When I first started investing as an LP, I was optimistic about replacing a big portion of my income with mailbox money. The allure of passive income is powerful, especially if it can make you less dependent on a job you would rather not work. If it were only so easy. I had to go through some experiences, personally, to see the landscape as I see it today. Now, after eight years entrusting my capital with sponsors, I have learned some lessons that have shaped my current approach. Here are some of the myths and some mistakes I made personally, or I see other passive investors make, that I hope you can learn from to avoid.
1. I thought the syndicated REPE (real estate private equity) space was small and niche.
I thought there was a relatively small group of sponsors who controlled all the commercial real estate in the country. Opportunities to access a piece of a deal and get in the game seemed rare to me. This is simply not true.
I remember the first passive investment I allocated to a multifamily property in San Antonio, TX. The offering memorandum used phrases like “generational opportunity.” If it were, I certainly wanted in.
The reality is, the real estate private equity space is massive. There are a lot of players and a lot of transactions happening. I’m still being exposed to new sponsors every week.
You are not going to miss a generational opportunity if you take the time to get to know a sponsor, evaluate their deal, and ultimately pass. You’ve just gotten sharper by adding a data point to your evaluation of future deals. The more you evaluate, the more you dial in what’s happening in the market and what appeals to your risk tolerance. There will always be another opportunity, so don’t get FOMO. Patience is prudent. And emotion is the enemy of rational thoughts.
2. I thought passive investing was 100% passive.
After you wire your funds, assuming things are going well with your investment, passive investing can be truly passive. But if you want to preserve and grow your wealth, you need a deal funnel to source opportunities. That takes some active work on the front end.
I found a lot of value by listening to podcasts, reading books, attending real estate conferences, and getting on distribution lists of sponsors I took an interest in —then reviewing their deals and underwriting, even if I didn’t have the liquidity to invest. Practice makes perfect and reps are important.
A lot of people find a sponsor who they like and trust, and after a few deals with them, don’t bother to evaluate deals they invest in moving forward. I think this is a mistake. Sponsors are people and people change. You always want to make sure your risk tolerance and investment goals are aligned with any new deal, even if it is with a trustworthy sponsor. Maybe their risk appetite has changed. If yours hasn’t, there could be a potential for misalignment. Again, this takes some work and is not entirely passive.
3. I thought a preferred return was the cash flow I could expect consistently from the investment.
It may be, but the asset may not be able to cover the preferred return during the early stages of the hold, before the business plan has been executed. Or, as we’ve seen a lot lately, property level expenses and interest payments (if floating rate) may rise faster than the income the property generates, eroding free cash flow to pay out to investors.
I remember getting a pretty lean distribution on an early deal I invested in, when I was expecting an 8% yield every quarter. That’s what the preferred return was advertised as after all! But a preferred return accrues over the hold period. If it is not paid out via “current pay,” there will be a catch-up payment made, when available, or if there are enough proceeds to cover it at the time of sale.
This is important for someone trying to replace income from their W-2. Distributions can be lumpy and inconsistent, which is typically a stark contrast from a direct deposit every two weeks from your employer.
4. I didn’t ask the right questions.
I had no structure to my initial calls with sponsors. You get 30 minutes, in most cases. Make the most of it. I certainly didn’t. I let the sponsor dictate the call, which typically consisted of their thesis, their track record, and how great they were. Many of these people are skilled sales people and have excellent pitches.
But salespeople should also be good at handling objections and adversity. I want to test that. When I go into introductory calls now, I have a plan. I’ve already done my research on their current portfolio, their exits, seen their content on social media, and am subscribed to their newsletter. I want to get into the weeds, if all I have is 30 minutes.
5. I thought that because I liked someone, I could trust them.
The fact is, it should be the other way around when it comes to being a limited partner. If I trust someone, I could potentially like them. We all want to do business with people we like. But when it comes to investing passively, you aren’t going to be a business partner of the sponsor, talking to them frequently, so is liking them an absolute requirement? Maybe for some.
What you really want is someone who is capable and will be a fiduciary of your capital and refuse to lose in the face of adversity. Someone who’s prepared for a number of different scenarios to unfold, with a plan for each. Someone who has ethical and moral standards. Someone who gives you access to their underwriting. Someone who provides you their SSN number and home address for you to conduct a background check. Someone who has done it before, many times over.
I extended trust too easily. I liked a few sponsors I invested with and found out later that I didn’t necessarily trust them.
6. I wasn’t as focused on a diversification strategy.
With high minimum investments, it can be hard to diversify the portion of your portfolio allocated to LP positions. I thought by just allocating to a few deals, I was diversifying from public markets and rounding out my overall portfolio.
This wasn’t true. These are ultra concentrated positions. If you sell $50,000 of an S&P index ETF to invest in a single-asset LP deal, you’ve lost diversification. You’ve sold a basket of 500 companies and traded it for a stake in a single property with a single person/company running it.
To be diversified as an LP takes time, but is worth striving for. Build into a rounded portfolio. Diversify by sponsor, real estate asset class, property class (A,B,C), geography, debt maturity, and position in the capital stack. You should decide on what portion of your overall portfolio you want to allocate to this type of investing, and then how much you plan to add each year. Work backwards from there. If capital is a constraint, consider joining a “tribe” where group investing with lower minimums can solve the problem. If single-assets feel too concentrated, explore investing in a fund.
7. I didn’t always take the time to read the Private Placement Memorandum (PPM).
The PPM is a comprehensive disclosure document, highlighting all the risks and what could go wrong with your investment. It can be 50-100 pages, some of which includes legal jargon. Subsequently, it can be intimidating. However, passing it over and assuming everything is disclosed in a webinar or offering memorandum is perilous.
The PPM explains how money will be made and profits shared. It lists all the fees you can expect to pay. It spells out your rights as an investor. It helps provide a window into the general partnership’s thought processes around specific scenarios during the investment’s hold period.
One example scenario is the treatment of capital calls. Generally, capital calls are not mandatory, but there could be consequences if you decide not to participate. These include losing your equity and rights in the fund, interest on amounts you did not honor, sale of your stake to a third party, and possible legal liability for damages to the partnership.
For my first few investments I skimmed these documents, without a clear understanding of what I should be looking for. Today, I read through them fully, making sure I address any concerns with the sponsor. No question is a dumb question.
8. I wasn’t an active participant in a community like PassivePockets.
Community is so powerful. This is a great place for education, to share experiences, ask questions, learn about investing strategy and opportunities. Maybe most importantly, it’s a place to vet sponsors. When I first started investing passively, I tried to do it all alone, without a network to lean on.
Today, I will never invest with a sponsor who is new to me before talking to other LPs who’ve participated in their past offerings. I want to know the good, the bad, and the ugly. More often than not, you can find someone within PassivePockets who knows who you’re dealing with. They might just save you from making a regrettable decision.
What it all boils down to? You want to be able to confidently answer the question – am I gambling or am I investing. Either is fine at certain times. You just don’t want to be the person who thinks they’re investing, when actually gambling.
The more informed you are, the better decisions you can make. Hopefully these lessons can help you avoid some of the mistakes I made early on.
About Paul Shannon
Paul has acquired over 200 residential units, by “recycling equity” and/or joint venturing. He has experience in underwriting, acquisitions, raising capital, property management, project management, and is a licensed Realtor.
Paul is also a limited partner, investing in over 40+ deals as a passive investor – Multifamily, industrial, sale leasebacks, preferred equity, 1st and 2nd position notes, ATMs, mixed-use development and private equity.
These experiences have led to the formation of InvestWise Collective, a customizable fund aimed at helping investors diversify out of traditional markets into passive real estate opportunities.