Why Angel Investors Should Consider Real Estate Investment
By Percy Nikora, Owner, Co-Founder
Introduction
There’s no doubt about it. Angel investing is a lot of fun. Angel investors get a front-row seat to cutting-edge technology, new product development, and more. There’s a lot of interaction with brilliant, inspiring people who are eager to launch their companies. On the flipside, there’s also no doubt that angel investing carries a lot of risk. Many of the companies seeking investment are still in the product development phase. They haven’t tested their product in the marketplace yet, and there’s a lot of uncertainty as to whether the company will actually succeed (and what it will take to get there).
Angel investing is certainly high-risk, high-reward. One way to mitigate that risk is for angel investors to diversify their portfolios with more stable asset classes, such as commercial real estate. That’s why a lot of seasoned investors come to Penn Capital to find out how to get the most return on their real estate investments. Our investors benefit from a team with unrivaled experience and bountiful insider knowledge.
In this article, we look at the many reasons why an angel investor might want to consider broadening their investment horizons by adding real estate to their portfolios.
Benefits of Real Estate Investment for Angel Investors
Angel investors should understand the range of benefits provided by real estate investment, including its low-risk nature, potential for high returns, and low correlation to other asset classes.
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Low-Risk
As noted above, angel investing carries significant risk given the nature of the investments—companies are in their nascent stages and still have much to prove. In theory, that high risk would translate into high rewards on a consistent basis, but unfortunately, most angel investors know that’s not the case. Angel investors often strike out three or four times (or more) before hitting a home run.
Investing in real estate provides more certainty. Unlike investing in startup companies and products, investing in real estate means investing in physical, tangible assets. Real estate has an entirely different risk/return profile than angel investing. The risk is significantly lower. Moreover, depending on the asset class, investors benefit from immediate cash flow. Take an apartment building, for example. Investing in a fully stabilized asset translates into nearly immediate cash flow returned to investors’ pockets. Compare this to angel investing, in which investors often wait years to be repaid—if at all.
Related: Penn Capital Investor Education
There are other benefits to investing in real estate, like depreciation, that help to further reduce risk. Depreciation allows real estate investors to legally shield (defer) income from taxes as it comes in. Real estate investors can also use what’s known as a “1031 exchange,” which allows them to defer paying capital gains tax upon sale if they roll the proceeds into another like-kind asset. Real estate investors can do this in perpetuity, growing their portfolios in the process, ultimately leaving investments to their heirs who then benefit from a stepped-up basis on the properties, thereby wiping out the capital gain taxes.
High potential for return
Most angel investors are typically investing in early-stage companies. The funds invested, whether it’s $500,000, $1 million or more – those are often the only funds the companies have available for working capital, product development, etc. These funds are rarely leveraged to attract other capital.
Compare this to commercial real estate investing. Nearly all real estate is purchased using a mortgage. Most lenders require investors put at least 20% equity in the deal. Thus, for every $1 an investor puts into a deal, they’re getting a four to five times multiplier on their money. That’s a powerful concept. As a result, cash-on-cash returns can be much higher when investing in commercial real estate compared to angel investing, which doesn’t have the same benefit of leverage.
Low correlation with other investments
Real estate is inherently illiquid, especially compared to other asset classes. It cannot be purchased and sold with the click of a button the same way, say, stocks can be. As such, real estate is not as subject to market fluctuations as stocks, bonds and other securities. This provides investors with some insulation during otherwise turbulent economic times.
The stock market may crash, for example, but an investor who owns an apartment building is likely to continue collecting rent payments despite the ebbs and flows of the general marketplace. As such, investing in real estate is a great way for investors to add stability to their portfolios.
Why multifamily real estate?
Those who are considering investing in real estate for the first time are often drawn to rental housing, and with good reason. Everyone needs a roof over their heads, which translates into consistently high demand for rental property. Some will start by investing in single family homes. Yet these are incredibly management intensive—they require time that most angel investors do not have to spare. Plus, a single vacancy for a month in between tenants can result in a 10%+ vacancy level.
An alternative approach is to invest in multifamily. It’s much easier to scale a portfolio of multifamily investments than it is single family rentals (SFRs). Multifamily properties, particularly those with 100+ units, benefit from certain efficiencies in property management, maintenance, marketing and more. Investors who pool their funds with others can buy larger assets, which are more likely to achieve better returns than a portfolio of smaller SFRs.
