How to Identify a Not-So-Promising Real Estate Investment
Investing involves risk, and the daily ups and downs of the market are beyond anyone’s control. What investors need to be extremely careful of, however, are the hidden risks that may cause an investment to go wrong, even when the market goes their way. Many investors shun investing in private real estate due to complexity, high fees, or concern about Madoff-like schemes. Each one of these arguments is valid, to an extent, but the reality is that private real estate is an asset class that can enhance the performance of any portfolio. There are great opportunities out there if you know what to look for, but avoiding the land mines along the way is equally as important. The market is filled with some excellent sponsors, but it is also filled with sponsors who are looking to do nothing but line their pockets with your hard-earned savings.
Long-term success in investing means putting yourself in a position to win from day one, which means it’s imperative to steer clear from the sponsor whose only interest is in enriching themselves. That doesn’t mean you will succeed in every investment, but it does improve your odds of making money in the long-run. Being able to distinguish a bad deal from a good one is not extremely difficult if you know what to look for. In many cases, even the most basic research can help you avoid a big mistake. Below, I analyze a private non-traded REIT offering, as it’s a great case study for what a potentially awful real estate investment looks like.
MVP REIT II, recently renamed to Parking REIT, acquires parking lots in the United States and Canada for the purpose of investment. I’ve identified six red flags about this investment that all investors should be aware of to avoid making a bad investment decision.
Red Flag #1: A CEO with a Questionable Track Record
The CEO of MVP REIT II is Michael Shustek. One would expect the CEO of a $500 million parking REIT to have significant experience in this asset class. Shustek has none to speak of. Prior to MVP REIT II, Shustek ran two other REITs, Vestin Realty Mortgage (Vestin) I and II, whose primary business was in making loans. Not only is his experience in acquiring and operating parking garages limited, the two former REITs he ran lost nearly 90% of their value under his leadership.
Red Flag #2: A Low-Fee Value Proposition
Any investment that is enticing investors with their low-cost fee structure is probably not worthy of your dollars. I recently wrote an article about the high cost of low-fee real estate and MVP REIT II is the poster child for the title. MVP REIT II’s prospectus claims they invest 100 cents of every dollar raised into the property. Considering the rest of the non-traded private REIT market invests less than 90 cents into a property, this was a big red flag. While the statement is legally true, it’s misleading and dishonest. The sponsor assumes that the investor won’t dig deeper to find the facts. But, in reality, there are enough fees in this investment to choke an elephant.
Red Flag #3: A Hidden, Outrageous Fee Structure
Sometimes a prospectus’ footnotes are just footnotes, but other times they reveal something very important. Notice footnote #1 in the image below that states the “sponsor or its affiliates” will pay the selling commissions and organizational costs. It would be nice to think a benevolent sponsor will pay an investor’s fees, but that doesn’t happen in real life.
MVP REIT II’s marketing materials are legally accurate, but confusing and misleading. There are tremendous fees paid by the investor after the investment is made. The table below is an approximation of the fees investors will pay over 10 years if MVP REIT II is successful in raising $500 million, assuming $1 billion in real estate is acquired using 50% debt and 50% equity.
|Total Estimated Fees|
|Acquisition Fees (one-time)||$25,000,000|
|Acquisition Expenses (one-time)||$10,000,000|
|Asset Management Fees (annual)||$100,000,000|
|Operating Expenses (annual)||$200,000,000|
|Disposition Fee (one-time)||$30,000,000|
Additionally, the prospectus shows that a long-term incentive plan was adopted by the board to attract and retain qualified directors, officers, employees, and consultants, which has the potential to add another $50 million in costs over the life of the investment. When you find sponsors hiding important information, you need to consider what else they might be hiding.
Red Flag #4: An Elaborate Fee Scheme that Benefits the CEO
The REIT fees are being paid via an elaborate revenue sharing agreement Shustek created between his new REIT and his old REITs, Vestin I and II. He uses capital from Vestin I and II to fund the offering fees of MVP REIT II. In return, the REITs get a piece of the fees outlined above, but he devised the agreement so he personally gets a large share of the fees as well.
