Experienced financial advisors point out to clients that real estate investment portfolio diversity will help reduce risk in their overall portfolio. You can achieve this in the stock market by purchasing several different stocks, or by investing in a fund that holds multiple stocks.

Diversification in real estate works much the same way.

  • Investors can build a diversified portfolio by buying a variety of individual properties outright.
  • Or, you can invest in one fund that owns many properties.
  • It is also possible to diversify your holdings by investing in fractional interests in individual properties through what is called a syndication.

Real Estate Investment Portfolio Diversity: Sole Ownership
One of the most common reasons why people purchase rental real estate on their own is to maintain full control over the investment. Decisions about leasing, operations, capital improvements, financing and disposition are solely up to the owner. This presents benefits and disadvantages.

As a sole owner, you can pick your own tenants and set their rental rates. You can also discuss any of their requests for concessions, such as rent abatement or improvements to their premises. Property management will be among your most important operational choices. Taking a look at the creditworthiness of prospective tenants will also be key. You have the option to profit from your own sweat equity by handling maintenance and management issues yourself, or you can hire contractors or professional property managers.

Sole Ownership = Sole Responsibility
You will have to do your own due diligence to assess what type of work, if any, will be needed during your intended holding period. You can also decide to what extent you will make capital improvements to the property —improvements that will raise the value of the property. You’ll decide when to do them and how to pay for those improvements.

If you want to use leverage, you can adjust the amount and terms of the loan, including the maturity date, amortization schedule and any interest-only period to accommodate your needs. However, you will typically have to provide a personal guarantee for the debt, which can range from non-recourse “bad boy” carve-outs, or exceptions, to full personal recourse. This will depend on the borrower’s experience, credit and relationship with the lender.

Perhaps the most significant trade-off for the freedom of sole ownership is that it ties up your capital in one project. While this lack of diversification can be minimized by buying a mixed-use asset (e.g.. a storefront with offices or residential spaces on the upper floors) or a multi-tenant property, you will only have exposure to one location in one market. If that market declines due to economic, environmental or other reasons, you probably won’t have as much of a return on your investment as you had hoped.

Real Estate Investment Portfolio Diversity: Real Estate Funds
One alternative to avoid having all of your proverbial eggs in one basket is to invest in a professionally managed real estate fund. Funds can take many forms, including public or private REITs or private placements. An REIT is a real estate investment trust — a business entity that owns and operates a portfolio of real estate.

Investors buy shares in the REIT and receive periodic distributions of income, as well as their share of tax attributes relating to the real estate. This includes both income tax obligations and depreciation deductions. In this way, rather than buying real estate directly, you will acquire shares of a fund that owns the real estate.

REITs: Public vs. Private
REIT holdings can include both real estate and mortgage loans. These trusts are required to distribute 90% of their taxable income to their investors as dividends. Publicly traded REITs are traded on stock exchanges, so they provide easy liquidity. Like mutual funds, they make disclosures and public filings as required by the SEC.

There are also private REITs whose shares are not traded; those investments are illiquid. REITs are professionally managed. The properties they buy are vetted by people with experience in the real estate industry. Those people also undertake and review due diligence for the properties and their tenants. REITs often get funding from institutional investors, so the credit and quality of the underlying assets tends to be high. Reporting is provided on a prescribed basis, and financial results are usually audited by a reputable national accounting firm.

Before investing, you will receive an offering memorandum that states the following:

  • The REIT’s investment criteria,
  • The experience of its management,
  • A description of the actual or anticipated financing and underlying real estate.
  • The benefits and risks of the investment.

If the REIT is publicly held, you will be able to liquidate your investment by trading your stock at any time.

Investment Funds: Less Responsibility = Less Control, Less Say, More Fees
Besides REITS, there are also privately held real estate investment funds, where professional managers acquire, operate and dispose of properties on behalf of their investors. Such funds work in the same way as a private REIT, but do not have a legal obligation to distribute a specific percentage of income to investors.

Among the negatives of using fund investments for real estate investment portfolio diversity are the lack of any voice or control on the part of individual investors for any part of the investment, and the fees charged in comparison to those earned through sole ownership. Depending on the size and nature of the fund, assets may be bought or sold after you invest, making it harder to know exactly what properties are part of the portfolio at any point in time.

Fees will include the administrative expenses of the fund itself and compensation for fund management, as well as the cost of outside professionals involved in the acquisition, debt financing, and management of the properties. These types of funds are likely to engage professionals in larger firms with national reputations.

