Real Estate Private Equity Disadvantages: Everything You Need To Know

Investing in Real Estate Private Equity can be a great solution to quickly invest in all types of commercial real estate from multi-family apartment complexes to medical, office, self-storage and of course, non-commercial single-family houses while letting someone else handle all the details. Yet, there are a handful of disadvantages that you need to know about, before investing in Real Estate Private Equity.

With the diversification, tax reduction and truly passive nature, investing in Real Estate Private Equity can be quite compelling for high wage earners looking to reduce their taxable income along with high-net-worth individuals looking for an alternative to the volatility of traditional stocks and bonds investing.

In short, it can be a fantastic alternative investment to diversify your stock and bond portfolio while reducing your taxable income. With that said, Investing in Private Equity Real Estate is not right for everyone.

In our last post, we discussed the advantages of investing in real estate private equity. You can read that post here. Below, we go into the real estate private equity disadvantages and why it might not be a good alternative for certain investors.

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What are the Real Estate Private Equity Disadvantages?

So far, most of the real estate investing series discussion has been about why one would want to invest, the reasons are fairly compelling.  In fact, I’m a big believer in them, with the caveat that this can be a good investment alternative for the right person.  I stated above that it is quite ideal for someone that is looking to diversify away from the stock market.  It is a very nice complement to an investment in stocks due to its low correlation to the market.  But, let’s discuss other reasons why this would make a poor investment choice?

Non Liquid

Probably the biggest real estate private equity disadvantage is that your money is tied up for the duration of the investment.  So, you would not want to use any funds that you potentially will need in the short term.  And although many deals do end earlier than anticipated, you should never count on it.  But with the proper laddering techniques and consideration of the quarterly or monthly income that the investments generate, you can anticipate money flow, just not the entire investment.

You have to remember that your money is being used to purchase a physical piece of property, so even if they wanted to, the sponsor can’t just write a check to give you your money back. 

Most Private Equity Real Estate deals have a target timeline that you will know before entering the deal. Generally speaking the deals range in duration from 2-10 years with most being 3-5 years in length.  This means your money is completely tied up, not available during the time.  You just can’t get to it, so it’s important you are only investing money that you can be without. 

Early exits occur when a buyer wants to buy the investment property. In this case, if the General Partner feels the deal is quite beneficial for you and the partnership, the operator can take the deal, getting your original invested funds back sooner than expected along with a great return on your investment (your profit).

It’s Complicated

The Deal Structure

Private Equity Real Estate deals can be complicated. Most follow a pretty standard template structure. But the first few that you research and ultimately decide (or don’t decide) to invest in will feel quite complicated. 

You have to remember that you are literally going into business with someone as a limited partner. You are putting your faith (and hard-earned money) into believing that they can pull off what they have promised to do.  So, it becomes quite important to perform a proper due-diligence which should involve …

• understanding what they are promising to achieve
• researching their operation and history
• understanding enough about the type of properties they are planning to purchase in order to assess whether they can achieve their stated goals
• investigate the location to understand whether what they are stating seems correct

There are a lot of fantastic opportunities in this space, but there are also an equal number (if not more) terrible investments. Mostly due to operators that do not have the experience to pull off what they are promising. I plan to add a future post discussing how to evaluate a company and deal.  But bottom line, these deals are harder to evaluate than a traditional stock.

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Taxes

Along with the above complication, your taxes will get more complicated as well.  Most Private Equity Real Estate firms send a single form called a K-1 to their investors annually at tax time.  If you are a DYI tax preparer and have never looked at a K-1, it can be intimidating. The complication compounds when the deal has multiple properties scattered across multiple states.

With this said, if you are at the point where you are considering an investment in these types of deals, you probably have a good tax preparer and K-1’s are simple for them to handle.  Also, note that if you are investing in a lot of these deals, it is quite reasonable for your tax preparer to charge you additional for the added work.

