Investing in real estate is an excellent way to earn passive, tax-advantaged income. Too often, people shy away from investing in real estate simply because they are not sure how to get started. For those looking to invest for the first time. Or for those who are looking to diversify their real estate portfolios even further, real estate funds can be a great option.
There are several types of funds. Individuals should evaluate all options in terms of their own risk tolerance and investment time.
This article explores the various types of real estate funds, distinguishes funds from syndications and REITS, and provides guidance on how to begin investing in real estate funds.
What Are Real Estate Funds?
Real estate funds, typically structured as limited liability companies (LLCs), invest in one or more real estate assets. Often it is a general partner or sponsor that leads them. These are the individuals who raise the capital from investors, or “limited partners”. Ultimately to fund the acquisition, construction, and/or renovation of investment properties.
There are many types of real estate funds, including real estate debt, equity and mutual funds. Real estate investment funds have proliferated in recent years. This is mostly due to changes in SEC regulations that have made it easier for individuals to purchase security shares of properties.
Types of Real Estate Funds
Just as commercial real estate can come in many different shapes and sizes, so too can real estate funds. Real estate funds are best classified into three “buckets”. These are real estate equity funds, real estate debt funds, and real estate mutual funds.
Real Estate Equity Funds
A sponsor sets up real estate equity funds, also known as real estate private equity funds, these are to raise capital and invest in commercial real estate deals. The sponsor will also generally have some of its own capital invested in the fund as well. This is usually to prove that they have “skin in the game” and will share in the risk/reward associated with the fund.
For those looking to invest for the first time,
or to diversify their real estate portfolios even further,
real estate funds can be a great option.
Real estate equity funds are typically “blind funds,”. This simply means investors don’t have specific knowledge about how their money will be invested. The fund will generally have specific parameters for investments.
For example, an equity fund might only invest in value-add multifamily housing opportunities in the outer-urban area within a certain metro region. This makes it clear how the raised capital will be utilized. However, the investors do not know, for example, that the fund will invest in X, Y or Z property.
With blind funds, investors are putting significant faith in the sponsor. Ultimately leaving them the responsibility to identify, acquire and execute deals based on their business plan.
Open-ended vs. Closed-ended
Real estate equity funds can be either open- or closed-ended.
An open-ended structure allows investors to enter and exit the funds with more fluidity. In other words, an investor can preserve liquidity by investing in an open-ended fund as these tend to have periodic redemption opportunities. Most open-ended funds aim to generate returns through regular cash flow instead of appreciation.
The challenge with open-ended funds, though, falls within the illiquid nature of real estate. This can make it difficult to establish a fair value of the shares an investor will get in exchange for their equity or sale thereof. If a property has increased in value, adding new investors to the fund can dilute the value of existing investors’ equity.
Closed-ended funds are different in that they pool capital from investors at the same time. They call this the “subscription” period and it typically lasts 12 to 18 months. Some funds will fill up much faster. Once they raise the capital, they close the fund and no longer accept new investors.
Closed-ended funds have a predefined termination date, usually 7 to 12 years after the fund’s inception. During this period, the investors’ capital remains committed, unless the sponsor provides a specific buyout option.
Real estate equity funds can be either open- or closed-ended.
The managers of closed-ended funds aim for significant appreciation by pursing development and value-add deals. This is typically because they only have a limited time to generate returns for investors. Once the properties are stabilized, most fund managers will sell these assets at opportune moments to maximize returns for investors (vs. relying on more steady, consistent cash flow).
Real Estate Debt Funds
Real estate debt funds pool capital from investors and then deploy that capital to make loans against commercial real estate. Most debt funds invest in either senior or mezzanine debt. In either case, the debt is generally collateralized by the real estate for which the loan is being made. They then use the property as collateral if the borrower fails to repay the loan.
Real estate debt funds appeal to investors looking to preserve their liquidity, as debt funds generally make short-term loans for commercial real estate projects. Most sponsors will utilize longer-term, traditional (i.e., bank, CMBS or life company) debt to finance their projects.
Real estate debt funds allow them to leverage private equity to fill any gaps in traditional lending. Real estate debt funds generally charge higher rates than traditional lenders. Therefore, once a property is stabilized, most sponsors will refinance to pay off the loans made by a real estate debt fund.
Investors in real estate debt funds typically receive regular interest payments and have a lien on the property as security. The returns from a real estate debt fund can be significant. Sometimes these returns can range from 8 to 12 percent, depending on the nature of the deal, quality of the sponsor and the current interest rate environment.
Real Estate Mutual Funds
Real estate mutual funds are funds that invest in financial securities such as stocks and bonds. As you might expect, real estate mutual funds invest more specifically in real estate companies. Those of which may include direct investments in real estate development companies, but can also include indirect investments through real estate investment trusts (REITs).
Real estate mutual funds are not limited to specific property types. Their investments may include residential real estate, commercial property, and industrial assets among others—and any combination thereof.
