5 Keys to Success with Real Estate Debt Funds

Investing in the right real estate debt fund can be very profitable—a bit like finding a great restaurant with very good food and large portions at a reasonable price. Investing in the wrong fund can be a lot like getting food poisoning. Everything might have seemed fine at first, but you ended up regretting the experience.  If you ask around among wealthy individuals you know, you will hear about both types of experience. As with researching a restaurant, there are common sense techniques you can use to maximize your chances of having a good experience, and minimize your chances of being disappointed. Below are five keys to achieving success.

1.     Meet the Fund Manager. You need to be able to trust that person to stick to the designated investment strategy; not cut corners; and not to steal money from the fund’s investors. Try to see the manager’s office and even meet his family and get a feel for his lifestyle. There is nothing wrong with enjoying success, but a manager who is feeding a lavish lifestyle is more likely to become addicted to bringing home very large pay every year (even if the underlying fund doesn’t perform in such as way that would allow it). Think of CNBC’s excellent show, “American Greed”. Almost all of the con men featured bought more and more toys over time, in the same way that a gambling addict can’t help himself from returning to the casino. Trust your instincts about the manager and better yet, bring an advisor who is good at reading people when you meet the manager.

real estate debt fund manager
real estate debt fund manager

2.     Make Sure the Target Returns and Strategy Match with Your Objectives and Risk Tolerance.  If you value capital preservation above all else, and want to maximize income, find a fund that takes as little risk as possible, and aims to hit “singles” rather than “home runs”.  There are simple techniques that fund managers can use to increase their chances of a huge return, but usually these same techniques increase the chances of losing money if the real estate market drops unexpectedly. Make sure that the fund manager’s philosophy and approach are in line with your own goals.

3.     Ask to See Details of the Underlying Investments. A real estate debt fund holds investments in real estate loans. Before you invest, ask to see the addresses and other details about the properties underlying the specific loans held at the time of your investment. Ask to see the loan documents such as the note and deed of trust for several of the investments in the current portfolio. Finally, you can check with any title company to check that the fund really is the beneficiary on the selected loans, because every loan must be recorded at the relevant County Recorder’s Office. Don’t skip these important steps! If the fund manager is unwilling to produce any of the requested information, you should not invest. Remember that Bernie Madoff refused to provide any details about his investment strategy. Any manager who refuses to provide details is either too lazy or too arrogant to want to do any extra work, too disorganized, or possibly isn’t really doing what they claim to be doing. In any of these cases, it is a major red flag.

4.     Visit One of the Properties. One of the beauties of investing in real estate vs. the stock market or private equity funds is that you can see the assets that are owned by the fund you invest in. Before investing, check out a property, preferably one that is in an area you know. Notice the condition of the property; are there people working on it? Are there occupants and/or tenants? Make sure what you see at the property matches up with what the fund manager said about the strategy of the property and the type of investments made by the fund. For example, several of Arixa’s funds are set up to invest in loans secured by homes being renovated for resale.  If you visited one of the properties and found a piece of raw land in an industrial area, you would know that something is not right.

5.     Make Sure You Understand How the Manager is Compensated, and that it is Reasonable to You.  The great majority of people will do what they are incentivized to do. How much is the fund manager being paid by the fund? Make sure you include any money being paid to an affiliate of the manager (such as a sister company or business partner of the manager). How much of that compensation is guaranteed, and how much is based on performance? What are the performance hurdles that determine the incentive portion of the compensation? Make sure you are comfortable with the manager’s compensation and if you don’t have the background to confirm that it is reasonable, ask a financial adviser whom you trust to review it with you and to give you his or her input. Danger signs to avoid would be unreasonably high compensation for the manager, regardless of the investors’ returns; and any incentives that would encourage the manager to take on undue risk (returning to the baseball analogy, swinging for home runs to make up for a series of recent bad investments).

Conclusion

The largest real estate debt funds tend to have mediocre performance because they have too much money to invest and not enough profitable niches to invest in. In order to support the lavish compensation of fund company owners, they tend to offer average returns but charge fees as if they are delivering top tier returns.

When venturing into smaller real estate debt funds, you need to do your own homework to make sure you have found a good fund and portfolio manager. Just like performing detailed due diligence before making a real estate investment, the rewards for your work can be both satisfying and profitable.