February 4, 2021

JF2347: Pros and Cons of Passively Investing in a Fund vs Individual Deals | Actively Passive Investing Show With Theo Hicks & Travis Watts

Today Theo and Travis will be talking about being a passive investor in fund deals and individual deals. They’ll be discussing them from a factual point of view. Hopefully, this detailed comparison will help you figure out which deals are right for you and your real estate business. 

We also have a Syndication School series about the “How To’s” of apartment syndications and be sure to download your FREE document by visiting SyndicationSchool.com. Thank you for listening and I will talk to you tomorrow. 

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Theo Hicks: Hello, Best Ever listeners and welcome to another episode of The Actively Passive Investing Show. As always, I’m your host Theo Hicks, as well with Travis Watts. Travis, how are you doing?

Travis Watts: Hey, Theo. Hey, everybody. Happy to be here.

Theo Hicks: Yeah, thanks again for joining us. And Best Ever listeners, thanks for tuning in. Today, we’re going to be talking about investing in real estate, individual deals versus funds. So as a passive investor and you’re working with a sponsor, is it better to invest in a single deal one at a time, or to invest in a fund? So to learn more about what investing in a fund actually looks like, versus a deal, logistically, we have a blog post on the website you can check out, called Passively Investing in Apartments, Fund, or Individual Deals, where we talk about the different types of funds and things like that. But today we’re going to focus more on the pros and the cons of investing in a fund, versus individual deals. So before we jump into those, Travis, anything you want to mention?

Travis Watts: Well, Theo, I think this is a very relevant topic. I’m asked this all the time. I probably would have had a different take on this five or six years ago. My perspective has even changed throughout the years. It’s something I’m asked all the time. You see a lot of these more maturing companies in the syndication space, a lot of them are going towards the fund structure just because they have the reputation, the connections, the deal flow, the ability to raise more capital… So it’s definitely worth checking into and asking yourself the question whether it’s right for you. We’ll try to hold back on opinions, at least until the end… But this is more of a factual pros and cons conversation.

Theo Hicks: Perfect. So let’s jump into the first pro, or con, or advantage, or difference between the two, and that would be the time commitment. So here we’re talking exclusively upfront. So when you’re investing in a fund, you invest your money, and then that fund will be used to purchase more than just one property… Whereas when you’re obviously investing in individual deals, you’re investing in one property at a time. So if you were to invest in, say, ten deals — or let’s use five deals, you can invest in one fund and invest in five deals without, having to continuously qualify multiple deals, qualify multiple sponsors, search around for deal flow, hope for deal flow. You’re going to say, “Okay, this sponsor is a fund, they’re going buy five deals. I’m going to invest in this fund.” And depending on how it’s structured it might be a one-time investment that goes into all five deals. Each deal comes in, you invest an additional amount of money to increase your investment. But overall, it’s more of a, “Hey, here’s a sponsor. He’s doing the fund. I’m going to invest.” As opposed to, “Oh, here’s the sponsor. Here’s one deal. I’m going to invest now. Oh, here’s another sponsor, I’m going to invest in their deal. And this deal, and this deal…” And having to do all that due diligence, which is not the same level of due diligence as a sponsor is doing, but still, it’s a bunch of [unintelligible [00:06:05].13] you need to read. So it’s going to be some ongoing time commitments as well, which we’ll hear about in a second or later on in this episode. But I think that’s one of the major advantages of the fund, is that from your perspective, it’s a lot less of a time commitment to invest in the same number of deals.

Travis Watts: Absolutely. Great points. I think what I want to cover first is the element of diversification. One of my favorite topics, one of the biggest reasons I became a full-time LP investor – and I’ll share with you a quick story of why that is. A couple of things happened in my life in my 20s. One was, I had this overly ambitious goal that I bought the single-family home that I was living in as an owner-occupied residence, and I wanted to pay it off. It was a pretty good deal, so I had a pretty low basis in this property, and I thought, “Man, I’m just going to go hard with this.” And I was hell-bent on just paying that thing off.

