jankythoughts2

Foreword

AML, KYC, MIFID, RegNMS, RegT, SEC, CFTC, FinCEN! Regulations and regulators! If you’ve ever worked in finance, you’ll know that the alphabet soup of regulations and regulators that need to be followed is long and overwhelming. Do we really need all of these?!

As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.

If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.

Cost of regulations

If you’ve ever worked in a financial company, you’ll know that other than legal, there is a compliance department, whose job, it seems, is solely to make your life miserable. “Can I do this?”, “No”. “How about this?”, “Hell, no”. “What can I do?”, “I’ll get back to you in a month. Or year.”

And to rub salt into the wound, compliance folks do not come cheap. Every large bank spends millions to possibly even billions every single year for compliance related reasons, or, in cases where there is a compliance lapse, for fines. All of these costs are directly the result of regulations mandated by regulators. And like all costs to a business, all these are directly or indirectly paid for by clients.

Which means, yes, you are getting a lower interest rate from your savings account, in part, because some of the gains are taken by the bank to pay for compliance. You are paying a higher fee (either directly or via spreads) when you trade stocks, because the broker needs to take part of your profits to pay for their compliance. You are paying a higher mortgage rate, because, you guessed it! The mortgage company needs to pay for compliance.

Is it really worth it? What about a world without regulations?

Road to Alabama

Let’s say you are driving in a car, on the way to Alabama (1). This is the new world, a freer world, a world where there are no rules. Street signs? Nope. Traffic laws? No, siree. Speed limits? LOL. You get the idea.

How would you drive? On the right side of the road? Is the right side still the right side? There are no rules!

How fast would you drive? What if you drive too slowly for someone in a fancy car and they decide to just bump you off the road? Again, no rules!

How do you navigate a roundabout? Go straight through over the middle? Turn left? Or right? NO RULES!

Would you even dare to drive?

Confidence

Let’s say you have $100k, and you need to stick it somewhere. Somewhere safe, so not your mattress. What would you do?

Would you give the money to your next door neighbor Blair, and ask them (nicely) to take real good care of it and leave it at that?

Would you give the money to your local loan shark? After all, Cameron seems to be really good with money!

Would you put the money in the bank?

I’m guessing most people would say the bank, and the next question is… why?

Insurance

One of the reasons why folks tend to choose the bank for largish sums of money, is because of the FDIC insurance. If the bank goes under, or there is fraud and the money is lost, or pretty much anything else, the FDIC, an agency backed by the full might of the US Government, will make you whole. It may take a few days or even weeks for them to sort out the mess, but you can be sure that you’ll get your money back. In full.

Are you confident of getting your money back from your Blair? Or Cameron the loan shark? What if they just laugh in your face when you ask nicely to get your money back? Who you gonna call (2)?

Now, how does FDIC insurance works? Why would the FDIC subject itself to this? What if the banks just collectively decide to defraud the entire nation, take all the money and go live in the Bahamas with their slightly scandalous college room mates?

Well, that’s where regulations come in. The FDIC is playing a statistics game. They know that regulators regularly conduct checks on the balance sheets of banks, and that if anything goes wrong, certain folks at the banks are personally liable and may very well spend the rest of their days in jail. Now, bankers make a lot of money, especially if you are at the top of the food chain in a big bank. Like, a lot, a lot. But a lot of money is really only useful if you actually get to spend it freely — it’s really no fun spending money whilst in jail. So there is just that amount of incentives for bankers, and thus banks, to toe the line.

Yes, not all bankers and banks will toe the line. Some will think they can get away with it, and maybe they can! And some other banks are just unlucky and make bad bets. Like, who would have thought calls on AMC would go to 0? So some banks go under, and the FDIC pays out for those banks. But because the vast majority of banks don’t go under, collectively, the FDIC manages to stay afloat by collecting a small premium from every bank, and directing those premiums to bail out customers of the banks that do go under. Insurance, at work.

