If you’re new to real estate investing, one of the questions you have to ask yourself right out of the gate is what type of investor you want to be.
Should you be a direct investor or an indirect investor? You can take advice and recommendations from others, but, ultimately, it’s a question only you can answer.
Before diving into the question, let’s first explore the difference between direct and indirect investing:
Direct investing is direct ownership of a real estate asset. That means you or an entity you own is on the title as the owner of the property.
Direct ownership also means being responsible for every aspect of the investment life cycle, including prospecting, due diligence, finance, acquisition, renovations, management, and disposition.
Indirect investing is indirect ownership in an investment property. Instead of acquiring a property directly through your name or the name of your business, indirect investing involves acquiring an interest in somebody else’s business or company (“Fund”) that, in turn, invests in real estate.
In exchange for your investment capital, you receive an interest (i.e., partnership or membership interest in a partnership or LLC or stock in a corporation) in the Fund with rights to profits and appreciation. These Funds have managers who oversee the various aspects of the investment as discussed above, freeing you from the prospecting, due diligence, finance, acquisition, renovations, management, and disposition responsibilities inherent indirect ownership.
For many investors, the question of whether to be a direct or indirect investor comes down to control. Investors who want to invest directly typically want to keep control of every aspect of their investment. They may outsource certain functions like construction and contracting, but ultimately, they oversee everything.
Having greater control also means the flexibility to pursue a particular investment strategy and how to achieve the objectives of that strategy.
For example, a direct investor can select properties with predetermined criteria based on factors such as location and property type (e.g. office vs. industrial) access to a variety of decision-crucial data on the asset including tenants, physical asset condition, and operating performance.
Having direct ownership and keeping operational control also means keeping control of the profits.
There’s less of a learning curve with indirect investing. Fund managers have already learned the ropes and jumped through the hoops of real estate investing – not only in general terms but also specifically, with particular types of assets, segments, investment strategies, and geographic locations.
The learning curve for new direct real estate investors can be steep – requiring significant time commitment and perhaps capital to pay others to acquire knowledge through materials and attending workshops and seminars to learn the ins and outs of real estate investing.
With indirect investing, someone has already gone through this learning curve – freeing you of the time and capital commitment of overcoming it on your own.
As an indirect investor, your personal liability for the Fund’s debts, obligations, or civil liability is limited to your investment capital. As a direct owner – whether holding title in your personal name or through a limited partnership as a general partner – you may not be able to hide behind the wall of limited liability, especially if you’re accused of fraud or abuse.
Without the protection of limited liability, creditors and plaintiffs may be able to pursue your personal assets to satisfy their claims.
In connection with bank financing, first-time investors will often be asked to personally guarantee a commercial real estate loan to protect the bank’s interest – even with strong loan-to-value.
When considering personal liability and loan underwriting criteria, direct investing adds another layer of potential liability and financial risk not found with indirect investing.
Diversification through indirect investing is the idea of not placing all of your eggs in one basket to spread out the risk of investing. With direct investing, because of the significant capital outlays of acquiring an asset yourself, you’re typically limited to acquiring one or two properties under your portfolio.
Indirect investing opens up opportunities to invest in Funds across a variety of variables including market segment, investment strategy (i.e., value-add, opportunistic, etc.), compensation structure, lockup period, capital commitment, geographic location, etc.
Imagine you had $200K to invest. You could put that all in one investment or spread that across ten $20K investments in ten Funds spread out across different asset classes across various locations. A general market downturn may affect one income stream but not all of them – ensuring continued cash flow through a recession.
If you have high-risk tolerance and don’t mind concentrating your portfolio on a small number of assets to maximize your potential returns on a per-asset basis, direct investing might be right for you.
THE BOTTOM LINE
The decision to become a direct vs. indirect investor typically comes down to three questions:
- How much time and energy do you want to commit to your investments?
- How much capital do you have to invest?
- Are you willing to commit to the education required to become an active investor?
The appeal of indirect investing is the avoidance of headaches. For savvy, affluent investors with little time to spare because of business or career demands, the indirect route is often preferred.
For investors who have time to spare and are willing to take the financial risks and make the personal sacrifices to make it on their own, the direct route is often appealing.
BRIDGING THE GAP
- What if you don’t have time to be a direct investor but want to enjoy the benefits of being one like enjoying higher rates of return and being able to tailor your investments to fit a certain investment strategy?
- What if you could enjoy the freedom of being an indirect investor but have a say in how and where your capital is used?
The good news is this is possible because of the transparency of most private real estate Funds where Fund managers make themselves available to potential investors to answer questions and address concerns.
Through proper due diligence and interaction with fund managers, as an indirect investor, you’re still able to control the direction of your investment by aligning your interests with the interests of the Funds you invest in – giving you the benefits of both worlds: the hands-free aspects of indirect investing combined with focused strategies and returns of direct investing.