My Real Estate Money Machine, Part 1

by: Samuel Smith


I allocate more of my portfolio to real estate than any other area due to its promise of providing an inflation-hedged income stream.

I allocate half of my real estate portfolio to publicly traded REITs and the other half to non-traded, private market investments in order to capitalize on the advantages that each platform offers.

Are you paying a liquidity premium?

As outlined in my recent article - An All Weather Income Portfolio For Financial Independence - I allocate more of my portfolio (30%) to real estate than to any other asset class. Why? It enjoys a natural moat through its limited supply and its irreplacibility as a basic necessity for life and business; it enjoys a long history as an effective way to preserve and grow wealth over the long term via rental income and hedging against inflation. By splitting my investments between publicly traded REITs and private market real estate investments, I believe I have created a highly diversified and effective money machine with strong potential to compound wealth for decades to come.

Private real estate investments - which are now easier for the average investor to access than ever before - offer a unique opportunity to operate outside of the restrictive bounds of "Efficient Market Hypothesis" enforced by the tens of trillions of dollars in annual stock market trades executed by increasingly well-informed and algorithm-driven investors. These alternative markets are ripe with opportunities for outsized profits due to their less efficient transaction structure and limited availability of public information. These factors create significant barriers to entry which in turn leads to far less efficient pricing. Investors with a competitive edge gained via experience and knowledge in particular real estate sectors and geographic markets can exploit these opportunities to consistently beat the public markets.

In the past, these opportunities were only available to individuals who were either willing to become landlords themselves, or accredited investors who would invest in selectively private REITs. However, with the recent passage of new regulations, non-accredited passive investors now have access to this market through an increasing number of real estate investment companies targeting these markets. Not only do these companies offer the "average Joe" the opportunity to own income-producing private market real estate passively, but they also create additional opportunities for alpha by pooling together tens of millions of dollars from hundreds and thousands of investors in order to acquire higher value, higher quality deals that previously were available only to institutional investors.

Furthermore, since these investment consist of direct real estate purchases with investor funds, there is no bidding up of share prices to levels above the book value of the underlying real estate in the investment fund as is typical of publicly traded REITs. Another way of describing this phenomenon is as a "liquidity premium": investors are willing to pay extra for the convenience of holding highly liquid publicly traded real estate investments rather than park their cash for 3-7 years in a fairly illiquid private market real estate investment. As a result, these private market deals often offer higher income yields and higher overall returns over the long term.

Additionally, these buy and hold investments offer the psychological benefit of not being bombarded with daily volatiility in share prices and the accompanying temptation of selling too soon either after a quick bump in share prices or after a significant market decline unrelated to the performance of the underlying real estate in the REIT. Many of these investment companies also offer real estate backed loans as a further way to diversify and enhance a portfolio's income yield while moderating risk levels.

I currently invest funds in several different non-traded real estate platforms, including Fundrise, Realty Mogul, Rich Uncles, stREITwise, Medalist Diversified REIT, Impact Housing REIT, and Groundfloor. Each of these platforms offers its own unique benefits, so I invest in each in order to lock in maximum diversification while enjoying the benefits of each.

Fundrise - my largest holding among these options - offers seven different REITs and funds diversified across the United States, primarily targeting single family and multifamily properties as well as construction loans and preferred equity. The Income REIT targets maximum income (as per its name) through real estate loans and preferred equity, paying out ~10% in dividends in 2017. Three regional REITs (East Coast, Heartland, and West Coast) offer a more balanced investment approach between multifamily investment properties and preferred equity and loan investments, yielding ~8% while also offering upside potential via property appreciation. Fundrise also offers a Growth REIT which targets value add multifamily investment opportunities as well as several "eFunds" which focus on aggressive capital appreciation via fix and flip and single family home development projects in major metroplexes.

One of the best features of this investment platform (besides the user-friendly nature of the website) is the ability to easily diversify investments between the seven different REITs/eFunds through a structured allocation model based on whether you wish to target more income or total return. Personally, I take the balanced portfolio approach in order to enjoy maximum diversification between debt and equity investments as well as a healthy balance between income and capital appreciation returns. Annual investment fees total ~1% of assets under management, which is higher than many ETFs, but significantly cheaper than many mutual funds, particularly when you consider that you are paying for the company's expertise and property acquisition and management skill in navigating a private market. Through approximately a half decade of operating history, the company has averaged total returns above 10% across its investments, including ~12% this past year.

