#43: Different Types of Real Estate Funds feat. Nathan Clayberg

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Welcome to the Passive Income MD Podcast where we talk about creating your ideal life through multiple streams of income. I'm your host, Peter Kim. If you enjoy hearing about this stuff, make sure to hit subscribe so I can bring it to you every week. Now let's get on with the show.

Hey everyone.

I'm really excited this week to talk to Nathan Kleberg and he is the Assistant Vice President at MLG Capital, which is a company that is probably well known to a lot of you. I've talked a lot about it on my blog. I'm a personal investor of theirs. For those who don't know about it, I'm going to let Nathan talk about it and we're just going to be talking about different funds today and different options for people that are trying to get into these passive private real estate investments. Why funds might be a good thing, why funds might not work out great for you, how there are different types of funds out there for different types of investors. Whether you're investing out of personal funds versus some of your retirement accounts. We're going to talk about that all today.

So.

Hey Nathan, how are you doing?

Doing well. Thanks for having me on, Peter. I'm excited to share a little bit about MLG and hopefully educate people on different options of investing.

Yeah, I mean I always love talking to you because you're a wealth of information. For those who don't know MLG Capital, can you first off tell us about who you are and kind of what your focus is?

Yeah, you bet. So MLG just kind of 40,000 foot view. We're a 34 year old private real estate investment company, been around for a long time now. During that time we've really been involved in every facet of the industry. Everything ranging from ground up development to brokerage and leasing. And nowadays we focus a little more on the acquisitions and management side of the company or side of the industry. But regardless, very experienced group. Our principals investing together for an average about 23 to 25 years. So they've seen a lot of, I think this is their first pandemic, but they still seen a lot. For the first 25 years or so of the company's history, we did all individually syndicated deals model that I'm sure you and many of your listeners are familiar with where you're just putting investors into one deal and we did really well doing it that way. I think if you took every deal that MLG has ever exited, we've averaged about a 2.24x multiple on an average hold of about six and a half years. So it's a pretty good batting average, one that we're proud of. But the syndication model does leave investors really exposed to a lot of single asset risk. And quite frankly, many retail investors don't have the access to deal flow in order to get effectively diversified within their real estate holdings. Especially following up 2008, 2009, you see the crazy things that the market can throw at you. We decided it'd be best for our investors to move towards a fund structure where investors are getting diversified both geographically and across asset classes. So that was kind of the catalyst for moving to the fund structure. Launched our first fund in 2012. It's been really well received by the marketplace. The first fund was just a $27 million fund. We actually just closed out fund four in November of 2020. It was a $250 million fund and just launched fund five about two weeks ago. It's going to be a $300 million fund. Right. To go to 350, we always give ourselves a range. But trying to get investors diversified in a basket of 30 to 35 different real estate properties.

So you mentioned that people are able to invest once and then they get a whole basket of investments. How does that work? Because when people make that investment, at this point, you haven't bought all those properties yet, right?

Yeah, people can invest at various times. We typically Fundraise for about 24 months, and people can invest at any point during that fundraising period. Really, you can think of it as buying into a mutual fund of real estate, where you're buying an interest in this partnership that gives you an interest in every property we've acquired previously and every property we will acquire for the rest of the fund. And so it allows you to effectively become diversified in your real estate holdings. Now it's going to change a little bit. If you come in at the beginning of the fund, the fund's not really well built out yet, then there'll be a lot of properties that are yet to be added, but you would still have an ownership, in theory, in all of those that that are yet to be added.

I think that brings up a good question. So if you're raising money for a couple years and the fund is open for, then I know that people have asked us before, are there pros and cons to investing on the early side of a fund versus a later side? And, you know, people are always trying to figure out, is there like an optimal time to do so. So do you have any thoughts on that?

Yeah, you know, there really are pros and cons to both sides. And I think it really kind of comes down to what your investment objectives are. You know, if you come at the beginning of the fund, you're, we have an 8% preferred return, and you begin accruing that for a longer period of time. And also we give a little bit of priority in the early quarters as far as cash flow to early fund investors. When we make our distributions, we're paying based on your percent ownership of the unpaid portion of the preferred return. So in the early quarters of the fund, as we're ramping up and we're, we're executing a strategy to grow the income of the properties that we're buying, we're usually probably be paying out in the 4 to 6% range. So say it's a 5%, that 3% difference is accrued and carried forward, and you would accrue that over time, early fund investors would have accrued a greater portion than someone who comes in towards the end of the fund, and as a result, they get a share of the cash flow that's slightly higher. But there are benefits coming into the end of the fund as well. If you want your cash to be tied up for a little shorter period of time, that that's a benefit, you get a little more visibility into the assets that are in the fund. And so you, in theory, kind of have a better sense of exactly what you're investing in. And also, you know, because you're in at the end, you're cash had it for a shorter period of time, it tends to juice your IRR a little bit. Whereas early fund investors may experience a higher multiple, but a little lower IRR just because it's such a function of time.

