Understanding Fully-Managed Real Estate Investments by Lion & Foster International

Understanding Fully-Managed Real Estate Investments Written By: Cliff Perotti International & Investment Real Estate Specialist

CopyrightÂŠ2015 Cliff Perotti

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Table of Contents About the Author .......................................................................................................................................... 3 Author’s Introduction ................................................................................................................................... 4 Real Estate Investing in General ................................................................................................................... 5 Fully-Managed vs. Going it Alone ................................................................................................................. 7 Real Estate Investment Goals ....................................................................................................................... 8 What is meant by “Fully-Managed” ............................................................................................................ 10 Fees to Expect ............................................................................................................................................. 13 Steps to Investing in a Fully-Managed Real Estate Investment .................................................................. 14 Accredited Investor Defined ....................................................................................................................... 17 Communication of Investment Activity ...................................................................................................... 17 Year-End Reporting and Your Taxes............................................................................................................ 18 Closing Comments ...................................................................................................................................... 18

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About the Author Cliff Perotti , is a 31 year veteran of the real estate industry, with over 600 properties and $100+ million in closed sales. He has been an International Speaker with the National Association of Realtors, Florida Association of Realtors, Womenâ&#x20AC;&#x2122;s Council of Realtors, RE/MAX of Indiana, Coldwell Banker Residential Services, the Council of Real Estate Brokerage Management, and Century-21 Real Estate. Cliff is the author of The Real Estate Entrepreneur (McGraw-Hill) and the Producer/Host of The Property Beat, a real estate talk show. Cliff has experience in all aspects of real estate, from analyzing, acquiring and negotiating; to managing, improving & selling property. He has extensive experience in the development of residential and mixed-use properties.

CopyrightÂŠ2015 Cliff Perotti

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Author’s Introduction Over the years, I have seen countless individuals invest in real estate by themselves, only to lose money because of their lack of experience, lack of time, lack of knowledge, and greed. For years we’ve all been hearing about how great real estate is as an investment, but there’s really no one to teach us the ins and outs of how not to lose your shirt. So, for my own clients who are busy professionals and want to be in real estate, but simply don’t have the time, knowledge or inclination to buy something on their own. I’ve always recommended using a fully-managed real estate investment to get started. This publication came about because of the large number of clients that were looking to invest in a fully-managed real estate investment, but didn’t know what to look for in a good investment or the red flags of a bad investment. I hope you find this publication a useful tool in deciding whether or not fully-managed real estate opportunities are a good fit for you.

Cliff Perotti Author

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Real Estate Investing in General When considering real estate investing, you should understand the general attributes of the investment compared to an equity stock or government bond. While I may have my personal bias towards real estate, the overall sentiment is that an investment into the stock market would perform better than real estate over the long term, so long as you disregard the benefit of leverage and taxation. In a December 2014 article by Diana Olick of CNBC, she touches on this very subject. She compares the S&P 500 performance to that of the Case Schiller Home Price Index. In essence, she points out that since 1890, the real S&P composite index has increased 12.2 fold (about 2.03% per year average). According to the article, during this same period, the housing index has only increased 1.5 fold, or about .33% per year. But is that the whole picture? Let’s first point out that this is a comparison of an equity held for investment versus a personal home. So this really isn’t an apples for apples comparison. Since most people do not purchase their home for all cash, one must adjust for the concept of leverage on the real estate side. Assuming the average buyer puts down 20% as a down payment, then the equity growth alone would be over 250% (2.016% per year average) for the same period. Suddenly, we’re looking at a comparison that is very similar. But you might say, “But if it’s leveraged, it will have interest expense that a stock doesn’t have.” Of course! But so what! You’re also renting out a property for rental income, which should cover not only the property’s expenses, but also its debt service. What better way to grow equity than to have tenants pay for the cost of ownership?

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And then there is the tax benefit of real estate ownership that tips the scales towards real estate. Given that you can deduct all expenses and interest paid on a real estate property, including the paper-expense of depreciation, you can actually end up with more write-offs than the property generates in revenues, which can save thousands in income tax. Of course, this varies with each personâ&#x20AC;&#x2122;s tax situation, but you get the idea. So for most investors, real estate is a strategic and important element of their investment portfolio and part of their wealth-building strategy. You can read the CNBC article at: http://www.cnbc.com/id/102249202.

