13 Passive Real Estate Investing Mistakes to Avoid in Retirement – Part 2

Part 1 of this series covered six planning mistakes: sizing, liquidity, distribution timing, borrowing, IRAs and inflation. Those decisions set the limits on what kind of investment fits your retirement. Part 2 covers the seven mistakes that happen inside those limits, when you are reading a specific offering and deciding whether to trust the people running it.

Mistake 7: Picking the deal with the highest projected return

Projected IRR is usually the most prominent number in a pitch deck and the easiest one to compare. It is also a forecast, prepared by the people raising the money.

Two things make it a poor way to choose between deals in retirement. First, IRR says nothing about when cash arrives. A deal can project a strong IRR and pay nothing until it sells in year five or six. Second, higher projections usually come with more risk: more debt, ground-up construction, or optimistic assumptions about the sale price.

Read the projected IRR alongside:

• The equity multiple, which shows how many total dollars come back per dollar invested
• The hold period
• How much of the return depends on the sale, versus cash flow along the way
• Whether the figures are shown after all fees and the sponsor’s share of profits

For how these numbers relate to each other, see How Returns Actually Work.

Mistake 8: Skimming the fee section

Fees are where projected returns and actual returns drift apart. Each one looks small on its own. Together they can include an acquisition fee, an annual asset management fee, construction or development management fees, a refinance fee, a disposition fee at sale, and the sponsor’s share of profits (often called the promote).

Fees paid at closing reduce the money working for you from the first day. Ongoing fees come out before distributions do. Over a seven-year hold, the difference between a lean fee structure and a heavy one can be larger than the difference between two deals’ projected returns.

Ask the sponsor:

• Can you list every fee in one place, with how and when each is calculated?
• Which fees are paid no matter how the investment performs?
• Are the projected returns net of all of them?
• Does the sponsor’s profit share start before or after investors receive their preferred return?

Typical ranges for common fees are in How to Evaluate Real Estate Syndication Sponsors: 5 Red Flags to Avoid.

Mistake 9: Ignoring the debt

Most private real estate deals use a loan, and the loan shapes the risk as much as the property does. Leverage magnifies results in both directions.

Here is what a 15% drop in property value does to investor equity at different loan levels:

Hypothetical $10 million property. Ignores fees, loan paydown and cash flow. For illustration only.

The terms of the loan matter as much as its size. A floating-rate loan raises payments when rates rise. A rate cap protects the deal only until it expires. A loan that matures before the planned sale means the sponsor has to refinance, possibly in a worse market. When a loan comes due at a bad time, the options are usually to sell at a lower price, refinance for less, or ask investors for more money.

Questions to ask:

• What is the loan-to-value, and is the rate fixed or floating?
• If floating, is there a rate cap, and when does it expire?
• When does the loan mature compared with the planned sale date?
• What happens if the property can’t be refinanced or sold on schedule?

Mistake 10: Taking the projections at face value

A pro forma is a stack of assumptions: rent growth, occupancy, operating costs, construction costs, interest rates and the price the property sells for at the end. Because so much of the return usually arrives at the sale, small changes to the sale assumption can move the result a lot.

Ask to see a downside case. What happens to your return if rents grow more slowly than projected, the sale price comes in lower, construction runs over budget, or the sale happens two years late? A sponsor who has stress-tested the deal can show you those scenarios quickly.

For the metrics behind this, see How to Evaluate a CRE Deal: IRR, Equity Multiple & More.

Mistake 11: Trusting a track record you can’t verify

Sponsors summarize their history in flattering ways: total transaction volume, years in business, the best exits. None of those tell you how investors actually did.

Ask for deal-by-deal results on completed investments, showing projected returns next to actual ones, including the deals that underperformed. Then check what you can on your own:

• Search the sponsor’s past offerings in the SEC’s EDGAR database, where many private offerings file a Form D.
• Look up any broker or salesperson involved on FINRA BrokerCheck.
• Check your state securities regulator for complaints or actions.
• Confirm property ownership through county records.
• Talk to current investors, including some the sponsor didn’t refer you to.

A sponsor with a solid record will expect these questions.

Mistake 12: Signing without reading the operating agreement

The pitch deck is marketing. The private placement memorandum, operating agreement and subscription agreement are the contract, and they control when the two disagree.

The sections that matter most in retirement:

• Capital calls. Can the sponsor ask investors for more money? What happens to your stake if you don’t send it?
• Transfers and estate planning. Can your interest pass to a trust or your heirs, and what does that process require?
• Sponsor discretion. Can the sponsor extend the hold, refinance or change the business plan without an investor vote?
• Investor rights. What can investors vote on, and under what conditions can the sponsor be replaced?
• Reporting. What will you receive, and how often?

For a meaningful investment, paying an attorney to review the documents is a small cost against what’s at stake.

Mistake 13: Forgetting what tax season will look like

Private real estate investors receive a Schedule K-1 instead of a 1099. K-1s often arrive late in tax season, and some investors file an extension every year as a result. A deal that owns property in another state may also require a nonresident state return.

Depreciation can make taxable income lower than the cash you receive during the hold. The sale is a different story: depreciation recapture and capital gains can create a large one-year jump in income. In retirement, that jump can affect how much of your Social Security is taxed and can raise your Medicare Part B and Part D premiums, which are based on income from two years earlier.

Talk with your CPA about the expected timing of a sale before you invest, especially if you are coordinating Roth conversions or other income planning. If you’re investing through an IRA, see Mistake 5 in Part 1. For more on the tax side, see Tax Benefits of CRE Investing Most Passive Investors Miss.

This section is general information, not tax advice. Rules change and individual situations differ.

A quick deal-review checklist

Before you commit to a specific offering, you should be able to answer yes to each of these:

• I’ve compared the equity multiple, hold period and timing of cash flow, not only the projected IRR.
• I have a full list of fees, and I know which ones are paid regardless of performance.
• I understand the loan’s size, rate type and maturity, and what happens if it can’t be refinanced.
• I’ve seen a downside case and can live with it.
• I’ve verified the sponsor’s track record on completed deals through sources beyond the sponsor.
• I or my attorney have read the operating agreement, including capital calls and transfer rules.
• My CPA knows when the deal expects to sell and how that fits my income plan.

Missed the planning side? Read Part 1: The 6 Planning Mistakes.

This article is for educational purposes only. It is not an offer to sell or a solicitation of an offer to buy any security, and it is not investment, tax or legal advice. Private real estate investments are speculative and illiquid and involve risk, including the loss of your entire investment. Examples are hypothetical and do not represent any actual investment. Talk with your own financial, tax and legal advisors before making investment decisions.