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Less Control

This was mentioned as an advantage above, but can be considered a disadvantage.  As a passive investor you are a silent partner in the investment.  You have very little control over how the firm runs the company. Although this means you are truly a passive investor, freeing up your time to handle other matters, for some it can be nerve wracking to not have a say.  This is very similar to investing in the stock market, where you invest in a company, but have very little control as to how they run their operation.  Obviously as a shareholder you do have a vote, but it is limited.

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Less Regulation

The majority of these investments are grouped under the SEC rules of Regulation D 506(c).  These rules govern how Private Equity Real Estate firms can raise money from private investors.  They have different regulations than a publicly traded company in the stock market. What this means for you is that they are technically more risky because they have more freedom in terms of regulation.

As a result of this, it is more important for you as a potential investor to properly vet the firm before investing.  Over the years, I have found a few truly fraudulent sponsors, and many incompetent ones where they just don’t have the experience to run a real estate operation.  And, as a result, your investment return suffers. 

The bottom line here is that you can’t assume just because they are complying with federal and state regulations that these companies are competent at what they do. You need to be wary of their claims.

Accredited Investor

Because of the lack of regulation, one of the requirements set forth by the SEC is that these types of investments are only appropriate for Accredited Investors. 

What is an Accredited Investor? Basically this means that you have a certain level of income or net worth, and the sponsor must confirm this.  You must also be a “sophisticated investor”, which ultimately means you understand what you are investing in and agree that it is a proper investment for you.

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An accredited investor, in the context of a natural person, includes anyone who:

• earned income that exceeded $200,000 (or $300,000 together with a spouse or spousal equivalent) in each of the prior two years, and reasonably expects the same for the current year, OR
• has a net worth over $1 million, either alone or together with a spouse or spousal equivalent (excluding the value of the person’s primary residence),

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The Minimum Investment Can Be Quite High

It’s rare that I see a deal that has less than a $50,000.00 minimum investment and many can be much higher.  In some ways, this minimum isn’t a bad thing since it reduces the number of investors that the fund needs in order to purchase the property(ies) that they are planning to acquire As a result, the fund can run leaner with fewer personnel handling investor relations. This ultimately puts more money back in your pocket. 

I have also found that the good funds tend to have higher minimums as they grow and succeed.  They prefer fewer investors merely for the simplicity. Also, as they complete deals with successful exits, the same investors want to invest again in their future deals.  If they’re good, eventually they get to the point where they have too much money to fund the new deal they are putting together as repeat investors are sometimes clamoring to get in. 

If / when this happens, they generally have two choices. They can be more picky with who they accept money from by raising the minimum to weed out smaller investors. Another solution can be to change their investment style (buying larger properties or multiple properties) to take advantage of the larger pool of money they have. 

The latter is something to be cautious with, since they potentially could be moving their business away from their area of expertise into the unknown and potentially more difficult terrain.  It’s not a deal breaker, but just something to be aware of. If they have a sweet spot in the types of properties they go after and that changes dramatically, it can impact the bottom line.

Is Private Equity Real Estate Right For You?

With the above real estate private equity disadvantages, you can see that investing in Private Equity Real Estate is not right for everyone. But, with the diversification, tax advantages and passive nature it’s hard to beat for certain investors. Specifically high wage earners looking to reduce their taxable income along with high-net-worth individuals looking for an alternative to the volatility of traditional stocks and bonds investing.

In summary, having some knowledge in deal flow and, of course real estate will help ease your entry into this world, but also having a good financial advisor that specializes in these types of alternative investments can mitigate any lacking knowledge. 

Many advisors stay away from non REIT real estate investments because quite honestly, it takes a lot of time to understand and invest in these deals. In fact, if you have an advisor that you are already working with that handles your stock market investments, don’t be surprised if they bad mouth these and any non-standard “alternative” investment, merely because they don’t handle them and possibly do not understand them. I have heard every excuse in the book from traditional advisors, but at the end of the day, if you are not comfortable with the volatility that your portfolio is encountering, these can provide a great diversification to traditional stocks and bonds investing.

What is your experience with real estate investing? Share your thoughts below …

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