CopyrightÂŠ2015 Cliff Perotti

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Fully-Managed vs. Going it Alone

The options for most real estate investors can be summarized in the following options, as shown above: •

Solo Real Estate Investing. Going it alone. Buying the property on your own with your own money, making or supervising your own repairs and upgrades. Advertising for, and screening of tenants. Collecting rents. Managing the property. This is a recommended path for someone who has the time, knowledge, and resources to effectively run a property. This type of investment requires that all money comes from you and can take up a lot of time keeping the property going.

•

Friend or Partnership Imagine…a friend comes up to you and says, “Hey, I’ll do all of the leg work and you provide the capital for a real estate investment. We’ll then split the profits 50/50.” That’s the typical scenario between partners, with one partner bring the muscle and

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experience to the table, while the other provides the capital. Occasionally, you’ll see a true 50/50 of capital, but not very often. The challenge with this model is that investors often have very different objectives and styles of handling issues that arise. A lot of friendships can be destroyed in this type of an investment. As you can see, this type of investment still requires a high capital requirement, but less time than going it alone. •

Real Estate Investment Trusts (REITS) A REIT is often a publicly-traded entity that is a corporation that invests and operates large real estate investment properties, e.g., shopping centers, high-rise office buildings, etc. The minimum investment is often higher ($250K+), so most often this is an investment device for higher net worth individuals. REITS are often focused on income generating types of investments, producing more average returns for stockholder/investors. But the good news with REITS is that they require no time, once your initial investment decision is made.

•

Fully-Managed Real Estate Investment This type of investment offers an interesting mix of REIT/Partnership. Usually, this type of investment is put together by a Sponsor/Manager, who is often a real estate broker or construction company or developer. The typical format used is a Limited Liability Company (LLC), in which capital investors are limited liability members, and the Sponsor/Manager is the Managing Member of the LLC. In this type of investment, the capital investment required is usually $50K-100K, so it requires less than a REIT, but typically doesn’t require any time of the investor, unless it’s to attend an investor update meeting of some sort. Because of the lower capital requirement and the liability shelter for the investor, the Fully-Managed Real Estate Investment offers an attractive investment option.

Real Estate Investment Goals A Fully-Managed Real Estate Investment typically has one of three major objectives. These are: • • •

Income Producing Growth Value-Added

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An Income Producing investment is self-explanatory. Investors get involved with this type of investment because they want a consistent income stream. An example of an Income Producing property is a NNN Leased building, such as a Post Office. In this example, the U.S. Post Office leases the property for 20-40 years, producing a regular and consistent rental stream of typically 6-9% annually. However, there is typically very little appreciation on this sort of investment, as the income (and thus value) only increases with an annual CPI adjustment (Consumer Price Index). So, if the CPI goes up 1.5%, then the building rents and subsequent building value will rise a corresponding 1.5%. A Growth Investment is typically a property that is located in the path of growth or neighborhood change. Income from a Growth investment model is low, at best, being typically around 3.5-5.5% annually. However, the investor gets a large equity return through normal growth trends in the area. An example of this type of property would be an apartment building in San Francisco or New York. The monthly cash flow will be poor, generating a low 3.5-4.5% return, but the equity growth through limited supply and high demand is exceptional, with properties appreciating in the 10-15% range. And finally we come to the Value-Added investment. The easiest way to comprehend this model is to visualize the “Fixer Upper” property. The property is acquired at one price then modified physically (i.e., adding onto or upgrading the property), or restructured in its use (i.e., changing the use of the property) to dramatically increase its value. A Value-Added investment typically has lower cash flow for the investor (0-4%), but has a very high accelerated appreciation, providing annual returns of 17-25%. A Value-Added investment has a lot of moving parts, so the risk is greater than either the Income or Growth models, but the greater risk also allows the potential for a greater return. As you can see, these three investment types offer different types of investment flavors for investors, who should select an investment that fits their own individual style and investment objectives.