And the thing that gives the FDIC that confidence? The thing that allows this statistics game they play? Regulations. Regulations which detail what banks can and cannot do with your money. Regulations which mandate banks keep a minimum amount of liquidity (float), and regulators which conducts checks to make sure the banks are following the rules.

Confidence, again

Other than insurance (and also for insurance, because this is something FDIC, SIPC, other insurance companies depends on), is the fact that by putting down regulations, and setting out what a bank and broker can or cannot do with customer money, it dramatically reduces the surface area of shenanigans that bankers and brokers can do.

Yes, some of the more creative ones will still do stupid things. And some of the less scrupulous ones will just laugh at the regulations and do whatever anyway. But the vast majority of them will know where the line is, and while they will push ever so hard against the line, they will likely not actually cross it (by too much).

Because of that self policing, confidence in the economy and the financial system blooms. Businesses can operate, because they know that when they are approved for a loan, their interest rates won’t magically jump 20% tomorrow. Savers can bank, because they know the banks won’t bet it all on red in Vegas. Investors can leave their cash in their brokerage accounts, because they can be sure that the money is likely there, as opposed to being used to buy magic beans or to fund the CEO’s lavish lifestyle (3), and even if the money is lost, the SIPC will make them whole (4).

And this confidence in the system, this ability to know how others will act, and what to expect, these regulations, they allow the modern world to work.

All regulations are equal, but some regulations are more equal than others

That’s not to say that all regulations are good. While most of them come from a good place, a lot of regulations are reasonable, and many regulations are simply needed for the world to even work, there are, clearly, some regulations which were either poorly thought out, or designed with less than altruistic concerns.

Which is not great, certainly, but welcome to Earth, population 8billion (5), where humans fail, and there’s a lot of us around to fail. Get used to it.

The whole point of having ongoing lawmakers is because we know that laws and the rules borne of those laws are not always good or right, and very often become obsolete over time. And the whole point of democracy is so that lil’ ol’ us get at least a bit of a say in how and what the lawmakers do and legislate. If every law and rule was perfect and will always remain perfect, then there’s really no point to having an ongoing government, is there?

So yes, things break sometimes, but hopefully, over time the bad bits will get replaced with somewhat better bits.

But claiming that we should do away with all regulations, because of 1 or 2 bad ones, is simply naïve.

Footnotes

1. To bring granny a basket of fruits and cakes. In your red car. What else could it be?
2. Ghostbusters! The answer is, always, Ghostbusters! With the exclamation mark.
3. OK, fine, bank/brokerage CEOs get paid a lot of money. So maybe some of that. But not all of it.
4. Currently up to a maximum of $500k, of which at most $250k can be in cash.
5. Yea, that just happened, in the Philippines, apparently.

Foreword

What is money? What is debt? How are they related?

Some people get all twisted out of shape calling fiat money “debt”, and that only gold or bitcoin or silver or whatever is real “money”. But is that really right?

As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.

If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.

Debt

Let’s start with the easy one. What is debt?

The Cambridge dictionary defines debt as “something, especially money, that is owed to someone else, or the state of owing something“. That’s fairly clear, ain’nit?

Island adventure

Let’s do a little thought experiment. Let’s say a bunch of people, including you, are on a remote island. None of you know each other, none of you have reasons to trust each other. But for your little society to work, and for everyone’s lives to improve, you need to work together, because it simply isn’t feasible for one person to do everything well — division of labor generally tends to yield much better results for everyone.

One day, one of the strangers, Alex, did a favor for you — they built a little fire pit for you, out of rocks they carried down from a nearby mountain. Your specialty is foraging berries, but Alex already had their meals today, and berries don’t keep long. How can you repay Alex?

One way, is for you to give Alex a token, a symbol of the value you owe them, for their work in constructing the fire pit. This token can be a cowrie shell, a pretty rock, a piece of leaf you scribble a mathematical puzzle that only you can solve, etc., pretty much anything — Anything that both you and Alex agree to recognize as an accounting measure of what you owe Alex.

