By: Paul Clark
In Forbes last Friday, this article from Ellie Perlman, the CEO of a real estate investment company, outlined the pros and cons of multifamily property investing and angel investing. Her conclusion (spoiler!!) is that real estate investing beats angel investing.
The final score looks like 3-0, but, whatever the details, it’s clear that for Perlman real estate is Clemson and angel investing is Carolina.
Well, everyone’s entitled to their controversial opinions. However, there are some factual errors and omissions about angel investing in the highlight reel that I’m paid to try to correct, so hold tight while I add some facts and butcher some sporting analogies. (Italics below are quotes from Perlman.)
Profitability vs Risk:
Perlman’s argument:
- Angel investing is high-risk, high-reward and the return comes from the big winners offsetting the frequent failures.
- Real estate investing is lower-risk/lower-reward: you can make 2x over several years.
This is true – these two asset classes have different risk and reward characteristics. That doesn’t mean real estate wins though. In particular, the two explanations for why real estate wins are:
- With most real estate investments, you’re not the only investor. Generally, you’re part of a syndication that has other people included, along with their money.
That is equally true for angel investing – there are always other people and their money in the deals. The VentureSouth Angel Fund III has 81 investors, and it coinvests with other angel groups and investors almost every time it invests. Wide syndication applies to both angel and real estate – that’s not a score for real estate.
2. Unlike a startup, if the real estate deal goes south, there’s still some equity remaining in the property. It can be sold, and real estate investors can recoup some or all of their original investment. If you’re an angel investor who put up all the capital and the startup fails, your money is gone.
This is a bit more arguable. On the surface, when startups die, all that’s left are broken dreams and branded swag; when real estate projects die, there could be land, a building, or other tangible assets that can be sold.
But, Angel (equity) investors are usually at the “top of the waterfall” because they have preferred equity; real estate (equity) are often not, as real estate transactions use leverage. This one only gets settled by good “return upon default” data comparing the asset classes. I don’t have that, but I suspect the results would be pretty even. Verdict: arguable at least.
So overall, I’m calling this a 1986 tie. Rather than the “absolute” risk and reward profiles, the risk/reward balance is the key – and that comes from how you invest, not what asset class you invest in.
Liquidity:
Perlman’s argument:
- Angel investments are illiquid.
- Real estate, on the other hand, is semi-liquid.
This seems reasonable, but here again the explanation given for why real estate is semi-liquid applies to angel investments too.
Real estate is semi-liquid because most real estate investments are part of a syndication, a limited liability corporation usually owns the property, and each passive investor holds shares in that LLC. Investors can sell their share after a period of 12 months (as long as the sponsor allows it).
Touchdown real estate. Except, hang on…angel investors can do the same thing! Many angel groups create investment vehicles (often LLCs) that aggregate multiple investors, and include provisions for transferring LLC units between the members in some cases. Those transfers happen fairly often.
So, the reason is wrong. But in this case I think the argument remains true. Angel investments are hard to sell and don’t pay quarterly or annual distributions; real estate investments tend to have more liquidity options.
So overall, win to Clemson real estate here (2015 win level?).
Tax Benefits
Perlman’s argument:
- Real estate has some attractive tax benefits.
- Angel investments essentially do not.
This is what prompted me to write this article. The tax benefits of angel investing are extremely attractive – in my opinion far better than for real estate. Perlman points to two benefits for real estate:
1. Offsetting costs and depreciation against income. True for real estate, but as angel investing isn’t aiming to produce income that needs this offset, it is not really relevant. Angels wants capital gains, not income, in part because capital gains face a lower tax rate.
2. 1031 exchanges, which allow deferring capital gains as long as you “roll over”, only paying taxes on the first gain once you finally stop “rolling over”. True for real estate. Would be nice if angel investing had the same benefit.
But wait! It does! It’s a Section 1045 roll over. Roll over proceeds from an angel investment into another deal and you can defer the taxes on the gain. Sounds like the same thing, because it is.
But wait, there’s more. If you held the angel investment for five years, the capital gain is 100% EXEMPT FROM CAPITAL GAINS! (This is the beautiful Section 1202 for Qualified Small Business Stock.) If you held it for less than five years but rolled over under 1045 to a total over five years, the deferred tax gets eliminated! (Or put another equally-confusing way, when you stop rolling over you don’t pay capital gains on ANY of the gains in angel investing.)
Naturally there are complexities, but angel investments are generally entirely exempt from capital gains. To echo Ellie: The bottom line, however, is that because of the total exemption from capital gains of angel investment gains the nod goes to angel investing.
So overall, point to Carolina angel investing here (2011 win level?).
Summary:
- 1 win each + 1 tie.
- Angel investing is not Carolina (thankfully)
- And (mixing up my teams) Section 1202 is the Dabo of the Internal Revenue Code.