The agreement between Vestin I and II, MVP REIT II and Michael Shustek is outlined below:
“The operating agreement of the Advisor provides that once we and VRM I have been repaid in full for any capital contributions to the Advisor or for any expenses advanced on the Advisor’s behalf, or capital investment, and once we and VRM I have received an annualized return on our capital investment of 7.5%, then Michael Shustek will receive 40% of the net profits of the Advisor.”
The Vestin REITs are on the hook to pay all the expenses of MVP REIT II and, in return, will receive a share of the fees produced by MVP REIT II. However, once the REITs are paid back in full, plus some interest on their capital, Shustek personally gets 40% of the remaining profits. Keep in mind that Shustek is the CEO of all three REITs, so we can surmise that this scheme was devised by him personally.
Red Flag #5: Conflicts of Interest
Every deal has conflicts of interest. The question is: does the manager do his best to avoid them or is he disclosing the conflicts of interest so he can legally act in a conflicted manner? There are more than 10 affiliated entities involved with this REIT and Michael Shustek either owns, manages or has a beneficial interest in all of them. The entities perform services for the REIT and the fees outlined above will flow through these entities and into his pocket. Shustek certainly isn’t able to be an impartial party to the negotiations between the REIT and these other entities.
The conflicts of interest are pretty clear but I was shocked to discover the following information: Shustek, as CEO, personally acquired a loan from Vestin II at a 60% discount to face value. And, within ten months of this transaction, the loan was paid off in full.
The excerpt below was taken from a section in the 10-Q of Vestin II:
“On November 25, 2014, Shustek Investments Inc., a company wholly owned by our CEO Mike Shustek, entered into a loan purchase contract with us to acquire a loan with a book value of approximately $2.4 million… The purchase price of the loan was approximately $3.0 million…”
Keep in mind that he was involved in originally making this loan and he was CEO at the time he acquired this loan. He was supposed to be representing the interests of the investor and maximizing shareholder value, but clearly failed at doing so. This is an individual who boasts in his bio that he taught an ethics class and wrote a book on first deeds:
“He is a guest lecturer at the University of Nevada, Las Vegas, where he also has taught a course in Real Estate Law and Ethics. In 2000, he co-authored a book, “Trust Deed Investments,” on the topic of private mortgage lending.”
Red Flag #6: Fraud Investigations and Complaints Found via Internet Search
By now, it should be pretty obvious that this is an investment to steer clear of. If nothing else, investors should always conduct a thorough google search about the CEO, the team and their past entities. In this case, a simple Google search revealed some very telling evidence of Shustek and the company he keeps. The search revealed self-dealings, FBI investigations, accounting fraud and countless complaints by investors. Another account and more detail of this elaborate scheme can be found here.
Some Products Should be Avoided Altogether
Some investment vehicles, like non-traded private REITs, simply aren’t investor friendly. Fees destroy returns on all investment products and when they cause your investment to be down 10% or more on day one, walk away. The lack of transparency and high fees is why institutional investors don’t invest in non-traded private REITs.
Unfortunately, these products are recommended all too often because investors understand them and they are easy for advisors to access. The word is getting out which is why non-traded private REITs have been falling from grace over the last several years. Nearly $20 billion in capital was raised in 2013 and that number fell to less than $5 billion in 2017.
Public Non-Listed REIT Fundraising 2007 – 2017e (in millions)
Source: The Stanger Market Pulse
To be fair, not all non-traded REITs are bad investments, but there are better choices available and the best real estate managers don’t pay to have their products sold. Public REITs are efficient, a great option and, according to Green St. Advisors, have outperformed private REITs by 3.6% on an annualized basis. For accredited investors, private equity funds also offer a great tool to access private real estate in an efficient manner.
Getting into a private real estate investment is easy, but getting out can prove to be difficult, which is why so much work must be done on the front end to understand the investment and hidden risks. You never know what the future holds with any investment, which is why putting yourself in a favorable position on day one is vital. Sometimes bad decisions have favorable outcomes, but that’s called getting lucky. Smart investing is about making good decisions that have a high likelihood of favorable outcomes. Look for a manager who has a good track record, invests alongside you, keeps fees to a minimum and avoids conflicts of interest. Look for red flags in an investment by using the tools at your disposal. It doesn’t take a financial analyst to do a simple google search or read the first two pages of a prospectus. You’ll be both a smarter and wealthier investor by asking questions and being curious.
To read a more in-depth perspective about MVP REIT II, click here.