – being honest with themselves – don't know how to determine where to invest or how to assess risk and reward. Of course, they could buy a public REIT but would have no real ability to value the REIT or what it owns. They could invest in a deal but are logically afraid that they really have no way to tell if it is a good deal or not a good deal.

One conclusion is to ignore real estate as an investment class, but with stocks racing to the moon and bonds yielding almost zero, there is a dangerous risk/reward profile to both asset classes, and real estate stands out as one of the few alternatives where the risk/reward profile may make a lot of sense.

I can't help you with public company investing; however, here is an outline of how you could invest in private real estate in a manner where you can manage your lack of underlying real estate knowledge but still end up with an intelligent risk/reward profile. The steps are as follows:

First – don't try to make money – instead, focus on not losing money. This may sound like sophistry, but trust me, it is not. I have watched many come and go during my long time in the real estate business, and those who tend to last over the long-term invariably think this way. They don't swing for the fences, but they never strike out either.

Second – don't waste your time trying to pick real estate or the real estate markets. You can't do it, and even if you try, you are competing against players who both (i) know the market deeply and (ii) have likely been doing this for many years. You are the sucker at Warren Buffett's poker game if you try.

Third – don't listen to pitches until you follow these remaining steps. By the way, this includes your brokers, wealth managers, and similar parties.

Fourth – take a deep dive into the party to whom you will be giving your investment dollars. Assess very carefully whether they have both

  1. A long-term track record that is clearly disclosed to you. This should be a minimum of 10 years and hopefully more like 20 years or more. Make sure the disclosure is clear and complete; and
  2. Deep expertise in the specific asset class in which you are investing.

As you evaluate the track record, assess whether the sponsor got lucky with one big deal that skewed his results or whether it is consistent that this sponsor just about always walked away with upside and an outcome that was at least moderately successful.

Fifth – do as deep a dive as you possibly can to see if there is even a single shred of dishonesty in the sponsor's background. I hate to say it but assume the worst. If the sponsor was accused of something in a lawsuit, it is not worth hearing the explanation – just move on. There is an old saying that a man who will steal a chicken will steal a horse. And even if the alleged dishonesty was over 20 years ago, I would still just walk away.

Sixth – assess the risk/reward profile of the investment, i.e., is it a super-safe coupon-clipper with close to zero risk and concomitant low upside. Or is it a development deal where there is development and other risk and presumably higher upside? My theory here is that you should be "overpaid" for your risk. And, of course, the risk/reward profile should be consistent with your investment goals. Hearkening back to my second point above, you are not trying to pick the real estate itself – but you are narrowing it down so that you have a risk/reward profile that is consistent with your goals.

Seventh – ask two critical questions of the sponsor:

  1. Is the sponsor putting real skin in the game? This means that you want to know – very clearly – how much actual investment dollars are being put into the deal by the sponsor's principals. This does not include his friends but can include his wife/husband, kids, and close family members. Be vigilant here that the sponsor might be saying he is putting in, say, $500,000 but might also be getting a $500,000 acquisition fee at closing, which means his risk is zero. The bottom line is that if the sponsor is not risking significant dollars on the deal, then you would be foolish to do so; and
  2. How is the sponsor being treated differently from you economically? Of course, the sponsor should have a better deal than you as, after all, he found the deal, is putting it together and is doing all the work. The question is the degree to which the sponsor is treated better than you. This is a judgment call you have to make. As you assess it, consider the fees the sponsor gets and the so-called promote (i.e., additional upside the sponsor gets for a successful deal). Consider if the deal turns out to be a dud or a 'blah' performer in the future, but the sponsor is still doing just fine by pulling out fees while you are pulling out your hair in frustration.

Eighth – don't put all your eggs in the same real estate basket. Even after doing the foregoing, there is a luck factor that you cannot quantify. So if you have, say, $1M to invest, break it up into four or five investments of $200K to $250K each.

To conclude, while it is very difficult to invest in any asset class in which you don't have deep knowledge if you invest by adhering to these guidelines, I propose that you have your best chance of success. You will have:

  • A high-quality sponsor
  • Doing what she does best
  • With very aligned interests
  • Across multiple transactions

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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