You're saying that basically when you invest early, you're not able to see what, I guess some of the properties are already in the fund. Right. But you're not actually, if you invest later, then you haven't gotten all those returns that some of the early investors have gotten. Right.

Right.

So let me ask you then, when you close out a fund and you go to a brand new one, is your investment philosophy just like, just. This is just good to know. For people who are investing in funds, is your investment philosophy, does it change from one fund to the next one, or is it pretty much the same idea and concept and it's just, again, a new set of investors?

The large kind of fundamental principles that we're relying on, I would say generally stay the same. Right. We believe in the fundamental concepts and the investment Thesis of investing in private real estate right now, specifically in multifamily and industrial. We really like those two asset classes and kind of the way they're positioned in the broader macroeconomic environment. But we do make tweaks, right, based on kind of what we're seeing in the marketplace. For example, in Fund 5, we're seeing some opportunities that we've more traditionally been a value add type player. But sometimes there are opportunities by really well located real estate that's a little newer, but it's a great basis and a location that you'd be happy to own in. And there's not really a value add proposition at those deals. But there's also less execution risk. So we always say we're in the business of doing smart real estate deals. We think that there's, there's an opportunity in those types of deals on occasion. And so within Fund 5, we're, we're being a little bit more open to considering those types of opportunities.

So do you mind, do you mind kind of making a little bit simpler for someone like me or somebody may not be super familiar with some of these concepts, like what does that mean? I know that value add means that, you know, maybe you take a place that needs a little bit more work, a little bit more kind of heavy operation, operational management type stuff from you. What do you mean by some of those other properties that may not need that execution wise? So what does that look like?

Yeah, that's a good question. So kind of in general you hear value add a lot. That's kind of a buzzword in the industry. You know, there's a lot of fruit in that type of investment, but you're always relying on some sort of execution of a strategy. It could be going in and doing renovations and raising rents. It could be being a little more efficient on the expense side, things like that. But there's risk that's involved with executing that. Right? What if you go and you do the renovations and tenants aren't willing to pay the extra a hundred buc. You know, a large portion of your return is kind of dependent on achieving that rent lift. Now we like to think that when we're, you know, making these types of investments, we're doing the necessary market research that we feel really confident that we can execute. But you could look at a different type of property where it's not really a value add proposition, but there's limited execution risk. Right. You don't need to go in and raise rents. You can just go in and manage it really efficiently. And if you bought it at the right price, in the right location, in a location that's experiencing job population growth proximate to general economic drivers. We have a lot of confidence that five years from now we're going to be really happy we own that asset at this price. And we're not taking on the risk of raising rents or executing whatever the value add strategy is.

So since the risk is you're considering somewhat of a lower risk, does that also kind of alter your returns or maybe expectations for returns for people that are investing in, in these type of investments, maybe they might expect a lower return, for example.

Yeah. So in Fund 4, we had targeted returns of 12 to 16%. In Fund 5s, we've kind of broadened that to say, 11 to 15%. Really just to give ourselves the ability to do these different types of deals that we would feel, like I said, involve a little bit less risk. Still, if we're going to be doing a value add deal, we would expect to see that kind of higher return profile just because you're trying to get paid for the additional risk that you're taking on.

Okay, got it. And I noticed that in this fund, like you did with the last one, there are two different pathways that people can take. And I think this is fascinating because I haven't necessarily seen this with all types of funds, but I thought it was clever to meet different investor needs. So I'd love to talk about the different pathways that people could take. And this is pretty important to understand how you can invest in funds in different ways. So can you talk about what you guys have done specifically with Fund 5 and kind of split into two, and then I'd love to kind of break each one out and try to understand them better.