Real Estate Investment Portfolio Diversity: Syndication Shares the Strategy
Another alternative to diversify your real estate holdings is to invest in a private real estate syndication. Syndications are a type of investment where many unrelated parties put their funds together to acquire a property or a group of properties sharing such characteristics such as a similar location or tenant. Syndications are put together by professional sponsors who enter into contracts to do the following:

  • Acquire the property
  • Raise the capital
  • Obtain financing
  • Operate and manage the property
  • Make distributions of cash flow and capital event proceeds to investors

Most syndications will spell out exactly which properties they own or will acquire ahead of accepting investor funds. Syndicated investments are commonly structured as limited liability companies, or LLCs. Investors acquire membership interests in the entity that owns the property, rather than holding title in their own names.

Unlike REITS, interests in syndications are not traded on public exchanges, and are typically illiquid. Recently, some crowdfunding sites have cropped up to provide another market for fractional interests in syndications. In these cases, the investments may have restrictions on transfers, such as prior sponsor or lender approval.

Syndication has higher returns, but you won’t see them quickly
Syndications also are not legally bound to give out a certain percentage of their income. While this may seem like a disadvantage from a cash flow standpoint, the rule allows the sponsor flexibility to form reserves or to pay for unanticipated expenses out of cash flow instead of making a capital call.
Typical returns for syndications are higher than yields on a REIT investment. Depending on the size and sophistication of the sponsor and the structure of the investment, as well your percentage interest in relation to the total equity, individual investors may have direct communication with the sponsor to talk about property operations. Additionally, sponsors may have more flexibility regarding the timing and nature of the investment’s disposition strategy than a REIT or fund, as these are not tied to a fixed fund liquidation date.

It’s Your Money, and Your Call
There are a number of alternatives to help with real estate investment portfolio diversity. All real estate investments involve risk, beginning with the level of experience and integrity of the individuals acquiring, managing and selling the assets. The party could be you or outside professionals. In any case, it is important for you to do your own due diligence to understand the risks, costs and potential rewards of your investment.

ASSUME YOU LEARNED about an opportunity to invest in a real estate project. The property is in a great location, has quality tenants and the underlying economics appear sound. Better yet, it’s within your range of risk tolerance.

However, the company offering the deal is an unknown—you’ve never heard of it.How can you determine whether the offering is legitimate and the sponsor is trustworthy?

When considering investing in a passive real estate deal, the qualities of the sponsor are arguably more important than the underlying real estate:

  • How much relative experience does the sponsor possess?
  • Is the sponsor credible? How do you know?
  • Does the sponsor have the necessary sophistication?

If you, a passive investor, want to maximize the success of your investment, then you must rely on the expertise of the syndicator, promoter or sponsor who puts the deal together. [1]

Why the Real Estate Deal Sponsor Is So Important
The sponsor is the party who:

  • finds the property and enters into a purchase and sale agreement;
  • assembles the capital and financing to acquire the property;
  • communicates with all of the investors;
  • directs and reviews all aspects of due diligence;
  • oversees the operations and management of the property, including leasing and maintenance;
  • provides financial reporting; and
  • arranges for the disposition of the property at the end of the investment period.

If the sponsor is not honest, experienced and diligent, you could lose some (or all) of your investment.

While many industries rely heavily on user reviews to provide general feedback about quality, this practice is not prevalent in the financial services sector. So how do you get good information to evaluate a sponsor?

Certainly, anecdotal information—such as a referral by a trusted source—is helpful. Here are some other, subjective, criteria that tell you how to evaluate sponsors.

What Is the Sponsor’s Track Record?
Understanding the sponsor’s experience with the type of offering at issue, both qualitative and quantitative, is a good starting point for your due diligence.

How long has the sponsor been in business? Who are its principals, and what kind of real estate experience do they bring to the project?

What is the nature of the sponsor’s experience with the type of asset in question, and the geographic location?

Experience with retail or office properties does not always translate to knowledge about, for example, managing a multifamily building. Similarly, a sponsor likely has more insight into, or resources in, markets in which it already has offices, employees or investments.

Relatedly, have any of the sponsor’s prior deals gone south? If so, why, and what did the sponsor do about it? A sponsor that has been in business for some time—especially during the Great Recession—should have some blemishes on its track record. Understanding how the sponsor handled difficult situations in the past, including timely and accurately communicating information to investors, provides insight into what you can expect if the new investment does not go according to plan.