Now, let’s say you and Alex settle on using cowrie shells — they are hard enough to find that neither of you are concerned about the other using newly found cowrie shells to deceive the other, and the shells are pretty enough that you wouldn’t mind keeping them just for their own sake. Further, let’s say that the rest of the group of strangers feel the same — that cowrie shells are rare enough, and valuable enough in their own right, so that everyone starts offering, and accepting, cowrie shells for goods and services bought and rendered.

Well, congratulations, you’ve just invented money — the cowrie shells are, essentially, money.

As you can see, money is, at least in this case, just a means to measure how much each person is owed by the collective body — the rest of the island (world). It is a physical manifestation of the debt that the rest of the world owes you. Nothing more, nothing less.

Intrinsic value

“Hold on there!” someone will be shouting right about… now, “Cowrie shells have intrinsic value as you’ve said, that’s why they are money”. Yes, I did say that cowrie shells, at least on that island, has some intrinsic value — they are pretty enough that everybody wouldn’t mind keeping them around just to look at them.

But you see, that doesn’t make cowrie shells money. It just makes cowrie shells pretty. There are a lot of things that are pretty, yet are not used as money — a medium of exchange, a scoreboard for tracking how much you owe the world, or how much the world owes you.

Part of the reason why cowrie shells is money on your remote island, is because everyone agrees they are money, and everyone agrees to accept or offer them as representations of value transferred. The fact that they are pretty is mostly irrelevant — the prettiness is a useful property for bootstrapping the economy, but beyond that has no real relevance to the day to day use of cowrie shells.

Similarly, a fiat currency can be bootstrapped into money by, well, fiat — a government can decree that within the borders under its control, some currency needs to be accepted and offered as legal tender for goods and services offered or rendered. The currency need not be pretty in this case for the bootstrapping — the credibility of the government, and how much people believe the government is able to enforce its legal tender laws, is the criteria for bootstrapping the currency. And once the currency is in wide circulation, and everyone agrees to use it as money, then it will be money, and it will, as before, track debt owed to (or by) each individual person.

Hyperinflation

Now, let’s say that for whatever reason a large portion of the population of the island decide not to use cowrie shells anymore at any point in time. They stop accepting cowrie shells, and start using their existing cowrie shells to quickly buy up goods or services from those who still use cowrie shells.

In time, more and more people will recognize that cowrie shells cannot be used to buy certain goods and services, and even though the shells are just as pretty, their “value”, how much each cowrie shell can buy, will start to drop. As more and more people recognize this, they will be more and more willing to exchange cowrie shells for less and less, resulting, eventually, in hyperinflation — the value of money essentially drops to, or close to, 0.

Now, I want to be clear here — hyperinflation and inflation are not the same thing. Inflation is just the regular ebb and flow of the value of money vs goods and services. Hyperinflation, on the other hand, is a loss in confidence in the value of money by a large portion of the populace, which then feeds on itself, becoming a death spiral for the value of money (1). The former is a measure of relative supply and relative demand, while the latter is a loss in confidence of money — two very different things.

You can have very, very high inflation (say 10-20% a year), without actually getting hyperinflation. There are countries with poorly managed currencies with such high inflation numbers for prolonged periods of time, but because enough people still believe in the currency (even if that belief means mentally adjusting by 10-20% a year), that hyperinflation simply does not set in.

In short, high inflation is a crisis of relative supply vs relative demand. Hyperinflation is a crisis of confidence in money.

Another way of looking at it, is that hyperinflation is one way how money stops being money.