Yeah, you bet. So this is actually what we've done here is kind of pretty common in institutional type funds. It's a little bit less common as far as being available to retail investors. And really it's two different entrance vehicles into the same fund entity. And they're the same as far as what you're investing in, the strategy, the leverage, everything like that, and the expected returns. The difference really lies in how they're structured from an income tax perspective. So the two vehicles, I guess, do you want me to kind of just dive into the differences between the two? So the first one, we call it our main fund or our private fund, and really that's structured as a traditional LLC vehicle. So that that's probably pretty similar to what you see with a lot of syndications or most other funds. Where everything is passing through directly to investors, and that's distributions as well as depreciation. MLG, we have nine CPAs on staff right now. We're pretty focused on maximizing the after tax cash flow for our investors and we're going to be pretty aggressive at accelerating that depreciation and passing that through in the first year if we can. Typically, that ends up being about 50 to 60% of what investors have invested. So said differently, and a million dollar investment last year, you would have received about $600,000 in passive losses, which for folks that are highly taxed and highly compensated, that can be a really powerful tool to offset and defer some of your income that's taxed to high rates and benefit from the time value of money. So we're absolutely doing that on our main fund investment. Now, one of the things that's important for investors to consider is that we are trying to get folks geographically diversified within our fund investments. And that could mean that we're going to invest in probably 10 to 12 different states. Now, two of our primary states that we invest in are Texas and Florida. So there's no state income tax, but you could realistically see eight to 10 different states that you would potentially create an obligation to file state tax returns in. So especially for folks who are coming in for smaller dollar amounts just kind of getting their feet wet, the additional potential 500 bucks or whatever the case may be of, of tax prep costs can start to kind of cannibalize some of your returns. Right. If you come in for $50,000, let's say, which is our minimum on the taxable side, and you have a $4,000 accrued pref, but you have $500 of additional tax prep. It does have an impact, but it's less of an impact than if you're going to invest 500,000. Right. Those tax prep costs are relatively fixed. So that's kind of how the main fund works. Any questions on that before we kind of talk about the other option?

No, I think that's the type of fund that we normally are used to, especially the ones that we've talked about on this blog and on the podcast and things like that. That sounds pretty standard.

Yeah, yeah. That is, I think, kind of the common mode of operation within the industry. But we actually have a second option that we think is a little bit more unique and does solve some problems for investors. And really we incept it. It's called our dividend fund. We incepted it for folks looking to invest through their retirement account. Into our fund. What we've seen happen in the past is if folks invest passively in debt finance real estate with their retirement account, they could be subject to an additional tax on those earnings called unrelated business Taxable income or ubit. You or some of your listeners may have heard of ubit, but that happens from the realization of passive rental income within your fund or within your retirement holdings. What we did is we inserted a private subsidiary REIT entity between the investments and the investors. And really this REIT just flows cash through it, but it reclassifies the income that you're realizing from passive rental income to dividend income. The dividend income avoids that potential UBIT issue, which is certainly one benefit. It also for folks who are considering a smaller investment and maybe wouldn't want to deal with that multi state filing obligation, they can avoid that by realizing dividend income within the dividend fund as well. So we found that that has been a really attractive solution for many of our investors. Now the dividend fund, if you're investing taxable dollars, doesn't allow for quite as powerful of a pass through tax benefit as far as what you might see in the main fund. But that REIT entity still is capturing some of those losses that are coming up from the properties and the cost segs that we're doing. And you're still receiving some of the benefit as a, as an individual investor. It's just maybe not quite as powerful or as efficient as it could be in the main fund.

How about returns though for people? Because I think that's probably the, you know, the tax benefits are obviously a huge part of this. Probably the primary thing is the returns. So how do the returns look? Just straight from a cash on cash basis, different between the two groups, the.

Returns are really going to be exactly the same effectively, I guess technically there's a very, very small difference. The dividend fund has about $20,000 of additional expenses. In fund four, which is a little smaller fund, we had about $40 million invested in the dividend fund. So the 15, 20,000 of additional expenses over the 40 million was really immaterial difference. So you're accruing to the exact same returns targeted to that 11 to 15% with 8% pref full return of capital and then a split thereafter.

Okay, so how does an investor decide? So it sounds like you come up with some of the criteria that seem to make sense for people who are kind of thinking one way or another. So not that we're going to help them completely decide, but it sounds like if you are an investor and you can really make, you know, use of those losses. Right. Those passive losses that normally happen with investing in these syndications or funds, the depreciation flows through to you. You're able to capture those passive losses. There's some listeners here who are watching this or listening to this, who are this real estate professional status have this real estate professional status. They're able to capture and take those losses and sometimes offset their regular income. But it sounds like if you're not really able to make use of those passive losses and you end up paying a lot in terms of state filing taxes, then it might make sense to go to the dividend fund. Does that sound right to you? Yeah.

