I’ve turned my Instagram feed into a nightmare of ads for investments in RV parks, Private Equity, and Multi-Family Real Estate.
It’s my own fault. We all know how advertisements follow you around on the Web, like when you mention wanting a new toaster in passing and then your feed is full of toasters.
I’ve spent the last week clicking on and signing up to get more information from every (potentially) bad investment I’ve seen on Instagram.
Why did I do it? For you, of course.
I’ve seen too many folks sold a bill of goods by shiny marketing and big numbers, and it makes me angry. I’ve been researching the scummiest ads I can find so I can break them down and explain why I think they’re probably terrible investments…and more importantly, use them to illustrate the red flags YOU should be looking for when you consider an investment.
The Growth of Alternative Investments: What Sponsors are Selling
I reviewed 65+ investments. Here are the most common marketing terms used:
· Passive Income
· Guaranteed Cash Flow
· Preferred Returns
· Tax Write-Off
· Tax Benefit
· Short Time Frame / High Returns
They all come down to income and taxes.
Why? Because retirees love cash flow, and these are marketed to retirees and high-income earners, as they’re the folks with enough money to buy.
Retirees need income to cover their expenses, since they’re no longer working. Historically that cash flow came from bonds, but over the last decade, 10 Year Treasuries have yielded 2.5% or less. It’s hard to cover 5% annual withdrawals when your bonds are yielding less than half that.
Sponsors often sell Alternative Investments as a replacement (or complement) to bonds.
They position them as a means of getting immediate cash flow, at a rate significantly higher than comparable bonds. You’ll often see the term Passive Income used, probably because everyone loves the idea of money without work.
Depending on the investment, they also like pitching tax benefits. Sometimes they’ll mention bonus depreciation, other times they’ll talk about IDC’s (intangible drilling costs) from oil and gas investments. This is meant to appeal to high income earners who want to lower their tax bill.
Be aware though, not all that glitters is gold.
I’ll break down why most of these promises are too good to be true below.
Who’s Buying: Accredited Investors
I should be clear. These investments aren’t available to everyone.
The investments I’m sharing today are available only to accredited investors.
An Accredited Investor is someone with:
· Net Worth of $1,000,000 or more, excluding a primary residence, or
· Someone making more than $200,000 per year.
They are expected to be more sophisticated and knowledgeable, so they’re supposedly better able to assess the risks and reward in potential investments.
I think that is pretty terrible logic, but the SEC didn’t consult me. The Securities and Exchange Commission defined the term under Regulation D.
The interesting point is that these investments are targeted towards individual, not institutional investors. The Yale Endowment, one of the world’s most successful institutional investors, isn’t beating down the door to write a check for any of these.
That says a lot to me. Why are the investment sponsors targeting less experienced individual investors, writing smaller checks, instead of focusing on the large pension funds and endowments that can write huge checks?
Simple. Institutional investors know that most of these are crap and would never invest in them.
The Growth of Alternative Investments: Why Sponsors Love Them
Most of these investments fall into an odd corner of regulation, 506(c), that has gained popularity over the last few years. These are private placements and not publicly traded, but sponsors (those offering the investments) are able to market them to the general public through ads like these.
Sponsors love them because advertising allows them to reach a much wider audience, which drives their profit.
Sponsors make their money in two ways:
1. Management Fees – Typically 2% of your investment, every year
2. Performance Fee – Often 20% of investment growth, sometimes based on growth beyond a hurdle rate, other times it kicks in once all of your initial investment has been returned.
Some sponsors build their business around maximizing the performance fee or carry. This is common in venture capital, and it does a better job of aligning interests.
Others focus on maximizing the management fee by growing the assets their firm manages. Sure, they would like to have great performance too, but their main goal is to increase the size of their portfolio. They would prefer 2% of a larger investment today, as opposed to 20% of a smaller investment in 7-10 years.
From a business perspective I get it, but I wouldn’t want to invest with a sponsor who takes that approach.
Alternative Investment Red Flags
You might be thinking Jeb, you haven’t even mentioned what these investments are even buying, and you would be correct.
Frankly, the underlying asset is usually irrelevant.
Instead, my decision to exclude certain investments is often based on trust, more specifically the lack thereof.
When I see multiple red flags, I can’t trust an investment, no matter how good the thesis sounds.
Here are the most common marketing red flags:
· No Taxes
· No Market Loss
· Selling based on preferred returns
· Marketing to a specific demographic, ie doctors or dentists
· Wildly optimistic return assumptions
· Passive Income
· Shelter X% of your income
Let’s break them down, including examples.
This ad gets two thumbs down from me. Here’s why.
The bigger red flag is the mention of guaranteed cash flow from Day 1. What often happens in this situation is a sponsor will raise more capital than necessary, then use some of the extra to subsidize early dividends. The end result is lower returns, as investor returns are diluted by the unnecessary capital.