Realty Mogul offers two REITs: an income focused investment that pays out an 8% annualized monthly dividend from commercial (primarily office and retail buildings) real estate debt and preferred equity holdings, and an equity focused fund that invests in multifamily properties and targets annual returns in the mid to high teens. Though their fees are a bit higher (~2% annual asset management fee) than Fundrise's, and I haven't been wowed by any superior performance, these funds do offer additional diversification through exposure to office real estate loans as well as monthly dividend payments (vs. the quarterly payouts from Fundrise).

StREITwise, apart from its corny name, only holds one property currently in its Office REIT. However, it is a pretty stable one: the Panera Bread HQ building located in St Louis, Missouri. Currently yielding 10% for an equity REIT along with the lowest fees of any of these REITs as well as a solid management performance history, the lack of diversification is a worthwhile risk to take to have this property in your portfolio.

Rich Uncles employs a NNN structure to their national commercial REIT. With monthly dividend payments at a 7% annualized rate while only using 50% leverage on high quality properties with credit-worthy tenants, their conservative business model and investment approach is certainly admirable. Additionally, their management also boasts considerable experience in the industry and the company's shares appreciated 5% in 2017, bringing total returns north of 12% for the year. While this NNN REIT certainly offers superior yields to a popular monthly-paying publicly traded NNN REIT (Realty Income (O)), the operating history is very brief (only 1 and 1/2 years), so investors should proceed with caution when approaching this investment.

Crowdstreet offered its first two investments to non-accredited investors this past year: the Medalist Diversified REIT and the Impact Housing REIT. The Medalist Diversified REIT offers exposure to 4 core property types (Anchored-Retail, Industrial/Flex, Multi-family and Limited Service Hotels) across key markets in North Carolina, South Carolina, Virginia and Georgia. Management has a highly successful track record and is paying out a 7% annualized quarterly dividend while targeting a total IRR between 13% and 15%. Perhaps the biggest red flag with this investment is that leverage is very aggressive at 75%, putting its risk potentially above its reward potential. However, I still maintain a position in the platform due to the diversified position in high growth markets and the strong dividend yield, and after an initial conference call with management and looking at their past successes in similar operations, I am confident they have the capability and contacts to successfully execute their strategy while mitigating risk.

The Impact Housing REIT targets value add opportunities to poor quality multifamily housing in metropolitan areas in an attempt to make a positive impact on inner city communities. Aside from the social benefit of investing in a difference-making fund, management boasts an impressive record of acquiring and transforming over $3 billion in multifamily properties since 2001 while and raising approximately $260M from private investors. Perhaps even more impressive, they boast a return profile of 8.55% annual cash on cash, and IRR of 24.74% on 28 projects containing 40 properties. While their 80% leverage profile is also very high, their history of results and community impact make them investment-worthy for me.

Investor Takeaway

For investors looking to add some alpha to their real estate portfolio, there are now an abundance of opportunities to do so. In addition to the potential for higher dividend yields and greater overall returns, these platforms offer additional diversification away from richly valued public markets while also making it easier to "stay the course" during economic volatility. For long-term buy and hold investors, it simply makes sense to invest in a fund that discourages investors from frequent trading (though you can in most cases withdraw funds early, but will have to pay a small fee) while also offering superior returns through the lack of a liquidity premium.

Despite these obvious advantages for private real estate investment platforms, I still like to hold publicly traded REITs due to their additional diversification, enhanced transparency and accountability from their managment teams due to greater scrutiny, longer management and REIT performance track records, generally greater and better options, and to capture potentially higher capital appreciation from buying at market troughs and selling at peaks through regularly rebalancing my holdings.

In my next article, I will outline my publicly traded REIT portfolio's holdings and watch list, including names such as Tanger Factory Outlets (SKT), Realty Income (O), STORE Capital (STOR), Simon Property Group (SPG), Stag Industrial (STAG), Kimco Realty (KIM), W.P. Carey (WPC), Vereit (NYSE:VER), National Retail Properties (NNN), Ventas (VTR), Omega Healthcare Investors (OHI), Physicians Realty Trust (DOC), Uniti Group (UNIT), Starwood Property Trust (STWD), CBL & Associates (CBL), and Granite REIT (GRP.U).

As always, investors should do their own research and thoroughly examine investment prospectuses before putting their hard-earned capital to work. Thus far, I have been extremely pleased with the performance of my non-traded real estate investments and will keep you updated on this as well as my publicly traded portfolio. I look forward to hearing your thoughts and advice in the comments section below. Thanks for reading.

Disclosure: I am/we are long SKT, UNIT, OHI, KIM, WPC, STAG, VTR, VER, NRO.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.