You know, it's generally wise to consult your cpa, you know, to figure out one, exactly how much they're going to charge you, two and how well you can use the losses. Like you just said, some people have other passive income or some people have that real estate professional status. So that's definitely worth a worthwhile conversation to have. But it's also kind of important to ask yourself exactly how much you would think about investing too. Like I said, a smaller dollar amount invested would potentially be a little bit more burdened by the additional tax prep cost than a larger dollar amount. So if you're an investor that's thinking of coming in for a larger amount or ramping up to a larger amount over the course of the next several years, then a lot of times the main fund starts to make more sense versus the dividend fund. So those are the things that I would generally be considering as I would make that decision.

So can you tell me some of the retirement accounts that people are using just so that people maybe something will trigger in their mind about what kind of retirement funds they can use to invest in some of these real estate funds?

Yeah. So if you're investing through your retirement account, we typically are working through your custodian. So the two big ones that we've been approved with are Schwab and Fidelity. We're working on trying to get approval of TD Ameritrade, so hopefully that pans out. We also work with a handful of smaller ones. Rocket Dollar, Millennium Trust, Midland ira, some ones like that, and generally any other small ones. We' get approved on their platform pretty easily. But doing so really allows folks to invest either through their 401k or IRA however they want to do it. It doesn't really matter if it's Roth or traditional. The tax rules are all kind of the same. You're just taxed upon distribution or you tax before you contribute money in a Roth situation.

Okay, so just to be clear, if they're doing this whole dividend fund, they're using their 401, they're using their Iraq, then they can totally avoid this whole idea of UBIT and that sort of thing by going into the dividend fund, whereas if they invested in the main fund, then it might trigger some issues there.

Correct. And we actually don't even allow people to invest in the main fund with their IRA at this point or any other retirement accounts. We just. Retirement account. We automatically funnel into the dividend fund.

Okay, and does that carry, like, the same type of minimums that it does in the main fund as well? Both of both sides?

It does not. So any taxable investment in either the main fund or the dividend fund is a $50,000 minimum for a retirement account. We do have $100,000 minimum. Really, we just have a little more compliance in dealing with the custodians. So we do ask for a little bigger check size there.

Okay. I mean, I'm curious now that you, you know, you have this long track record. You mentioned this is the first pandemic your group has been through. I think this is the first for everybody, most everybody here, especially those of people who are listening to this. So what have you seen in the market, especially through the last six months? And kind of does that make you optimistic about things in the future? Entering 2021, obviously you are raising your next fund. So it sounds like you're optimistic about something. Right. But I'm just saying, what have you actually seen in the market since then? And how have you guys as MLG really addressed these issues to make sure that obviously the previous funds that you have are going to be successful moving forward?

Yeah, that's a great question. I think kind of first, people ask me this frequently, and one of the things I always say is if you're kind of readjusting your whole strategy at this point, you're probably a little bit too late. Right. It's kind of too late to make some of the changes in the assets you've already bought. And I've been just really thankful that we invest first, out of a diversified fund and second, that we generally are trying to be a lower leverage group, typically targeting around 60 to 65% loan to total capitalization. That just gives you a lot of cushion in dealing with whatever the market throws at you. In this case, it's pandemic, but it could be something else. We're really well positioned because of our leverage point to kind of weather any storm that we're faced with. As we look at what's happened over the course of the last nine months, we've seen across our portfolio probably around a 6 or 7% drop in collections. We've also seen some pretty significant savings in the way of interest expense. We have about 40% of our portfolio is financed with floating rate debt and we always buy an interest rate cap to avoid the risk of rates going back up. But the net impact to cash flow has actually been pretty small in our fund because of the offset of the interest expense savings. Now when we look at the portfolio as a whole, generally we're seeing class A or higher end type product in good locations tends to be faring a little bit better. In theory, those tenants have a little, a little more cushion in their financial situation. They're able to work from home and their jobs have been less impacted. So collections in that type of product within our portfolio have actually been really strong. Where we've seen a little bit more issue is on the more workforce housing type product, where those jobs are generally a little bit more exposed to service and retail sectors, which have been hit pretty hard during this whole pandemic. And that's where we've seen some more issues on the collection side. So I think as we kind of move forward, we definitely are being really cognizant of what type of asset we're buying and what can be reasonably expected going forward from a collection standpoint. But then we start to look more broadly and say, okay, what are the fundamental forces at play here? We have a strategy that gives us some cushion to deal with the short term by being diversified, being low leverage. What do we feel about the long term prospect of investing in real estate at this point? And for us it really comes down to the fundamental concepts of supply and demand, right? Multifamily and industrial, which are two by far favorite asset classes. We're about 95, 96% occupied pre Covid and the demand drivers, especially in multifamily, aren't going anywhere, right? Populations continuing to grow, usually about by 7/10 of a percent per year. Culturally, we tend to see more and more households being formed as people are moving out from their parents household sooner and forming their own place. Problem is there's pretty limited supply, right? The construction costs have increased so much in both single family homes and in apartments that people can't oftentimes buy homes, but they also can't afford to live in the new class A product just because it's so expensive to build. Rents have to be higher. So when we consider kind of those forces, we generally start to think that long term, if we can get into value product at a good price and just spruce it up a little bit and make it feel like the newer, nicer product, but at a price point that's more reasonable for most renters, we think that it's still a really attractive investment overall.