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What is meant by “Fully-Managed” There is a lot of work that goes into making a real estate investment successful. As an overview, here are the simplified steps to a typical “Fully-Managed” investment:

•

STEP 1: Search for the Right Property & Write the Offer o Typically takes 3-6 months o The Sponsor/Manager may write 6-8 offers before getting a property o Typically, 200+ Hrs. in this step o Property Investigations & Analysis to Determine Best Path for the Property o Analysis of Options & Determine Investment Objectives o Arrange for Financing of the investment

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STEP 2: Develop the Business Plan & Raise Capital o Create the Ownership & File All Entity Filings o Market the Investment o Conduct Investor Calls/Meetings o Gather Investor Capital & Work with IRA Custodians STEP 3: Close Escrow on the Target Property o Maintain Communications with Investors & Contractors o Begin Implementation of the Plan

•

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STEP 4: Daily Operations o Property Management o Hire and Oversee Onsite Manager (For Larger Properties) o Maintenance & Tenant Issues o Collect Rents & Pay Bills o Monthly Reporting to Investors STEP 5: Obtain Development Entitlements & Bids o Project Management Begins o Working with Architect & Engineers, Expediters, etc. o Work W/City & County Planners o Obtain Formal Bids from Contractors o Select Contractors STEP 6: Obtain Development Financing o Select Lender Candidates o Negotiate Terms o Apply for Investment &/or Construction Loan o Prepare Package o Appraisal o Work with Attorneys to Review and Execute Loan Docs STEP 7: Construction & Upgrade Period o Maintain Daily Onsite Presence o Work with Tenants, Architects, Engineers, Contractors o Manage Financed Construction Loan Draws o Keep the Project Moving STEP 8: Lease-up and Selling of the Property o Market Rental Units o Screen & Select Tenants o Once the Property is Fully-Occupied:  Marketing of Property for Sale  Contract Negotiation  Close Escrow o Final Distributions o Close out the Entity

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As you can see, there are a lot of steps and a lot of work that is done by the Sponsor/Manager in a Fully-Managed Real Estate Investment.

CopyrightÂŠ2015 Cliff Perotti

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Fees to Expect As you can see from the sample list of activities that may be required in a Fully-Managed Real Estate Investment, there are often specific fees for each of the activities that may be required for your specific investment opportunity. Furthermore, different providers might be involved in each of these roles necessary to accomplish the activity. For example, if a real estate broker will be used to sell the property, a commission will have to be paid to the broker. The following picture summarizes the typical types of fees that you can expect in a Fully-Managed offering. Itâ&#x20AC;&#x2122;s important to understand that these fees should already be included and disclosed fully in

any investment offering package that is given to you, and that not all of these fees apply to every investment offering. Typically, these fees will be either paid to the Sponsor/Manager, if they are doing all of these various jobs, or to third party vendors, if the Sponsor/Manager is using other such vendors to do the work. When all is said and done, depending on the complexity of the investment CopyrightÂŠ2015 Cliff Perotti

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property and roles needed to create the investment success, there will typically be total fees of 25%-40%. This is all taken into account and disclosed in the investment offering documents. While you may feel like this sounds like a high percentage, remember all of the work being done and all of the players needed to accomplish the investment objectives. As long as you, as an investor, are making a good return as set forth in the investment business plan, you should not resent the Sponsor/Manager making a profit. Otherwise, it would not be worth the risk and effort and there would be no investment opportunity.

Steps to Investing in a Fully-Managed Real Estate Investment Regardless of whom you invest with, most Sponsor/Managers will follow a process that is shown in the following diagram and explained below.

ď&#x192;ź Initial Contact This is the first time you contact the Sponsor/Manager. You may have heard about their offering from friends, or responded to some sort of advertising. In this first contact, the Sponsor/Manager will typically make an appointment with you to have a more CopyrightÂŠ2015 Cliff Perotti

