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WHITE BOARD WORKSHOP
Paul Keough, Principal at TurnKeough Wealth Management
Today we have probably one of the brightest guys I've ever met on the show, Paul Keough. He shares some fascinating insights into how the world of wealth managers and RIAs handle private equity real estate investing.
There is a lot to learn from Paul, as you might imagine, both as an investor and also as an RIA or wealth manager. We talk about the pros and cons of private real estate, how to succeed in private real estate in a recession, how to use an RIA to invest in private real estate. And particularly interesting to me is how Paul explains the structure that he puts in place at his practice to invest in real estate on behalf of his clients.
What You're Going to Learn
- How to Connect the Dots Between Investment and Equity in Private Real Estate Deals
- How an RIA Helps to Mitigate the Risks of Private Real Estate
- How to Succeed in Private Real Estate
- How a Wealth Manager’s Perspective Informs Public Vs. Private Real Estate
- The Strengths and Weaknesses of Public Real Estate
- The Benefits of Investing in Private Real Estate
- Why Real Estate Investment Trusts (REITS) Are Like a Tradable Market
- And much more!
Listen To or Watch the Full Podcast Here
Connecting the Dots Between Investment and Equity in Private Real Estate Deals
Adam: So now when you go ahead and identify a sponsor in a project that you like. What is the structure pull? How do you set that up inside your firm to actually connect the dots between the investment itself, the deal and the investors equity? Are you creating an SPE? Are you creating a fund? Just tell me what that how does it how do you do that internally How does it work?
Paul: Yeah, that's good. That's a good question. So I'm a broker. I was a Wall Street analysts. Luckily, I have I'm a true independent broker. You will want to make sure first you're working with a fiduciary who put your interests first and as per client, follow regulations. That's number one. And so there's two ways. Basically, you can find a private custodian who can then custody the money and pool it. Number two is you can go directly to that organization and write a check to them. Obviously, the second one's more of a risk. You were writing a check to ABC Capital Company and they just opened up. There's a possibility of fraud if they've existed for 35 years and they have a track record of 25 successful private investments. You're probably OK. And so those are the two basic ways you can go and I really encourage all investors to go from zero percent private investing to one. If you're at one, go from one to five. If you're at five go to 10. Just like foreign investing, half the world GDP is outside the US. We only invest in the US. So if you're one percent foreign, you should go to five. If you're five, you should go to ten or you're missing out on growth. So you don't want to miss out on half the world's growth outside the US. You don't want to miss up on half the investments in the world which are private. And so that's why I encourage people to truly diversify to alternatives, private and foreign.
Adam: So just one more question on this. Just so I understand this. If you find a sponsor who's got a PPN and they want to raise money and you're representing clients, you've got however many hundred clients, billions of dollars under management, and you want to channel some of that capital into that sponsor's project. Are your investors writing checks directly to the or your clients writing checks directly to the sponsor? And if so, how are you making a living from that? Is it not coming through like some kind of conduit that you have internally, perhaps?
Paul: I have decided not to create a conduit internal. I think it creates a compliance and regulatory mess. It looks like a shell game. I just want to be involved. I don't think that's the right way to go. Look at Enron. I mean, it just I just don't think it's the way to go. So if it's IRA money, retirement money at risk, the money could go to a private custodian. It basically will say, so and so's name. It'll say IRA, FBO, Joe Smith. So it's actually written to themselves, but it's helped by a private custodian. If it's non-qualified money or post-tax money or a direct investment, you are writing it to that capital company. Now they'll often create themselves a shell company that says X, Y, Z, Investment Pool, LLC. So that's the way. Now, how do I make money? On the private side I don't want to get in the way of growth when I was a venture capitalist. We didn't have a return for three years, which is actually very good sometimes every 10 years. And so during that time, to take a fee makes no sense because all you're doing is harming the investment by taking capital away from the investment. So on the private side, what I do is take nothing until the end. And then I take what's called a two and 20 The same thing hedge funds do, two percent management per year, plus a 20 percent take on the profit. And by then, if we have a 10 Bangar, they want to give me more money. So two times five years would be 10 plus the 20 is 30 percent they had a 10 Bangar, I'm taking three fold. They're taking sevenfold and they're begging me to take more money and I can't. So they want tax deductions. So that's the way to do it is back ended. So that while the investor is waiting and stressed out and not making any money, I'm also waiting. So I'm in conjunction with the investor in my interests are aligned with him.
Adam: Absolutely fascinating. So you take a two percent assets under management fee, whatever they put on an annual, but not not on an annual basis? At the end.