The real estate fund manager is responsible for investing in securities on investors’ behalf. They will perform all due diligence on investment opportunities and strive to diversify and balance the fund’s portfolio. The fund manager will oversee all day-to-day associated with the fund’s operations. This includes when to buy or sell securities based on a number of factors, such as the fund’s objectives.
506(b) vs. 506(c) Funds
506(b) offerings allow both accredited and non-accredited investors to participate. On the other hand though, only accredited investors can participate in 5069(c) offerings.
To qualify as an accredited investor, an individual must have an annual income of at least $200,000 for the past two years (or $300,000 in joint income with their spouse) or a net worth of at least $1 million, excluding their primary residence.
506(b) fund offerings require investors to self-certify that they believe they are accredited investors. Issuers of a 506(c) offering must verify that investors are accredited, typically by using a third-party verification service. Most CPAs can issue a one-page document on behalf of an investor to certify that they meet the accreditation thresholds.
Real Estate Funds vs. Real Estate Syndications
People will frequently use the terms “real estate fund” and “real estate syndication” interchangeably, but this is incorrect because they have distinct differences.
When someone invests in a real estate fund, they are investing in a vehicle that will then go out and purchase or lend against one or more real estate assets. When investing in the fund, an investor may or may not have any idea what assets the fund will ultimately be investing in. Instead, they are investing based on the fund’s investment parameters, business plan or strategic goals.
A real estate syndication is much different.
While syndications also pool capital from private equity investors, they are raising capital for a specific deal. These deals have already been identified and can be explained to investors. For example, a fund may invest in value-add multifamily real estate located throughout the Midwest. A syndication, however, may raise capital for a value-add multifamily property located at 123 Main Street in Cleveland, Ohio.
Real Estate Funds vs. REITs
Some people consider a REIT, or real estate investment trust, a type of real estate fund. However, REITs and real estate funds are two distinct investment vehicles.
A REIT is a company that invests in and holds real estate assets, much like a fund might do. However, when someone invests in a REIT, they are purchasing a share of the REIT holding company—they are not investing in the real estate owned by that REIT directly. It is like buying stock in any major corporation, like Apple, Google or Pfizer. Stockholders do not invest in the products these companies sell, but rather, the companies themselves.
A REIT is a company that invests in and holds real estate assets, much like a fund might does. However, when someone invests in a REIT, they are purchasing a share of the REIT holding company. Meaning they are not investing in the real estate owned by that REIT directly. It is like buying stock in any major corporation, like Apple, Google or Pfizer. Stockholders do not invest in the products these companies sell, but rather, the companies themselves.
Benefits of investing in REITS
The benefit to investing in REITs is that there are low barriers to entry. Unlike funds, which often have a minimum contribution amount (say, $10,000 or $50,000), REIT shares often trade for less than $100 a piece. For those looking to invest gradually, or spread their risk across many sponsors, REITs can be a great, low-cost option.
REITs also provide tremendous liquidity, more so than real estate funds. You can easily buy and sell shares of publicly traded REITS, even on a daily basis.
How to Invest in Real Estate Funds
There are a few primary ways to invest in real estate funds.
The first would be to invest in a private equity real estate fund being offered directly by a developer (the fund sponsor). There are hundreds, if not thousands, of developers raising money for equity funds at any given point in time.
Most individuals learn about these funds through word of mouth, among friends and family who have also invested. Sponsors can also be identified online. However, it’s crucial for investors to research the fund sponsor before investing.
Real estate debt funds are somewhat less common but still very prolific. A fund manager, not developer, typically leads real estate debt funds by gathering capital and lending it to commercial real estate projects.
Crowdfunding platforms like Crowd Street and RealtyMogul have made it easier than ever for individuals to invest in real estate funds. These platforms will offer either their own fund offerings, or access to others’, or some combination thereof. Remember: investors must have a strong knowledge of the offering type (506b or 506c) and meet the requirements for accredited investors status if necessary.
You can invest in a real estate fund with just $10,000. Each fund determines its own requirements for the minimum equity investment. Some funds require a more significant up-front investment, as high as $100,000 to $250,000 or more.
There are many reasons for investors to consider real estate funds when looking to grow and diversify their investment portfolios. Investing in a fund, unlike a REIT, is a great way for investors to own a share of actual real estate—not stock or other interest in a company that owns real estate the way that they gain when investing in a REIT.
Funds offer a range of opportunity
Moreover, investing in a fund provides access to high-quality. Whereas oftentimes institutional-caliber real estate that individuals would not have access to otherwise given the high barriers to entry. Finally, it’s worth reiterating the tax advantages associated with owning real estate. Real estate funds own real, tangible property that can be depreciated, resulting in highly tax-advantaged income for investors.
Real estate debt funds are somewhat less common but still very prolific.
Real estate debt funds are generally spearheaded by a fund manager, not a developer,
who pools capital to then lend against commercial real estate deals.
Investing in a real estate fund may seem complicated, but it is actually quite easy once you have identified the funds that meet your investment criteria. Again, it is important to do your due diligence on any fund sponsor prior to investing, just as you would conduct due diligence before investing in any individual asset. The more homework you do in advance, the less likely you’ll encounter surprises down the road.