Forgeries

Let’s say instead of losing confidence in the cowrie shells, someone stumbled upon a little cove on a remote part of the remote island, where cowrie shells are just all over. They secretly take these cowrie shells and start using them to buy things, and entirely stop working. If they do this at a small scale, most people may not notice, and while inflation may set in (prices will go up a bit to reflect the relative value of money vs goods and services has shifted), confidence in cowrie shells won’t be loss, and life goes on without hyperinflation. If, however, they do it on a large enough scale, effectively introducing a level of supply of money that’s so large that society (the rest of the island) can never repay the debt as symbolized by the new supply cowrie shells, then things will likely go haywire and hyperinflation will likely set in.

To counter the demise of cowrie shells, you found something else, a shiny yellow rock, that is, again, very rare, but because it wasn’t money, nobody has been really collecting it, and so you are the only person with a lot of it. Can you just unilaterally demand everyone use the yellow rock as money? Maybe! Obviously everyone else will be at a severe disadvantage to you, and clearly they won’t like that very much. Some other people can probably find other things, maybe a leaf scribbled with an arcane math problem only they managed to solve, or a series of auditable numbers carved on a giant stone, things that are also hard to forge, but that they themselves have a lot more of than the rest of the island. Those people will also make the same demand that their thing is the new money.

So why yours and not theirs?

Ultimately, the choice of what to use as money depends on the interplay of 2 things:

1. Who has the clout, the ability (by persuasion or by force) to convince more people to accept their choice
2. What is the thing most people agree to use

Essentially, being hard to forge, even impossible to forge, does not automatically make something money. Humanity has known for decades about cryptography and how to make essentially unforgeable artifacts. Yet none of these have become money in and of themselves — instead, they are used to secure existing money, by encrypting transactions made in USD, EUR, GBP, etc.

Summary

To become money, having the properties that are necessary for being money is not enough. You also need that bootstrap, and you need that bootstrap to morph into popular support by the populace. Finally, to prevent your money from stopping being money, you also need to maintain the people’s confidence in your money, essentially in perpetuity.

But underlying all of these, is the basic premise, that money is, simply, debt. Money represents debt owed, and is the unit of accounting so that society can decouple the 2 parts of a barter trade — instead of you and Alex trading a fire pit for berries, you get the fire pit now, and Alex gets the berries later, with money acting as a measurement of the debt you owe Alex in between.

Edit:

The key, then, to remember, is that the value of money does not come from within — it comes from without. Money is money not because it has intrinsic value. Instead, money is money because it has extrinsic value — its value is entirely bestowed by the willingness of others to take that money as payment for their goods and services. Claiming something is hard to forge or highly divisible is necessary, but not sufficient. Claiming something has intrinsic value because it can be used in industries, or looks pretty, is mostly irrelevant. Claiming something is backed by something else, is irrelevant, unless that backing is either a form of widely accepted money, or that backing involves the ability to persuade others (again, either by persuasion or force) to accept the backed asset as money.

Footnotes

1. Wikipedia defines hyperinflation here, which includes a mathematical definition of hyperinflation, which is basically 50% increase in prices of general goods and services on a month over month basis, over a prolonged period of time, essentially the death spiral mentioned above. On a year over year basis, 50% month over month translates to roughly 129x increase in prices per year.

Foreword

I’ve received, over time, numerous requests from various people inquiring about real estate syndication. Here is a quick summary of the space, and the things I look out for when evaluating a new deal.

As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.

If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.

Real Estate Syndication

As way of a quick introduction, real estate syndication is a fancy way of saying a “real estate fund”, or, in some cases, “real estate private equity fund”. The former (real estate fund) is more general, and encompasses various real estate strategies (explained below), while “real estate private equity fund” refers specifically to funds which buy properties, improve them somehow, and then sell them again — Similar to how generic private equity funds buy companies, improve their operations, and then sell the companies again either on the private or public markets.

Terminologies

Before we dive in, here are some common terms which will come up over and over again in this space.