Paul: So, again, if the investment if you take the two percent from the investment, you've hurt the investment. And just hurt the capital. Is that two percent per year or that's total two percent? Two percent per year. So five years goes by. It's two times five is 10 percent. Got a 20 percent take of the profit is 30 percent.
Adam: Fascinating. Wow. That's a lot of money. But you waited.
Paul: I waited five years and at that point. If they got seven X and I end up with three X, they're begging me to take more money and I can't.
How an RIA Helps to Mitigate the Risks of Private Real Estate
Adam: Let me ask you though from a wealth managers perspective, there are some who won't touch private real estate. Because, I don't want to put words into your mouth, Paul you're the expert that's why you're here. I want to ask you, but with publicly traded real estate stocks, like REITs, Et cetera, there are analysts reports you can look at detailed analytics, whereas the private side, you don't have that advantage. So what are the what is the resistance typically that you think RIA's, wealth managers have to private real estate versus publicly traded real estate?
Paul: Yeah, that's a good question, Adam and it's certainly something taken seriously. We always want to talk about risks first. And there's something called Blue Sky Laws. If you've heard of those and you can imagine once upon a time, someone's swindling people with snake oil that would cure your Covid-19. Or the Spanish flu at the time. So you can imagine there are all these terrible things that happen. That's why we have blue sky laws. That's why my industry is the most regulated industry in the world. And it needs to be because there are scams. So there's been a lot of there's been a lot of private scams, not just real estate, but anything, venture capital, private equity, you name it. And Europe is much more conservative than the United States. They tend to be debt only. In the United States we're more aggressive. We tend to look at equity more aggressively. Now, Europe's doing that, too now. But traditionally, Europe was debt only United States brought this equity idea to the manifold in a very aggressive way. So Americans were very aggressive about equity and taking risk. But it's important to know that there is risk. Now, how do you mitigate that would be the would be the question. So really, it's about the managers. Who are the managers? And when I was a venture capitalist, humans, it's real estate, location, location, location, private investing is people, people, people, because great idea. Bad managers. It's gone. You're actually you are looking at the strength and reliability of people. Are these people prudent? Are they putting the interests of the investor in front themselves? What kind of terms do they have in their contract? So it really takes experts and that's what we do as generalists.
As we noted, those experts and become somewhat of an expert in real estate and other fields like biotech. And just by the fact we've been doing it for a long time. But you want someone who's a fiduciary, you want to fiduciary to have good channel checks with their suppliers. You want customer referrals. You want interviews with the managers. You want to believe those people. I mean, it's just like you interviewed me, but we pre-interviewed to make sure Paul's a normal guy. So it's the same thing. I go I call him and I see. Who are these people? What are they like? Are they are they people that I would trust? Are they people that I would let in my house? Are they people that I would let play with, my children? I mean, there's these kinds of thoughts you have and on a scale of one to 10 and if the person is a zero out of ten. Should you be doing business with that person? So I think some of that is very good diligence you can still do. There is more on just the scrutiny of the private side today than there was even 20 years ago, because there are organizations, there's angel investor groups, there's there's a lot of social networking. There's a lot of experts that can communicate with each other faster, better, cheaper today than even 10 years ago. And so, yes, but it is it is a risk. But I'd say that's the same for any private investor.
How to Succeed in Private Real Estate
Adam: All right, so we got into specific niches. Tell me something about the advantages of investing in private real estate. Like, for example, correlations, we talked about this a little bit, but non correlation with the stock market illiquidity premiums, presumably, Et cetera. Tell me something as a kind of as a classic loan, the strength and weakness. So why are you doing it?
Paul: Well, one is the rental income, as I was saying. And if you're retired. Retirees. They want distributions that are that are going to satisfy other expenses. And the growth rate has to beat their distribution rate. But I work with a lot of retirees. Retirees have to R&D there. That's required minimal distribution of their retirement accounts. That could be three to four percent. So the investment better double that number. You better get seven to eight percent growth every year consistently so that they're not draining their IRA accounts and running out of money. So when you think of that position, it's a really good fit for an IRA, for a retired first. Now, the active person for the active person who's working and thinking, do I want to put my money in private real estate? You don't have to take the distribution. You can take that growth and the growth, just like dividends but could be reinvested. So if you can get a seven, eight percent steady growth while the market's going down, you could be 40, 50 percent above where the really market is because you're going up and the market's going down. And so it's a really good hedge on a recession. That will be the second reason that you think of income, income, meaning rent as a good source because you don't get to distribute it to yourself. Remember, like a dividend, you don't have to take the dividend, you can just have it reinvested. You don't have to pick the coupon from the bond. You've could have reinvested. So the same thing with rental income. You don't have to take the rental income as income and distribute it to your own checking account.