What’s more, while every commercial property type (multifamily, office, retail, etc.) benefits from depreciation, there are more ways to take advantage of depreciation when investing in multifamily housing. This is because personal property is eligible for an accelerated depreciation. This includes things like appliances and bathroom vanities – items that would otherwise be provided by the tenant in an office or retail lease. Instead, multifamily investors can use what’s known as a “cost segregation” study to accelerate the depreciation of personal property over 5-, 10- or 15-years instead of the typical 27.5 (residential) or 39-year (commercial) period. Multifamily units contain many forms of personal property, paid for by the owner, that the owner can depreciate for greater tax benefits.
Interested in getting involved in multi-family real estate investments? Let Penn Capital help you discover why investing in multi-family real estate is the best return on investment with our free investment guide.
How Angel Investors Can Get Started in Real Estate Investment
Angel investors should start by understanding the nuances of different property types (residential, commercial, retail, industrial, hospitality and the like). As noted above, we’re partial to multifamily investing for a number of reasons.
Angel investors will then want to allocate a certain amount of capital to invest in real estate. Depending on how much money they’re looking to invest along with their risk profile, this will steer the geography, property class (Class A, B, or C), investment strategy (core, core-plus, value-add, opportunistic), and investment vehicle (direct investment as general vs. limited partner, through a syndication, etc.).
Angel investors with higher risk tolerances, for example, may be more open to investing in an opportunistic development deal located in a secondary market than someone who is looking for a “safer” investment to balance their portfolio, in which case they might only want to consider stabilized properties in large markets.
As noted above, investing in larger deals, particularly when investing as a limited partner alongside others, will allow angel investors to grow their portfolios faster and with less day-to-day oversight than someone who opts to get started by directly investing in single family homes.
Why work with an angel investor?
There are already many sources of equity for those looking to source capital for their projects—so why target angel investors? Angel investors can be a great partner for several reasons.
First, angel investors are already familiar with making “private placement” investments. They understand the unique structure of these deals and what’s needed to move the process forward.
Second, angel investors tend to have a higher risk tolerance than other investors. As such, they can be a particularly great source of capital for those looking to pool funds for more opportunistic or value-add projects. Related, because angel investors are investing their own personal funds (unlike a traditional bank, pension fund, insurance company, etc.), they can be more nimble, providing flexible types of financing across real estate product types.
Lastly, angel investment is already considered an alternative asset class. In that regard, it has parallels to commercial real estate, another alternative asset class. While many investors are hesitant to invest in alternative assets, it’s angel investors’ bread and butter. They understand that alternative asset classes are unique and act differently than traditional securities. Any angel investor looking to diversify their portfolio by adding alternative assets will certainly want to consider investing in commercial real estate.
Angel investors vs. Venture capitalists in real estate
There are two primary distinctions to be made between angel investors and venture capitalists. The first is related to where each sits on the investment timeline. Angel investors tend to invest very early on, when companies need seed funding, Series A or Series B funding, for example. Venture capitalists tend to invest in Series C rounds and beyond. The risk profile is different depending on where the investment is made. Angel investors tend to have a higher risk tolerance than venture capitalists.
This is partially due to the second distinction: angel investors are investing their own money. Compare this to venture capitalists, which are investing on another’s behalf. As such, angel investors may have specific criteria for investing compared to VCs, the latter of which tends to be more focused on industries as a whole, with a mandate to achieve certain return targets for their investors.
Angel investors are not driven by the same absolute need to realize certain return thresholds and therefore, often have their own motivations for investing even if it means being willing to accept a lower return. Anyone looking to raise money from angel investors will certainly want to understand an angel investor’s motivation before approaching them with a deal.
Conclusion
As fun as angel investing can be, it also requires a certain level of babysitting – mentoring founders and CEOs, sitting on boards, providing ongoing support and oversight. While some people thrive in this environment, others can quickly become frustrated. Commercial real estate provides an alternative path for investors looking to diversify their portfolios.
Compared to angel investing, real estate is much less time intensive, especially when serving as a limited partner. LPs who invest in a syndication or fund can rest assured knowing that the project sponsor is dutifully overseeing all investment logistics and day-to-day real estate activities. It’s a win-win for those looking to maintain strong returns while taking on significantly lower risk.
Are you an angel investor looking to invest in real estate? If so, give us a call today.
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