Sponsor, General Partner, GP	The people who found the deal and are marketing it are generally called the sponsor. The people who actually run the day to day operations as well as make major decisions on behalf of all the other investors are called the general partner (or GP for short). In general, the sponsor will usually be the GP, so the terms are used interchangeably in most cases.
Broker	The people/entity which is purely marketing the deal on behalf of the sponsor. The broker typically takes a cut of the profits, either in the form of a front load (a fee up front as a percentage of committed dollars they bring in) and/or an equity stake (usually a percentage of the profits). While brokers are common for really large deals (hundreds of millions to billions of dollars), they are uncommon for smaller deals (under $100m). Personally, if a smaller deal has a broker (or worse, many brokers), I would consider it a sign that the sponsor is new to the game and simply doesn’t have a large enough rolodex of investors to call upon. Some common brokers are FundRise, CrowdStreet, YieldStreet, etc.
Investor, limited partner, LP	The people who actually put money into the deal. While the GP earns their profits from sweat labor, the LP earns their profits from equity labor, i.e. actual return on actual cash put into the deal. In particular, the LP is also limited in that they have no say in the day to day running of the deal. This is important! A key determination of who has limited liability (and thus can walk away from a failed deal by “only” losing their investment) vs who has unlimited liability (and thus may be personally liable for any losses/debts) is who is responsible for making decisions and who actually made decisions. Before you take part in any deal, make sure that you are joining as an LP, unless you are comfortable making decisions for the deal, and taking responsibilities for the consequences of your decisions.
Capitalization rate, cap rate	The capitalization rate of the deal. At the start of the deal, this is obviously estimated, but when a deal exits (sells of its assets), the “exit cap rate” is also of interest and is typically actual (instead of estimated). Cap rate is simply the “net operating income” divided by the value of the asset. In a hand-wavy sort of way, you can think of it as the inverse of the P/E ratio that is so common for stocks.
Internal rate of return, IRR	The imputed return of the deal (either estimated or actual, depending on context) over a period of time, annualized to one year. The IRR is more complicated than simply the return of the deal divided by the amount invested — the timing of the return of capital and profits is important! A deal that takes in $100, and then immediately returns $100 the next day, while also returning another $100 over the next year, is a much better deal than one that takes in $100 and returns $200 at the end of the next year. Both deals return $200 over a one year period, but the former returns your capital almost immediately, letting you put that capital to further use. Think of it this way — assuming you can and do put all cash thrown off by the deal back into the deal and compounding at the same rate, then 2 deals with the same IRR and same period of compounding will return exactly the same amount of money at the end of both deals.
Levered returns, levered IRR	Almost all real estate funds use leverage, because without leverage (and the associated risks!), most real estate deals simply do not make sense — you can get much better returns with much lower risks by just investing in the stock markets passively. Levered returns or levered IRR is simply the actual (or estimated, depending on context) return or IRR after including the multiplicative effects of leverage and taking out the costs of leverage (i.e. interest fees).
Gross return, gross IRR, fund level return, fund level IRR	“Gross” basically just means “fund level” in this context, which means whatever number listed, is for the fund before the GP takes their cut, but after all other applicable fees, such as property management, expenses reimbursements, legal fees, etc. While these numbers are interesting, the more important numbers are the “net” ones. Always be sure to ask the GP for the net numbers, and if you have both net and gross numbers, then you can get a sense of how much the GP is getting paid.
Net return, net IRR, investor level return, LP level return, investor level IRR, LP level IRR	“Net” basically just means “LP level” in this context, so the number listed is the actual (or estimated, depending on the context) return that you, as the LP, will get. These are the numbers you want to use when comparing two otherwise equal deals.

