What are these mysterious cash flow positive real estate vehicles?

For anyone who is interested in investing in real estate, one undoubtedly runs across individuals or groups who speak or write about cash flow positive joint ventures or some other variation of this phrase linking real estate, passive income and investment returns.

The pitches tend to have a familiar refrain: there a generalized notion of positive cash flow related to real estate. However, there are very rarely little specifics mentioned. Read positively, it follows standard sales and marketing tactics: sell benefits and not details. Read negatively, the generality of the pitch seems evasive and troublesome.

Several years ago, I briefly investigated the possibility of investing in real estate. For a wide variety of reasons, I took a pass. Nevertheless, it was interesting to discover just what some of these vehicles were.

The following is by no means an exhaustive over-view of the topic; some of these may not be favor anymore or tweaked to reflect the market. I readily admit this may not be current information and I am more than happy to be corrected for the education of all concerned. But, to dis-spell the mystery of cash flow positive vehicles,  here are some nuts and bolts of some private real estate investment vehicles being offered. I have avoided real estate related securities (other than the one exception below). I have added some quick and dirty pros and cons.

1. Investing in 2^nd (or 3^rd mortgages): Million Dollar Journey had a thorough post on investing in 2^nd mortgages. These types of deals are typically found through mortgage brokers or real estate lawyers. Pros: mortgage grants you security to your investment. Returns can be higher than stock returns (8%-12% for 2^nd mortgages 12% + for 3^rd mortgages). Steady cash flow. Can be invested through RRSP and income received on a tax deferred basis. Cons. 2nd mortgage is, practically speaking, not fully recoverable if the appraised value of the home drops or the borrower is not significantly paying down principal on mortgages (in other words, beware the interest only mortgages in an uncertain real estate market). RRSP administrators are known to be difficult.  High returns = higher risks. Some key factors to consider: Borrower’s financial standing and understanding of historical appreciation rates of real estate in that localized area.
2. Co-ownership with a “finder.” In a nutshell, finder has found an income producing property and has secured financing but requires some more money to meet the lenders financing conditions. Investor contributes the remaining down payment in return for a proportionate interest of title and cash flow after finder takes a property management fee.  Pros: Participate in both monthly cash flow and appreciation of real estate. If finder performs property management functions, income is as passive as one can get. Cons. As partial owner, if the roof needs replacing, you may need to make a capital contribution to the property. Cash flow return may be quite modest after expenses and property management fees are paid (mid to low single digits). There are a certain politics involved in determining the finder’s value. Some key factors to consider: Do you trust the finder to be reliable? Understanding the rental market in that localized area. What’s the exit strategy (needs to be formalized in a joint venture agreement).
3. Special purpose loan to a finder. This has multiple variations.  One variation is finder requires a loan for special purpose typically extra capital to acquire a property to flip or capital used to improve a home already acquired to rent out. Investor loans money which can be secured or unsecured depending on negotiations with a quick exit event (sale of home, refinancing once home is improved and can be reappraised etc). Sometimes there is a bonus payment to the investor on exit. Pros: Rate of return can be high given short use of funds. Cons: Is the actual exit event realistic or pie in the sky? Some key factors to consider. Due diligence on possibility of exit is key. For example, can the property actually be flipped for the appreciation claims? Can the units be rented out for what the finder says it can be?
4. Limited partnership units. A quasi real estate and securities investment. A general partner (GP) has identified a property which it will acquire and manage. Limited partners (LP) contribute money to make the down payment. In income producing properties, LP’s receive distributions proportionate to their interests. The GP assumes the liability of the project. The LP’s loss is limited to its investment. Pros. Ability to invest in more sophisticated projects. Losses are capped at money invested. Limited partner offerings can fall under securities law legislation meaning a relatively high level of financial disclosure. Projects tend to be larger scale (apartments, entire condos, commercial premises). If structured properly, can be quite tax efficient. Cons. Depending on jurisdiction, it is only offered to accredited investors (hence it is more popular in Western Canada where the threshold of an accredited investor is lower). Much larger cash contribution required. Cash calls can occur and, given the larger scale of the project, they can be quite substantial per unit. Less control given larger pool of LP holders and GP controls the entire project. Some key factors to consider. GP has the experience and knowledge to manage the project properly. Investor understands the financial statements provided in more sophisticated projects.

Four Pillars has a tangentially related post on purchasing foreclosed properties.

The level of due diligence has to work on at least two levels- on the individual the investor is partnering with (or the potential borrower) and with the property itself. One could argue that it is better invest in real estate with a Grade A partner and a Grade B property than the other way around.

At the end of the day, real estate investing is much like stock investing. One has to conduct its own due diligence thoroughly. Just because the investor can touch and see the investment does not mean there is less opportunity for abuse by the intermediary or it is a good investment. Good luck.