So when I finally did that and accomplished that, I had my little moment of celebration, and then two days later, I thought, “What if a tornado hits this house? What if a flood happens? What if this thing starts having foundation problems?” It was a 1932 house, it was very old, out in Denver. And I thought, “I don’t want to have this much equity tied up in one thing.” And I got to thinking about the opportunity cost of having that much capital in one place that I couldn’t otherwise go invest. So long story short, I went out and I got a HELOC, a home equity line of credit, I ended up just doing investments instead. And I essentially just remortgaged the house. So diversification played a big role in that regard.

The other thing was, for those that know my background, I had a lot of single-family rentals out in Colorado, and I had a lot of equity in each one, as that market was driving up rapidly at that point from 2010, 11, 12, 13, 14 etc. And I just got uncomfortable with having that much equity in one location in a 30-mile radius, all in the same asset type. So that led me to discover what the syndication stuff was all about, and the ability to diversify, not only your capital, where you’re putting 25k here and 50k there, and this kind of thing, but in different regions, different demographics, different sectors, different sponsorship groups. So it sits well with me. That doesn’t make it right for everyone. Not everyone is of the mindset of valuing diversification, and rightfully so. Some folks have made multi-millions just focusing on one little niche and putting all their money there. So that’s just my take on it.

So the first topic here within diversification would be, as I mentioned, your capital diversification. The ability to spread out your risk in terms of your dollars and putting them in different deals. The way I look at funds in the syndication space versus individual deals is – I guess you could draw a parallel to index fund investing in the stock market, where you’re buying the index where you have a bunch of stocks in it, versus picking your own stocks. And for anyone that’s really read through statistics, very few people are successful at picking their own stocks and outperforming the overall market sector. So that’s kind of how I look at this, too. And I mentioned earlier that if you’d asked me about six years ago about funds versus individual deals, I probably would have said I prefer individual deals, because I want to choose which one I want to put money into. But in my experience, some are winners and some are losers. I didn’t always pick the best deals. When a sponsor has five deals a year to choose from and I choose one or two, sometimes you get a home run and sometimes you get half the return you were expecting. So a fund allows more of a blend there.

But here’s another thought too, in terms of a minimum investment. Anyone who’s been an investor in the private placement sector knows that a common minimum investment could be 50,000, it might be 100,000. And you’re talking about one deal. So if you go do 10 deals, you might be having to put up a million dollars just to get in the 10 deals that way. In a fund, the minimums often are the same; it might be 50k, it might be 100k, but there might be 10 deals within that fund. So you can spread your risk with a lot less dollars. If you do the math there, you might be putting $10,000 into 10 deals, for example. So it’s just another way to spread risk. It really comes down to you, how much money you’re looking to put to work. If you have 10 million dollars to put the work. Yeah, different story, right? But if all you have is 100k, this might be an advantage, to you to partner in a fund, potentially.

And the last thing I’ll mention here… Well, two quick notes. Geographic diversification I alluded to; there isn’t one perfect market. And markets are changing all the time, right? Businesses are moving around, people are migrating to different places, the political scenes are changing… So it’s nice to be able to place bets on several different markets that you’re a fan of, instead of like I was years ago, all up and down the front range of Colorado, between Fort Collins and Denver. If anything politically had changed there, or they said taxes are going to double, I would have been kind of screwed, right? So it’s nice to place your bets elsewhere.

And then sector diversification. What I mean by that is, depending on the fund and depending on the sponsorship group, there are different sectors, right? So you could be in mobile home parks, you could be in self-storage, you could be in multi-family, you could be in office and retail, in all these different sectors, which is really nice too, for the same reasons that I just pointed out – things change, things evolve, and maybe one day one of those sectors looks a lot better than the other. So it’s nice to be able to diversify that way. So that’s really all I got on diversification. But that’s the meat of it for me in terms of funds, is being able to diversify.