Strategies

There are 4 main strategies for real estate funds:

Development	This is where the fund takes in capital to build a new property. There are two exits: a) The property is sold to buy/hold investors. b) The property is converted into a buy/hold investment for long term holding. In some cases, a fund may even opt for both — the property is sold to an affiliated buy/hold fund, and existing investors can opt to collect cash of the proceeds, or to roll over their investment into the new buy/hold fund. If too many investors opt to collect cash, then investors rolling over may be given the opportunity of putting in more cash, or the GP may find new investors or even put in their own money to make up the shortfall. In general, development funds are the most risky, as a lot of things can go wrong during construction, and delays, additional costs, etc. are common. Also, during the period of construction, there is no cash flow — the property is not in a rentable state! As a result, a successful development deal tends to have the highest returns.
BRRR(R)R – Buy, Rehab, Rent, (Refinance), Repeat	This is a strategy popularized by some influencers, such as the founder of BiggerPockets.com. The basic idea is to a) Buy a piece of property that is somehow mismanaged, either because management has let it fall into disrepair, the property isn’t positioning it properly for the local market, etc., b) Rehab the property by fixing the issues identified, either by fixing whatever’s broken, or renovating the property to position it as more upscale, etc., c) Rent out the property with the fixes in place for higher than what it was previously rented for, d) (Optionally) Refinance the property at the new, higher, valuation to take cash out of the deal, e) Repeat the entire process. Generally speaking, if the goal is to sell off the property to recapture capital invested, then the refinance step may be skipped and instead the property is sold off. This is the “real estate private equity” strategy. If the goal is to keep the property as a long term profit generating asset, then refinancing may be a good way to get some (or in some cases all) of the invested capital back so that it can be put to use in a new deal. In general, this strategy is less risky than development, but more risky than buy/hold. As a result, it tends to have returns in between the other 2 strategies.
Buy/hold	This is the simplest strategy where the deal is to simply buy some property at some perceived fair price, and the GP is in charge of handling the day to day operations of the property, while returning a portion of the rental income to LPs as dividends. In general, this strategy is the least risky of the 3, but as a result, also has the lowest returns.
Opportunistic	This is a catch all phrase for “everything else”. In these types of funds, the sponsor has a lot more leeway to do whatever they deem is appropriate, which can be good (if the sponsor is good) or bad (if the sponsor is not). Be sure to read the incorporation documents to know exactly what the sponsor is allowed or not allowed to do, and make sure you are comfortable with everything listed before you sign your name!

Evaluating a deal

When I evaluate a deal, I look at 2 main things:

• The sponsor
• The deal itself

Sponsor

In the case of the sponsor, the things I look out for are:

Is the sponsor trustworthy?

Anyone can put up a website and ask for money. Anyone can claim 10, 20, 30% IRR.

Doesn’t mean they mean it or that they can do it.

There are lots of unscrupulous sponsors who put up misleading and/or outright faked information to get investors, and I’m not particularly interested in investing with them.

Does the sponsor have the experience to bring the deal full cycle?

Even if the sponsor is acting in good faith, they may simply be too inexperienced to handle the deal and the stresses involved. If everything goes well, this may not matter, but if something breaks, I’d like to know that the sponsor has seen similar situations before, and/or at least have a vague idea how to handle the setback, instead of just throwing their hands up in the air and possibly sobbing in the corner.

Evaluating the sponsor

One of the best ways to evaluate if the sponsor meets both criteria, is to see what their track record is — if they have been running the company behind the fund for at least 8-10 years (roughly the time it takes to bring a fund full cycle, or at least 4-5 individual deals), and they’ve done so without changing their name (personal and company), then that’s a good sign that:

• They have been successful enough that they aren’t sleeping on the streets.
• They have built up enough of a reputation/goodwill that they are unlikely to throw it all away just to scam lil’ ol’ me.
• They have been doing this for a while, so they are at least somewhat experienced and are not flying in the dark.

Now, this isn’t a hard and fast rule — some sponsors worked for other funds, and are just starting out on their own.  If they were reasonably successful before, and they are just starting out because of ambitions (as opposed to, say, embezzling from the prior fund), then that’s a good sign too — while the fund itself doesn’t carry much reputation/goodwill, the sponsor themselves might.

I’m also not entirely opposed to working with new teams, as long as they show they know what they are doing — I’ll have to talk to them more.  But the point is that new teams tend to make mistakes, and I’m not particularly inclined to foot their tuition bill.

