Eight Tips for Investing in Commercial Real Estate
Pooled Equity Investments Using IRA Funds

By Ron Sann, Founder and Principal Ratel Investments

Most financial experts agree that commercial real estate investments, as part of a balanced investment portfolio, both reduce risk and increase yield. For individual investors who want to use their IRA funds to invest in income-producing real estate, there are three primary options:

1. Individual or direct ownership of real estate, such as a small apartment building or single-family rental property
2. Investment in publicly traded Real Estate Investment Trusts (REITs)
3. Investment in private commercial real estate Pooled Equity investments

Of these three options, pooled equity investments are the least well known. Pooled equity investments are investment vehicles that enable multiple investors to jointly purchase a large commercial property, such as a 100+ unit multi-family apartment building or a diversified fund that in turn invests in multiple commercial assets. For investors, pooled equity investments combine the financial diversification and tax advantages of direct ownership of real estate without the burden of having to directly identify, purchase and manage complex commercial properties.

Based on my experience, I have found the following eight criteria critical when evaluating the attractiveness of a pooled equity investment.

1. Alignment of Interests
The first criteria when selecting a pooled equity investment is to ensure that the financial incentives of the sponsoring firm are designed so that investors benefit ahead of the sponsor. The key compensation items to examine are the non-performance-based fees to the sponsor (acquisition fees or structuring fees) and the degree that a sponsor puts its own funds at risk in the investment. Carefully examine how much true equity, not retained fees, a sponsor places at risk in the investment. Look for a minimum of 5% of the total equity to come from the sponsor. Also, examine how the sponsor is being compensated. Look for a generous preferred return to the investor prior to the sponsor receiving material compensation. An investor wants the majority--at least 60%--of the sponsor’s compensation to come from the ultimate financial success of the project, not from up-front fees, which are independent of the profitability of the investment

2. Investment Vetting
Almost nothing can offset a poor purchase decision. Carefully examine the sponsor’s underwriting process for the asset. In a rising real estate market, many sponsors are successful. What you want to estimate is how the property/fund may perform under stress. Examine the purchase price market capitalization rate and the ratio of the purchase price to the in-place cash flow. Then compare it to longer term trends for that type of asset in that local market. Understand how the asset compares to replacement cost in the local market. Can a newer property be built for a similar price and create direct price competition? Other important elements to examine include a property’s location in a sub market, local job creation, population growth patterns and the asset’s operating history. Further, make sure the sponsoring firm has investigated with the local planning department officials the number of new building permits that could result in future competition. Finally, put your hat on as a perspective tenant and thoroughly analyze existing competitors. Would you select the perspective property at the proposed rental rate?

3. Property Underwriting
On paper, most real estate investments look compelling. However, in practice, achieving a high rate of return is far more difficult. A potential investor should pay particular attention to the exit rate market capitalization assumption. Is the sponsoring firm assuming that in the future a prospective buyer will pay more richly for a set of cash flows than the current market will bear? Examine what assumptions are imbedded around the movement of interest rates. Does this investment work if the interest rates move in an unfavorable direction? Additionally, examine the underlying assumptions on issues such as future rent growth, vacancy and changes in operating expenses. Finally, analyze the asset under different scenarios. Does this investment make sense if the world is different, and more difficult, than anticipated?

4. Risk and Return
Risk and return are related. Investors should not be misled by high projected return numbers. The key for investors is to understand what types of risk are associated with an investment and to get compensated appropriately for accepting that level of risk. For example, a ground-up construction development investment with no tenants should provide a materially higher projected return than an existing asset with in-place tenants. Ground-up construction requires higher returns, when compared to an existing leased asset, because there is a heightened chance that the project will not achieve the original projections. Additionally, it is crucial for investors to understand the risk if they are taking on hidden liabilities from an investment. For example, do they have personal exposure on the debt, or the risk of an unanticipated future capital call, or even legal liability from unplanned events, such as legal action at the property level.

5. Historic Performance
The historic returns of a sponsor are an imperfect but best available surrogate for future performance. To offset real estate’s illiquidity, an investor should expect a return premium, at least 5%, when compared to long-term stock returns. Beyond the return numbers, a wise investor will look to see that the sponsor has weathered both up and down markets and has experience in the types of properties they are currently proposing to purchase.

6. Proactive Management
Real estate is an operating business. Poor implementation of a strategy will undercut even the best designed plans for creating value. We recommend you invest with firms that have a strong focus on the day-to-day details of each asset. Often a real estate purchase involves a capital improvement program. There is a wide disparity in different firms’ ability to timely and cost-effectively manage these types of large, complex improvement projects. Finally, a property’s ultimate customer always is an individual. Good real estate managers never lose sight of the ever changing needs of their tenants.

7. Understanding of IRA’s Tax- Related Issues
Investors should determine that the sponsor of a pooled equity investment is familiar with the tax consequences of investing in leveraged real estate using IRA funds. The combination of IRA funds and the use of debt creates a unique reporting requirement. The sponsor should be familiar with the IRS rules around unrelated debt financing and unrelated business income tax (UBIT). Most importantly, the pooled equity investment should have access to a custodian, such as Equity Trust Company, who can help investors efficiently and cost-effectively reap the benefits of investing in a pooled income fund using their IRA funds.

8. Investor Communications
Investors should expect regularly scheduled communications from the sponsor, which include financial statements and detailed reporting on the key operational metrics of the property. Additionally, the sponsor must provide timely tax reporting and, as required, periodic alerts for time-sensitive developments.

The above article is authored by Ron Sann, Founder and Principal, Ratel Investments, LP. Ratel is a real estate investment firm specializing in value-add commercial real estate investments. For more information, visit Ratel’s Web site at www.ratelinvestments.com or e-mail Joe@ratelinvestments.com.

Disclaimer: Equity Trust is a passive custodian and does not provide tax, legal, or investment advice. It does not endorse or recommend any contributor, company, or specific investments. Any information communicated by Equity Trust Company is for educational purposes only and should not be construed as tax, legal, or investment advice. Whenever making an investment decision, please consult with your legal, tax, and accounting professionals.