Theo Hicks: Yup, that’s definitely one of the main advantages. And kind of going back to what you’re saying about if you have $100,000 as a minimum, and you want to invest in 10 deals. That’s a million dollars in 10 deals. And kind of going back to the time commitment thing, right? You have to find all 10 deals, and hope you pick the right ones. Whereas you can still invest a million dollars in 10 deals, it’s just now you can do it one time, and then invest $100,000 and see what comes in, increase the amount without having to find the new deal, do a bunch of due diligence. So yeah, that kind of plays into the time commitment part.

And then obviously, the reduction of risks is also huge as well, because you’re diversified, as you mentioned, across multiple deals. So if you said a sponsor has five deals, some are home runs, and if I pick the strikeout, then I’m in a bad spot. So if you invest in those same five deals, all of them in one fund, then the home runs could offset the strikeouts or will outperform the average, which is good. But it also comes down to, [unintelligible [00:13:00].11] but a potential advantage (keyword being “potential advantage”) that investing in individual deals has is the upside potential.

So if an investor has 10 deals and two of them perform really, really well, and you happen to pick that deal, then you’re going to have a higher return than if you invested in all those 10 deals in the fund, and two of them are home runs, maybe two of them were strikeouts, and the rest were average, right? Then you would get the average return. So the really good ones will average out, the really bad ones and get an average return. So again, this is kind of pretty standard though for investments. The less risk involved the less the potential upside is going to be. But again, it depends upon the fund. Because if you’re investing in a fund where you do participate in the upside on sale, then is still going to get upside. It’s just if one deal does amazing, you’re not going to have an amazing return, because it’s going to be offset by the other returns.

As Travis mentioned, it kind of depends on your level of risk. So if you only have 100 grand to invest, there’s much less risk to invest in a fund than to do hoping you’re selecting the right deal. If you got $10 million, you’re trying to double that money, then taking a portion of that and investing in individual deals might be fine.

Something else we have in this list is reporting, too. So I’m sure Travis knows this as well, but when you’re investing in five, 10, 20 deals, especially if they’re spread across multiple sponsors, you’re getting emails constantly with updates on these deals. The format obviously is different, the information included is different, when you’re getting the reporting, the financials for each sponsor might be different, for each deal might be different… Whereas when you’re investing in a fund, most of the time the sponsor is going to have just one email for however many deals are in that fund. The format is going to be the exact same every month, every quarter. The reporting is the exact same every month, every quarter. And that kind of goes back to what I was mentioning earlier about the ongoing time commitment, where you’re not having to balance 20 different emails, 20 different investor reports… It’s just one email with the performance of the fund, any extra information that the sponsor decides to include about maybe the individual deals… But it’s still going to be in one location, which is definitely going to save you a lot of time and headache.

Travis Watts: One thing I’ll add to that as well – you’re absolutely right on the emails. Hence the Actively Passive Show, right? You get in this thinking, “Oh, I’m a passive investor” and then all of a sudden, you’re reading reports and T12s all the time. And one other thing is K1’s. This is the tax form you get in a real estate partnership most of the time. And when you’re doing individual deals, you’re going to get one K1 tax form per deal. So for me, I have a ton of K1’s. And every year my CPA just looks at me and hands me a higher quote, because it’s a beast. You’ve got to keep track of all your bases, and your carry forward losses, and all this stuff. I have so many K1’s.

When you’re in a fund, depending on how it’s structured, you might just have one K1 statement, even though there may be 10 different properties inside the fund. That can be a huge time-saver and a cost-saver too. So just a side note on that.

Theo Hicks: Yeah, and kind of on that same note, the paperwork upfront as well, right? When you’re investing in a fund that’s going to buy 10 deals, 20 deals, assuming some of you are going to invest one time and then not add extra investments later, it’s just one set of paperwork, right? You fill out one PPM, you get qualified as an accredited investor one time. Usually, it might vary. I’m not an attorney, I don’t work for the SEC, but just generally speaking, the paperwork is a lot less, as opposed to having to sign and fund 20 different pieces of paperwork.

Travis Watts: Yeah, and with that also is the accreditation stuff. If the group’s doing the 506(c) stuff, you have to be third-party verified. And every 90 days those letters are expiring. So as you’re going throughout the year, it’s like a quarterly thing. “Oh, I’ve got to go get another letter of accreditation again to go do this deal.” And it’s a headache. It is active, and it does take several hours of your time. So it’s just something to think about.