You could just have it sit as cash and reinvest it back into the property or a different real estate investment. There's a third reason. The third reason is really specific to people who sell their property or sell a business or sell a piece of land. It's something called a 1031 exchange. If you sell land and you would have had to recognize capital gains on that land at a certain point, if you do want a 1031 exchange into a private REITs or REITs or real estate investment, like in kind, you sold real estate, you bought real estate. There's no tax cuts. And so there's a third reason that private real estate is very attractive. And, their scale from very large companies to very small, the very large ones, you've got liquidity, the very small ones, you can get that really high return. And so that's how people think about it. They think where do I want to put the money. Do I buy a McDonald's? You could do that. Do I buy a house and become a landlord myself? That's pretty messy. And what if they Section nine on you and you can never get rid of them and they don't pay the rent? Or do I go with the huge conglomerate that's dealing with thousands and thousands of rental units and they manage it and I just passively get income and some of that's pass through. And so that's why people look at 1031s in retirement. You got to work with a fiduciary and you've got to work with a good tax lawyer who knows how to do 1031s so you don't get taxed.
Adam: Exactly. Yes. So the tax code is obviously private real estate, definitely tax beneficial, isn't it? All right.
Paul: Because you've got the tax benefit year benefit of the 1031 exchange and then you have the pass through as well. So there's really two tax advantages to real estate.
Public Vs. Private Real Estate – A Wealth Manager’s Perspective
Adam: I'm dying to hear from you what wealth managers think about the world of real estate. So why don't we kick off with my first question that you and I have been talking a lot about back and forth on what we're going to chat about. So let's start with what are the strengths in from your perspective, particularly as a wealth manager, what are the strengths and weaknesses of public real estate? You can certainly contextualize that in this crazy Covid-19 world in which we are all surviving and thriving, some of us. Go ahead Paul, floor is yours.
Paul: Thanks, Adam. Thank you for having me on your show. I'm happy to speak to you or your crowd and help investors or helping small businesses and investors right now. We can't we can't move fast enough. We can't get to enough people and so many people who need help. Real estate has definitely some advantages. The public side, of course, you have liquidity. It's public. So you can track it and there's better transparency. There's also what's called a tax pass through where part of your investment, when it's returned to you as a distribution, can be perceived as a return of capital instead of income. So there's that advantage, the disadvantages. It moves like market. So we've seen public real estate drop 37 percent this last month. And that's upset a lot of people. And we knew that real estate was at a high premium. But really, if you think about it, if you were selling your home, Adam, or if I was selling my home, it felt like our house actually changed in any perceivable way in a month. But if it was publicly traded, it would have dropped thirty seven percent and its unrealized loss. So that's the disadvantages. So the strengths of private is that there's always a delay in any kind of correction. So just like you and I, if we sell our house, nothing changed with my shingles or my brick or my fireplace and so forth to drop 37 percent in one month, it just doesn't make any sense.
So on the private side, when we do a private transaction, you are shielded from the public market to a certain degree and this time you can see is a good thing right now at this time. And, you know, there's a lot of diversification on the private side, just like I was I was a venture capitalist in the past on the private side. You tend to see new ideas. You tend to see better, cheaper, faster ideas. The brightest minds are often on the private sides. You see creative things in real estate and new ideas in real estate that you don't tend to see on the public side. The weaknesses, of course, lack of transparency, not traded, lack of liquidity. It's hard to get out of it, because you and I trying to sell our house. We need a buyer and the buyer backs out we don't sell our home, if they don't come to the close we don't sell our home, if a loan doesn't come through. So there's a lot of limitations on the on the private side that would dissuade people. But right now, it's a very good time to be on the private side because valuations haven't really shifted much and the market is active and there are a lot of great creative ideas.
Strengths and Weaknesses of Public Real Estate
Adam: Tell me about the strengths and weaknesses of private real estate.
Paul: This these are this is going to be I'm going to be very picky Adam, because what I'm going to tell you right now, I would not have said two months ago. I would not said in 2009, for example. So I feel that the situation we're in, you said the Covid crisis, the situation we're in, I believe, should be categorized as a government action. And since, if it's a government action, that means it can be reversed. Right. So look at China and South Korea, where they reversed it and are getting back to normal. So now it could become a recession or a depression if drags on long enough. And I very much believe in the sort of the U Recovery with the possible second U or a small W if we haven't yet again next season. So the reason I'm stating that is that I think that's important to the thesis of what you do in the private side. When we have this kind of situation, let's say it is a recession or it looks like a recession. Whether it's the government action or recession, it looks and acts like a recession. So if it looks and acts like a recession, there are two areas along, kind of five sectors within private real estate. I particularly like right now, multifamily unit and rentals, apartment rentals. If you look back in 2009 to 2012, what parts of real estate did well, those two. Why, people couldn't buy homes,factories were not expanding, industrial wasn't expanding, they couldn't get loans. So what was actually going up? Rentals. You saw rentals, multi-family unit, condos, apartment complex rent.