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elaborate discussion and mutual sharing of information. At this stage, they may require that you sign a Non-Disclosure Agreement (NDA) or Confidentiality Agreement.  Discussion with Sponsor/Manager This step may be accomplished on the phone or in person, if you live close to the Sponsor/Manager. The primary purpose of this step, for the Sponsor/Manager, is to assess your level of interest, experience and investment objectives, i.e., determine if their investment is a good fit for you. The secondary purpose of this step, for the Sponsor/Manager, is to get your questions answered that you may have about them or the investment offering. Obviously, this is your primary purpose at this step. After this step, if they haven’t done so before, the Sponsor/Manager will require an NDA before they can provide you further information about the investment.  Non-Disclosure Agreement (NDA) or Confidentiality Agreement The NDA is required by the Sponsor/Manager to prevent the unauthorized distribution of their investment offering materials. If you have spoken of the investment to a friend, who is also interested in the investment, don’t just give him/her a copy of your investment documents, but connect them directly with the Sponsor/Manager. That way, they get their own questions answered directly and you maintain compliance with your NDA. Speaking to your friend about the specifics of an investment, could be violating your NDA.  Private Placement Memorandum, Limited Offering Memorandum, Business Plan or Investment Package While there are potential differences between these three documents, they are often used interchangeably in discussions. Whatever you call it, this is the package of paperwork that includes everything you would need to read in order to make a decision about the offering. After you’ve had a chance to read the entire package, you should speak again with the Sponsor/Manager, to get your questions answered…even if you don’t have any questions! There are always questions about your specific situation that arise and you should re-convene in discussion with the Sponsor/Manager to resolve any unknown or outstanding issues. These may be as simple as where to wire your money to, or how to invest with your Self-Directed IRA.  Accredited Investor Questionnaire For most of these investments, you will need to be an Accredited Investor, which has a very specific definition, as provided by the SEC. A Sponsor/Manager who is only working with Accredited Investors will require you to complete a Questionnaire that includes all of the questions needed to properly determine you accreditation. By signing at the end Copyright©2015 Cliff Perotti

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of this Questionnaire, you will be certifying that your answers are true and correct. The Sponsor/Manager is not required to investigate the accuracy of your questionnaire, but to merely have it on file and make sure that your responses fit the definition of an Accredited Investor.  Subscription Agreement This is the form in which you agree to buy into the investment opportunity. It typically requires the Sponsor/Manager to countersign it before the Sponsor/Manager is agreeing to accept you as an investor. This consent may take up to 10 days and is there to allow the Sponsor/Manager to allow the best possible combination of investors and to review your submitted questionnaires, form, etc.  You Submit Your Investment Funds Generally, the Sponsor/Manager, after accepting your Subscription Agreement, will require your investment funds to be delivered, either in cashier check form, or wired into their account. In the event that the investment does not move forward for whatever reason, these funds will be returned to you.  Investment Starts Once the Sponsor/Manager has collected all of the investment funds from investors, they will declare the fund closed, acquire the target property, then start working on the investment, in accordance with their business plan. Depending on your speed as an investor in reviewing documents, the source of your investment funds, and the Sponsor/Manager’s requirements, this whole process typically takes 2-3 weeks from start to finish.

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Accredited Investor Defined While there are some exceptions to the following, a typical individual investor must meet ONE of the following two criteria to be considered an Accredited Investor: 1. Earn an individual income of more than $200,000/year, or a joint income of $300,000, in each of the last two years and expect to reasonably maintain the same level of income, OR; 2. Have a Net worth of $1+ million, either individually or jointly with his or her spouse (without including your primary residence).

Communication of Investment Activity Once you invest in a Fully-Managed Real Estate Investment, how do you know what’s going on with that investment. The level of communication, and the methods, will differ from Sponsor to Sponsor. Communication methods from the Sponsor/Manager to you, the investor, may be accomplished through any of the following:  Regular Updates  Wiki Update Weekly  Monthly email newsletter  Semi Annual Webinar  Annual Meeting  Investors may be able to:  Email questions  Telephone Investor Relations Department  Reports  Financial reports quarterly  End of year K-1

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Year-End Reporting and Your Taxes Because most of these Fully-Managed Real Estate Investments use a Limited Liability Company (LLC) structure, you can expect to receive an IRS Form K-1 in March of the following year from your investment Sponsor/Manager. This form will provide you a summary of the profits or losses, any distributions, and any depreciation allocated to you. While the K-1 reports this information, it may or may not be usable by you, based upon your individual tax situation. You should consult your tax advisor for further information.

Closing Comments We hope you youâ&#x20AC;&#x2122;ve found the information contained herein as useful. If you would like to discuss your investment objectives in real estate with us, you can reach us at:

Lion & Foster International, Inc. 145 Corte Madera Town Center, Suite 442 Corte Madera, CA 94925 Email: CPerotti@LionandFoster.com Office: (415) 367-4200 Mobile: (415) 298-1759 Skype: (415) 729-3351 UK: 44 020 3287 6411

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