Okay. I mean, that sounds. Sounds like you guys have a strategy for that. And it sounds like 20, 21. And moving forward, you're really optimistic about at least the. I mean, I guess the outlook for you guys. I mean, it's funny because, like, different places that you look, I mean, I guess depending on the market, obviously it has its own cycles and that sort of thing. You've mentioned California, Florida. What are some of the other states that you found yourself kind of like heavily targeting, especially at this time?

We actually don't really invest much in California more.

Sorry, I'm at Texas and Florida.

Yeah, yeah, yep. But we really like some of the Texas markets. They're experiencing a lot of growth. We found that there's kind of been a trend that's been happening over the past few years where Americans are kind of moving away from some of what would be historically considered the core markets into what have typically been more secondary markets across the country. I'm talking Dallas is kind of becoming more core, but that fell into that category. Austin, Houston, Atlanta, Charlotte, Phoenix, some markets like that that have generally not been considered kind of a core market. And people are kind of moving from downtown core to suburban secondary. And that's generally right where we've kind of had our bread and butter. And that's been in our wheelhouse for a long time. So we think that we're going to keep focusing on those types of markets, really honing in on sub markets that are experiencing significant job and population growth. You know, we want to be near the best jobs. We want to be where the best schools are different, things like that, that we're really kind of dialing in on the exact place in a market that you want to be, because really, real estate does come down to, you know, sometimes which side of the street you want to be on. Right. It's a very, very local game. So we're kind of considering both the broader macroeconomic trends in larger markets, but also what's happening in specific submarkets that we want to be in.

All right, thank you for that. You know, before we, you know, thank you for your time and before we let you go we spend so much time on kind of like blog podcast courses that we have just really focusing on really helping people do the proper due diligence for these type of deals. Because I think that's where it all starts, right? Once you kind of are in the deal, you're in the deal to the end. So I'd love to get some advice from you. What do you think the number one thing, when somebody approaches you or somebody else to figure out whether it's the right person to invest with or whether it be a good group to invest with, what should they be asking you to make sure that, hey, they're doing kind of their proper due diligence? I mean, there's so many things to ask. What's like the number one question that you think, you know, if you gave someone advice that they should be asking you?

Yeah, that's a really good question. You know, I think when we're doing due diligence on a deal and I bring a deal to our investment committee and say, this is an asset that I think we should buy, one of the questions that they'll always ask me are, okay, what are the critical assumptions that I have to believe for this. To believe that this deal is going to hit these returns? Right. I would really appreciate if people would ask that question, say, what are the critical assumptions that I have to believe for this deal to succeed? And a lot of times what you'll find is that the critical assumptions that sponsors are pitching are maybe a little bit less believable and achievable than they're making them sound, especially if you're doing some market research. For example, if a sponsor is saying, well, we just have to achieve $300 of rent growth in the next two years and sell it at a 5 cap and we'll hit a 15 IRR. You know, that maybe doesn't sound quite as believable as some other set of assumptions that you could say. So that's what we're kind of using as our barometer for whether or not a deal is an attractive opportunity. I would think it'd be interesting for listeners to ask sponsors that question and put them on the spot and say, okay, you know, what do I have to believe to have success here?

That's a great answer. Thanks for that, Nathan. Well, thanks again for your time. Really appreciate it. Obviously, MLG has an amazing track record. You've done a great job with all the funds. I've seen the track record of you guys. And honestly, you've just been a great resource for people here. At Passive Income md. So I want to thank you for that. Take care and let's talk again soon. Best of luck.

Yeah, great. Thanks, Peter. Appreciate the time and hopefully make some listeners some money here soon.

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