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Evaluating Passive Real Estate Investments-

TICS (Tenants in Common), 1031 exchanges, REITS, Real Estate Mutual Funds, LLCs, Limited Partnerships. The types and number of passive real estate investment opportunities are exploding. And as proclaimed by their sponsors, these investments can offer the benefits of diversification, professional management, access to “A” type properties, and potential high returns as a passive investor. But how does the investor determine which investments merit his attention, and which should be eliminated outright?

The first item to evaluate is the issue of fees. The investor needs to determine exactly how much of his investment is going into real estate and how much is being eaten by fees. The larger the percentage of his investment actually purchasing the asset, the greater the chance for a good return and the less the chance of taking a loss. As an extreme example, if 20% of the investment is eaten by various fees, and only 80% of the investment is actually invested in property, the investor faces a 20% loss of capital as soon as he makes the investment. Additionally, only 80% of his capital is working to earn income or appreciation. This is a huge amount to make up just to get back to break even.

Types of Fees

Front End Fees- These are the fees that are taken out of your investment before the money is invested in any real estate or asset. These can include organizational fees, sponsor fees, commissions to investment advisors, legal fees, accounting fees, underwriting fees, reimbursements to sponsors or any other fees you can imagine. These fees are transparent and usually listed in the prospectus or private placement memorandum. If these fees are greater that 10% I would eliminate the investment from consideration outright. I look for front end fees of less than 5% to make a deal worthy of consideration. Ideally I’d rather pay no front end fees and have 100% of my money invested in the property. This is possible if the sponsor sells directly, has no selling expense and is willing to take his profit on the back end when the investment is sold or as the investment earns current income. Although “no front end fee” arrangements are rare, some sponsors do offer them. These deals will have the best chance of success.

Hidden Fees- These fees are not accounted for separately. They are often “hidden” as part of the purchase price of the property or as part of an ongoing expense. A thorough reading of the prospectus will usually uncover these fees. An example of a hidden fee would be when the purchase of the property has already been completed and the fund is repurchasing the property from the sponsor at a higher price than the sponsor paid. The sponsor might also obtain a percentage of the property ownership for himself while having the investors pay all acquisition costs. If the fund is paying a commission to a real estate broker to represent itself in the transaction, then this is also a fee which must be evaluated. In summary, any money paid by the investors and not directly going to the original seller to purchase the real estate or the asset is a fee or expense which must be “earned back” by the investment before the investor can get to break even, let alone profit on the investment.

Ongoing Fees- Ongoing fees are fees paid by the investors on a continuing basis usually from the ongoing income produced by the asset. These fees can be structured a number of different ways. The sponsor may receive a straight percentage of the current income, a percentage after the investors receive a preferred return, or a fixed fee to “manage” the operation. These fees should not be confused with property management fees which are fees an investor would pay for property management whether he had invested directly or through a passive investment entity. Of course, if the sponsor is the property manager, and the property management fee is greater than the fee charged in an arms length transaction, than the excess must be accounted for in the evaluation. Other ongoing fees would include yearly legal fees, accounting fees, directors payments, etc.

Back End Fees- Usually charged when the asset is sold or as a percentage of the “profit”. Other back end fees are real estate commissions paid to brokers to sell the property, points paid to mortgage brokers to obtain a mortgage on the property, and “dissolution” fees associated with the ending of the investment entity.

In any passive real estate investment, the sponsor must be provided an economic incentive for the promotion, management and risk of handling the “deal”. However, it is important for passive investors to know what they will be paying for these services. Many of these fees are difficult to quantify since they may be charged as a percentage of some profit number realizable in the future. Others may be stated as a percentage of ownership interest. To do a proper evaluation the passive investor must look at all fees under all likely scenarios and determine exactly how much extra in fees the investment is costing him. If the investor does not have the knowledge to accurately make this determination, professional analysis is available by CPAs, Real Estate Counselors, and Financial Analysts.

Look for my next article on Evaluating Passive Real Estate Investments where we will discuss alignment of interests between the investors and the sponsor.

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