Theo Hicks: And then I’m going to do the natural transition to the next thing we’ll talk about, I guess the last thing we’re gonna talk about, which is why do sponsors do funds? What are the benefits to the GPs, general partners, and managers of the fund? And one of them — I’ve just mentioned paperwork, right? And so instead of having to create an LLC for every single deal, and multiple PPMs, and all that paperwork, they can just do it one time. One PPM for the fund, and then that’s used to buy individual deals, as opposed to having them do that each time. I’m sure there’s definitely going to be paperwork for each individual deal, but it’s much less for each deal when you do it upfront for the fund.

And then something else that is a benefit to the sponsor is the fact that since it’s a fund, they have a much better understanding of the amount of capital they’re going to have to invest.

So behind the scenes, whenever the sponsors are negotiating deals, one of the things that the sellers want to know, the lenders want to know, the brokers want to know is how are you going to buy this thing? How are you going to raise the capital? So obviously, having a track record of closing on deals is important. Being able to show them that you qualify for the net worth and liquidity requirements is important; but the actual downpayment, where’s that coming from? You’re not going to have passive investors giving you money on an individual deal until it’s under contract, until they’ve reviewed the investment summary, seen the conference call… And then they’re going to send you the money. Whereas the fund, you start raising capital sometimes before you even have a deal. You might start the fund with a deal, it all depends… But you need to have commitments. So when you’re talking to brokers, lenders, sellers, you can say, “Hey, I’ve got this much money in commitments already.” All you need to do is do the capital call. Or if they funded it already… It kind of depends on how it’s structured.

Much more confidence from a seller’s perspective if the buyer is doing a fund, as opposed to having to raise capital… Because what happens if they can’t do it? What happens if something happens and investors don’t want to fund the deal anymore? Whereas with the fund, they’ve already signed the paperwork. So they might not have actually put the money in there, but they’re legally obligated to — from my understanding — to invest. And there’s also the advantage that comes from the revenue coming in to pay the people involved with the fund. So since they’re getting the money sooner, they can use the fees that they collect… Because usually there are fees collected based off of the amount of money that’s invested. These fees can be used to pay themselves, to pay the people on the team that is involved in making sure the fund is maintained.

And one last thing I want to mention, because we have talked a lot about how great the fund is and you did talk about the benefit of the individual deal for upside… Something else that’s important too is that you’re not going to be a newbie sponsor doing a fund. You need to have a track record. So funds are good for sponsors who are already established, whereas — why doesn’t everyone do a fund? Well, they can’t. When you’re just starting out, you’re not going to be able to create a 10 million dollar fund. It’s more of a grind on each deal to raise that capital. But once you’re established, once you have a track record, once you have a large database of passive investors who trust you, then you can be confident that you can hit that funding goal, so that you can buy those deals. So I think that’s key, because — that’s why every single GP isn’t doing a fund… It’s because they can’t.

Travis Watts: That’s a great point. And that’s kind of one of those observations, right? As an LP investor, you see a company that’s doing funds, or a fund, and maybe that suggests that okay, you have the reputation, the track record, the experience to pull this off… Especially if it’s fund two, three, four, five etc. I’m always trying to catch the wave with these groups, so to speak, before they get so big that they’re not taking investors anymore, they’re relying on their returning investors, or they’re going to go public, or whatever they’re going to do; take institutional capital, whatever. So I’m trying to hit that threshold where these companies are getting big enough to do a fund, but they’re not so big that they don’t really need you at this point. So that’s kind of a strategy side note.

So I think overall, I’ll bring this up one more time, because I think it’s important to draw the parallel between the mutual fund, the ETF, the index fund stock investor wanting the diversification, wanting to participate in the overall returns of the market, versus the individual that says, “No, I’m going to pick my own stocks. I know best, and whatever.” And rightfully so, maybe. And that’s kind of what this comes down to is who are you as an individual, and what is your risk tolerance? If you’re looking for only choosing the home runs because you think you can identify that, then individual deals make a lot of sense in that regard, as you pointed out.

