Education, Finance, Investment Advice

What are Real Estate Funds and
How Do I Invest in Them?

smartland-what-are-real-estate-funds-and-how_do_i_invest_in_them.mp3 We look at the different types of funds, how funds differ from syndications and REITs, and how to get invest in real estate funds and... Listen to this article

Introduction

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 to diversify their real estate portfolios even further, real estate funds can be a great option.

There are several types of funds. All can be worthwhile but should be considered in light of an individual’s own risk tolerance, time horizon and investment objectives.

In this article, we look at the different types of real estate funds, how funds differ from syndications and REITs, and how to get started investing in real estate funds.

What Are Real Estate Funds?

Real estate funds are entities, usually structured as limited liability companies (LLCs), that have been created to invest in one or more real estate assets. They are spearheaded by a general partner, or “sponsor”, who raises capital from investors, or “limited partners”, to fund the acquisition, construction, and/or renovation of investment properties.

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.

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 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” – real estate equity funds, real estate debt funds, and real estate mutual funds.

Real Estate Equity Funds

Real estate equity funds, sometimes referred to as real estate private equity funds, are funds established by a sponsor who is raising capital to invest in commercial real estate deals. The sponsor will generally have some of its own capital invested in the fund as well, to prove that they have “skin in the game” and will share in the risk/reward associated with the fund.

Real estate equity funds are typically “blind funds,” meaning that investors do not know exactly how the 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 provides some definition as to how the capital raised will be deployed, but 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 to identify, acquire and execute deals based on their business plan.

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. Moreover, most open-ended funds are structured to provide returns through recurring cash flow rather than appreciation.

The challenge with open-ended funds, though, is that the illiquid nature of real estate 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. This period is called the “subscription” period and will usually be 12-18 months long. Some funds are fully subscribed much sooner. Once the capital has been raised, the fund is closed and will not accept new investors. Closed-ended funds have a predefined termination date, usually 7 to 12 years after the fund’s inception. Investors’ capital will be tied up during this period, unless there is an explicit buyout mechanism offered by the sponsor.

Real estate equity funds can be either open- or closed-ended.

Because closed-ended funds only have so long to generate returns for their investors, the managers of closed-ended funds are incentivized to pursue development and value-add deals that result in significant appreciation. 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, and in either case, the debt is generally collateralized by the real estate for which the loan is being made. The property is then used as collateral in the event the borrower defaults on 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, and therefore, once a property is stabilized, most sponsors will refinance to pay off the loans made by a real estate debt fund.

Those who invest in real estate debt funds will generally receive periodic interest payments, as well as security that’s charged against the asset’s property. The returns from a real estate debt fund can be significant, ranging 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, like mutual funds more broadly, 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, 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 (including single-family homes), 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 conduct all due diligence on investment opportunities and work to ensure the fund’s portfolio is well-diversified and balanced. The fund manager will oversee all day-to-day associated with the fund’s operations, including when to buy or sell securities based on a number of factors, such as the fund’s objectives.

506(b) vs. 506(c) Funds

Sponsors who want to crowdfund capital for their real estate deals will need to structure their funds under either SEC Rule 506(b) or Rule 506(c).

506(b) offerings allow both accredited and non-accredited investors to participate. 506(c) offerings, on the other hand, require an investor to be accredited.

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

The terms “real estate fund” and “real estate syndication” are often used interchangeably, but this is done so in error as there is a significant difference between the two. 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 when indeed, 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 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.

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.

Related: REIT vs Real Estate Fund: What You Need to Know

REITs also provide tremendous liquidity, more so than real estate funds. Shares of publicly-traded REITs can be easily purchased and sold, 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. In any event, it is important for an investor to do their due diligence on the fund sponsor prior to investing.

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.

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 should be sure they know which type of offering is being made (506b vs. 506c) and ensure they meet the accredited investor threshold if need be.

Investing in a real estate fund can be done with as little as $10,000. Each fund sets it own parameters as to how much equity is needed to invest in that specific fund. Some funds require a more significant up-front investment, as high as $100,000 to $250,000 or more.

Conclusion

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. Moreover, investing in a fund provides access to high-quality, 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.

Are you interested in investing in real estate? Contact us today to learn more about the ways in which Smartland can help to deliver exceptional results.


Was this article helpful?
reaction thumbnail No

View More
Resources