While past performance does not guarantee future results, it is helpful to understand how a sponsor’s projected returns compared to what investors actually received. Beware of a sponsor that indicates that all of its prior investments outcomes were favorable!

Does the Sponsor Have Skin in the Game?
During the Great Recession, some financial institutions created investment products for other people’s money—not placing any of their own funds at risk. This structure numbed the institutions’ natural instinct to avoid assuming too much risk; economists call this a principal-agent problem.

A sponsor’s investment of its own capital (or its principals’ personal funds) indicates the sponsor’s confidence in its own work product. This is especially true if the sponsor is earning a promote—getting paid ahead of, or hand-in-hand with, investors during the course of the deal (or upon disposition).

What is in the Agreement Between Investors and the Sponsor?
When you invest in a syndication, you entrust your capital to the sponsor. You must understand what responsibilities the sponsor agrees to undertake on your behalf—and any rights and remedies you may have if the deal does not progress as originally projected.

You should also determine whether you or any of the other investors can influence major decisions (i.e., a sale or refinance), and to what extent you can liquidate or transfer your interest to someone else.

  • If additional funds are required in the future to preserve or improve the investment, can the sponsor make capital calls?
  • What will happen to your investment if you do not contribute additional money?
  • Are there any circumstances under which the sponsor can rescind your investment?
  • How are you protected from malfeasance by the sponsor or other investors?

All of these considerations should be addressed in the offering materials.

How Does Sponsor Make Money on the Deal?
Sponsors earn fees for putting investments together. The investment documents should clearly disclose what fees will be paid to the sponsor, and when. Some fees are typically assessed up front, while others may accrue over time—such as an annual asset management fee. There are also fees that may be charged upon disposition or refinance of the property.

Some sponsors make their offerings available to the public through the use of registered representatives or financial advisors.

Others enter into subscriptions with the investor directly, in person or over the Internet.

Note that if you invest through a third party:

  1. The third party should, at a minimum, have the appropriate credentials, such as securities licenses, to make the offering available to you; and
  2. The representative earns a commission for bringing you into the investment (in addition to whatever the sponsor earns). This means you should also find out whether that person may have any conflicts of interest. Sponsors who rely on outside brokers to solicit investors may have a larger up-front fee to enable them to pay commissions and still make a profit.

Some deals have a promote structure, where the sponsor receives a percentage of cash flow or proceeds ahead of or concurrently with distributions to investors. You should understand whether and to what extent the sponsor is entitled to fees if investors do not receive the projected cash flow (or worse, if they lose their invested principal).

If there are third parties involved with the investment, such as outside property managers or joint venture partners, the prospectus should reflect how their compensation is calculated—especially if they are affiliates of the sponsor, may have conflicts of interest or do not receive a market rate fee or distributions pari passu with investors.

The parties who create and offer the investment opportunity to you are entitled to compensation for their work. As an informed investor, you should be aware of what those fees are, as well as when and how they arise.

Check References
A legitimate sponsor will be able to identify legal counsel, financial or tax advisors, and lenders it has worked with to serve as references. Further, the offering documents should include opinions from a reputable, independent law or accounting firm.

Other valuable references include the sponsor’s joint venture partners or investors. Find out who the sponsor worked with and why, particularly partners who played a role in the operation of the project, and let them speak to the character and capabilities of the sponsor.

It may seem like a long list of “satisfied customers” would be a good sign of a reputable sponsor. However, that is not necessarily the case if investors are individuals or family offices rather than institutions.

A good sponsor keeps confidential its investors’ information, and a good sponsor does not reveal its clients’ identities without express permission (do you really want your colleague/neighbor/ex-spouse knowing about your finances?).

In the End, Do Not Ignore the Fundamentals of the Deal
Of course, you must always analyze the real estate aspects of any particular investment. Ensure that you are comfortable with the underlying property and deal terms.

Investments in most syndications are illiquid; you should not commit yourself to a project expected to tie up your funds for longer than you are willing to part with them.

Further, the deal should have an exit strategy—a plan to dispose of the asset after a certain period of time, and a fallback plan in case the market, tenancy or some other factor changes during the holding period.?

An investment inconsistent with your personal risk tolerance or time horizon will be a poor choice for you, regardless of the strength of the sponsor.

[1] I will refer to all of these parties generically as the “sponsor” for simplicity.