And so if you're investing in the private side of real estate, my recommendation turn your recommendation is rent, because people, especially millennials, feel very a lot of millennials, I feel, are really unfortunate situations where they can't invest. The way I did, I'm 50 when I was in my 30s. So I feel really, really feel a pain for them. And what's the challenge for them and everyone? Is that rental actually goes up in recession. It's kind of hard to find the things that work in recession. It seems to me to be a strange thing to say, but in every phase of the economic cycle, you can make money. So in recessions, you can make money off rentals and rental income is very steady. In fact, your occupancy goes up instead of seventy five to eighty five, you might have 90 to 95 percent occupancy and multi-family unit goes up as well. Townhouse or townhouse strips. Almost certain you see those in the UK as well. The townhouse strips and people round them out. I mean so you get the townhouse communities are completely filled up. And so if you're renting, if you're investing, that's where you should go. I don't like industrials. I don't like a single family because those are debt based. And if that blows up, you're back to the derivative prices. I don't like industrial because you have to put large amounts of investments into them intermittently and you can't predict when it's going to happen. You need new air conditioner. There's asbestos, a new regulation comes on board and now you got to do this, that or the other thing and so those are the two particular areas.
The Benefits of Investing in Private Real Estate
Adam: So for moving away from the generally publicly traded liquid kind of assets that you normally associate with wealth managers into the private real estate world. What is the what are the primary drivers for doing that? Why do you take on that burden now of going out and getting to know a sponsor? Tell me why that is a good thing?
Paul: Very fair question. So first, the investors have to be qualified as accredited investors to do that. And that takes a fiduciary like myself to say you have enough assets and enough income and if you lost this money, it would not detrimentally affect your life. So that's number one is screening people. Number two is, so when I was a venture capitalist if you're going to take that kind of risk, where you have less liquidity, less transparency, less information. And you may hold it five years you have no control over the sale. Just like the sale of your home. It's difficult, right? We can't we can't predict that. If you're gonna do those things, the investor demands higher return. So the benefit to the investor is high return venture capital. When I was doing biotech, my lead investment in Wolverine Venture Fund, Handylab doubled the fund size and the fund and the fund members over five years. We doubled the funds. What that really means is that investment went up like tenfold when some things went up OK, somethings sat flat, somethings lost money. We luckily had a 10 banger so the whole fund did well. And so I let people know that there's high risk. But with high risk investors demand high return, and if the high return doesn't occur they move on to better organizations.
So that's where we look at history. You can look at what are the returns in the past? How well have they interviewed managers? How well have they scrutinized those firms without micromanaging them to death? Did you feel totally competent, like Shark Tank? So, you know, it's a balance, really. It's a balance system where the more risk you take. You should have more return, other inefficiencies. And I'm pleased to say that the private mark is one of those inefficiencies. If you have good research and you find good managers and you network well and you have a good system of due diligence, you may find private investments whose returns are well above their risk profile. So we've seen things in the 20, 30, even 40, 50 percent year over year return ratio, which is very, very attractive. Having said that, we're seeing that kind of stuff. There must be stuff going to zero. And so and so that's what you have to do, is be able to tolerate the risk, the investor has to be able to swallow it if it doesn't go anywhere. It's a cherry on top if they win, you get to brag if they win. Who cares if they lose? That's how you have to treat it.
Why Real Estate Investment Trusts (REITS) Are Like a Tradable Market
Adam: So when we're talking about public real estate, we're talking about things that are traded as though they were a stock like REITs. Is that right? That's what you're referring to there.
Paul: Correct. So real estate investment trust. Is bits and pieces and parts of properties. That was put the problem in 2008 is that the derivatives mathematician's with P.H.D's, like my brother Charlie, were chopping up all of these houses into little bits so no one could determine what part you owned, if any. And so that's where REITs got a bad name. But traditionally, the good part of REITs is when it's real assets and you actually own things, which most REITs do. And then they're trading publicly because people see real estate like any other industry. Some people want to buy it. Some want to sell it. And therefore, it is tradeable.
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