The absolute worst case is the “serial founder”, who creates new companies (not deals) every 5-6 years, and completely leaving out mentions of their prior endeavors.  This suggests that their prior attempts were less than stellar, and I’m not a fan of the deception, even if by omission.

There are other ways for sponsors to prove their mettle, such as being able to conduct a Q&A with ease and confidence, having a large social media presence for a long time (reputational risk if they mess up, also, if they did mess up, someone would have probably pointed it out, so you should look for those bad reviews), etc.

Another thing about sponsors — it’s usually about the team.  The more things that the sponsor does inhouse, the more likely they have control over their own destinies (and thus your investment).

If a sponsor is just a broker (i.e.: they seek investors, put the money in the fund, take a cut, then give the rest to another sponsor to do the actual deal), then understand that you are paying fees twice.  Once to the broker, and another time to the actual sponsor doing the work, whom you may never meet — because if you’ve met them, you may get the crazy idea that maybe, just maybe, you should cut out the middleman and make more for yourself.

Now, there are benefits to this arrangement — if you are deploying huge sums of money (say O($10m+)), then maybe it’s too much work to find all the deals yourself, and a broker is useful.  But if not…

BTW, and I may be wrong on this, but I believe that all such brokers need to be licensed (For example, https://dos.ny.gov/real-estate-broker for single deals. For funds, see SEC/FINRA rules).  If someone is clearly brokering a deal, and does not clearly list their licenses, then you should worry.

Deal

As for the fund, usually just understanding what the fund is doing will give you a good idea of what to expect. As discussed above there are generally a few types of funds:

• Buy/hold, sometimes called core/core+
• Buy and flip, sometimes called value add, or BRRR(R)R
• Build new, sometimes called development
• Whatever crazy scheme the sponsor can dream of, sometimes called opportunistic

Note: All numbers below are approximate for the period just before Covid19. For the 2 years after Covid19, real estate generally returned significantly higher numbers (a few multiples of the below in some cases) due to all the upheaval as people moved around. We’ll have to wait and see what post-Covid19 brings…

Now, if a fund is a buy/hold, then you’d expect levered net IRR to be in the 6-10% range, with cash flow generally steady from day 1.

For a buy/flip, you should generally see net IRR in the 12-15% range, though I’ve seen as high as 20-25% when the fund gets lucky. Cash flow in the first year is probably close to 0.  Cash flow in the 2nd year may be half of preferred (~4%), and then 8% in 3rd year, before 8-12% in the next 2-3 years.

Development funds can see net levered IRR be as high as 15-20%. Cash flow in the first 2-3 years will be 0.  No renter’s gonna pay you rent for an apartment that does not exist yet. So, if you come across a development fund, that promises 6% cash flow starting from the first year, you’ve gotta ask yourself this:

Where the hell are they getting the money in the first 1-3 years, while the property is being built, to pay me?

And the answer is, probably, they just took in more money than they really need, and are paying you with your own money. Which generally means:

• It’s a marketing gimmick.
• Actual net IRR is likely to suffer, since this additional money is non-productive, and just a paperwork transfer.

Location, location, location

Finally, for a deal to make sense, the strategy must fit the location.

• It doesn’t make sense to build class A+ buildings in a depressed neighborhood with median income in the $30k’s.
• It doesn’t make sense to do heavy renovations on a fund with many single family homes.
• It doesn’t make sense to build large apartment complexes in a city with heavy net outflow of households.
• It doesn’t make sense to value add a property that just recently underwent renovations.
• Etc.

Also, note that there are some states which are just extremely hostile for real estate investments, and a fund that tries too hard to make it work there, probably can make substantially more returns by just focusing their attention elsewhere. These states tend to have laws which make it hard to turn a profit on an investment, by severely restricting the landlord’s abilities to manage their property the way they see fit. For a discussion on this, see Affordable Housing.