And a lot of people too, by the way, a lot of people investing in syndications are just busy professionals. We’ve mentioned this over and over – the doctor, the dentist, the lawyer, attorney, pro athlete, entrepreneur. They’re busy. So if you don’t want to take up 12 months of your time working with all these operators and trying to cherry-pick the best deals that you can find in all of this, if you just want to say, “Look, here’s 100k, you go do the work for me, and update me monthly, or whatever”, then funds can also make a lot of sense; as you pointed out, the time commitment element to it.

And another great thing you pointed out Theo, is that maybe a hybrid of the two strategies makes sense. Maybe there’s that one, two, or three deals that are out there that you think “Oh, man, that just seems so great. I want to be part of that deal.” But then, generally speaking, I’ll just invest in various funds, maybe in different sectors as well. So you’re participating in a lot of different ways.

So think of those parallels… I think there’s a lot of advantages to funds. The more we go through this real estate cycle that we’re in now, the more we’re in COVID, with all the unknowns, the more I personally like the idea of a fund structure myself. But that doesn’t mean that that’s right for everybody. That’s just my take. And as you know, at this point, I really value diversifying. So that’s my biggest takeaway.

And one last thing I didn’t mention earlier about markets, just real quick, is that markets – they’re changing all the time. Right now you’re seeing Tesla, and Oracle, and HP – they’re leaving California, they’re moving to Texas. Everyone seems to be moving to Texas. Well, that’s great right now and for the foreseeable future. But what about in 20 years? What if in Texas they say, “Well, we’ve never really had a state income tax, but now we are going to have one and it’s going to be 10%.” A lot of people are going to be exiting Texas. So one thing to kind of drive that point home, one thing I always look at is the lifecycle of the business plan. And five years to me is kind of a sweet spot. It’s much easier to predict what may happen in a particular market over the next five years than it is to go into a deal indefinitely, where you might be holding it for 20 years. Who knows what the world looks like in 20 years. So something else that’s part of your own criteria that I always talk about – know your criteria, know your risk tolerance. But in a nutshell, that’s kind of my take on funds versus individual deals.

Theo Hicks: I highly recommend checking out that blog post we have at joefairless.com, Passive Investing in Apartment Fund or Individual Deals, because there are different types of funds. And the funds can be structured in any number of ways. So it’s important to understand not only the high-level overall, what are the differences between individual deals and funds, but getting more detail on what are the differences between the different types of funds, right? The evergreen funds versus the closed-ended funds. We go in that in that blog post. We kept it high-level here. If you want to go into more details, check out that blog post we have at joefairless.com.

And then we also at the end give a breakdown of the funds and individual deals to kind of try to summarize what’s ideal for you, and not what’s absolutely universally better, but based off of what your risk tolerance is, where you’re at in your investment career, what’s the better investment for you. And I also liked how you said, “Or you just do both.” You can just diversify across — there’s diversification in funds, but it also diversification between funds, between funds, and individual deals… So there are multiple ways to get diversification, so I’m glad you added that.

So that’s what we have today for funds versus individual deals. Travis, anything else you want to mention before we close out the show?

Travis Watts: No, I think we hit it pretty good.

Theo Hicks: One thing I want to mention… Travis and I are going to start doing a new 60-segment that we’re going to post to the Actively Passive Investing Show on YouTube. And we’re going to answer your questions. So if you’ve got any questions about what we talked about today, what we’ve talked about in the past, or anything related to passively investing in apartment syndications, the best way would be to email me, theo@joefairless.com or in the comment section of however you’re listening to this. Submit those questions and we will read your name aloud on the show and we will answer that question for you.

Travis Watts: Alright, very good. Thanks, Theo. Thank you, everybody.

Theo Hicks: Yeah, so everyone, thanks for tuning in, as always. Travis, it’s always great to get your wisdom on these topics. Best Ever listeners, have a Best Ever day and we’ll talk to you tomorrow.

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