Sponsors do this because they know that most investors are happy to receive a dividend check and won’t ask too many questions about what that check actually cost them.
The second red flag is the actual thesis behind the investment.
It’s presented as stabilization and lease up of an existing Class A housing complex. They’re projecting high (14-16%) returns in a 2-year period.
This doesn’t pass the smell test for me.
Going back to my piece on commercial real estate, CRE valuations are driven by two things, Net Operating Income and Cap Rates.
NOI (Net Operating Income) can be increased by increasing your top line (raising rents, lowering vacancies, those sort of things) or by lowering your expenses. Some force an increase in value by buying a class B apartment building and upgrading it to a class A building, then raising the rents to match. Others buy buildings that are half occupied and fill them, keeping everything else the same but increasing NOI.
Either way, I don’t see how either of those are options in a brand-new complex that is already a class A space.
So that leaves Cap Rates. Remember, CRE is like a bond, when rates increase, values decrease. Likewise, when rates decrease, values increase.
Without seeing the numbers in their projections, I imagine they’re basing their returns on a drop in interest rates. They can show a 33% increase in property value by doing nothing more than using an 8% cap rate at purchase and a 6% cap rate when they sell. Maybe it happens, maybe it’s adding lipstick to a pig and calling it a great investment.
This one is a quick no from me, for one simple reason.
They lead with Preferred Return, which is misleading.
Preferred Return doesn’t mean that you’ll actually make that much, although many of the investment sponsors would like you to think that.
It’s really just the return required before the sponsors begin getting a split of the profits. Example:
12% Preferred Return
15% Actual Return
80/20 Split
Your net return would be the 12% preferred return plus 80% of the return above the preferred return. You would net 14.4%.
Preferred Return is a common term in private equity and real estate. I have no problem with the concept. My issue here is that it’s presented in a misleading manner.
This ad targets doctors, leading with the potential tax benefits for high income earners. They even directly equate this investment in storage buildings, to the way that the ultra-wealthy minimize their taxes.
Maybe this is a great investment, maybe it’s terrible. I have no idea. I do know that they spend more time talking about potential tax benefits than they do explaining how they actually make money.
You know what also lowers taxes? Losses. Hopefully that’s not their play here.
This falls under the heading of wildly optimistic returns.
A lot of smart investors began buying whiskey barrels a decade ago and they’ve done quite well since then. Now the market has changed, and production capacity has skyrocketed.
The easy money has already been made and I’m extremely when I see 40% annual returns. My first thought is that the sponsor is either ignorant of the actual state of the whiskey market or they’re being less than truthful. I’m not sure which is worse.
To be fair, I’m not sure they really knew what they were writing here, as their assurance doesn’t make any actual sense. I mean Up to 40% ROI per annum could mean that you make 39.5% per year or it could mean that you lose 5% per year. Both are equally valid per their assurance.
The heading on the picture reads This Seems Illegal.
Which is pretty accurate, since he’s almost certainly encouraging tax-fraud.
I should note, starting a private foundation and then using said foundation to employ a family member is totally legal…so long as certain rules on self-dealing, among others, are followed. If your net worth is $10,000,000+ and you want to seed the foundation with $1,000,000+, this begins to be a viable option. It brings up some deductibility issues, but those are beyond this piece.
That said, the above example is fraught with landmines.
The biggest landmine is self-dealing, which I mentioned above. If you, or your family as disqualified persons, deal with the foundation, you need to make sure you’re providing goods or services at a market rate and at arms-length. Doing anything otherwise opens you up to liability.
So, paying your kid a $50,000 salary to manage the PF, when the total foundation assets are $150,000, is going to be a huge red flag. That’s not a market rate salary and it’s an easy item for the IRS to challenge.
There’s a good reason this guy has a disclaimer that this isn’t financial advice. It’s terrible advice for the vast majority. Private Foundations can be great planned giving vehicles, but they require a large initial investment to justify. Most donors are better off using Donor Advised Funds.
This isn’t even an alternative investment. It’s just a scummy way of selling an insurance policy.
When it says Tax Free income, it really means that loans from the policy are tax free. If you actually want to take a withdrawal from the policy, anything above your basis is taxable.
Oh, and be careful. Policy loans can lead to a huge tax bill if the policy collapses. All of a sudden, those “tax-free loans” become taxable distributions.
No Market Loss sounds great, till you learn what it really means. In the case of IULs, it means that your returns are also capped. Insurance companies have to make their money somewhere. It’s also a half-truth, as you can still lose money due to fees or surrender charges.
Overall, IULs are a tool in the toolbox and can be useful…but rarely. Most of the insurance salesmen pushing them are likely A) not licensed to sell anything else and B) don’t know enough to realize they’re selling bad products. They're often sold as the Rich Person's Roth IRA, which is both an effective way of selling them (to not-Rich People) and a sleazy way of doing business.
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