Introduction
Commercial real estate was once considered an “alternative investment,” but increasingly, it has become more mainstream. Given the high costs associated with owning income-property, most individuals are limited to buying small multifamily or small commercial properties.
Real estate investment funds provide another entry point for those looking to invest in commercial real estate. They are particularly appealing to those who want to own commercial property, but who want to take a hands-off approach to daily management activities. A real estate investment fund pools capital from many investors, and then the fund’s sponsor oversees all the fund’s activities, including property management in the case of a fund that buys and renovates and/or holds property for some time. Investing in a real estate fund is a great way to generate passive income for those who are interested in owning real estate, but who do not want the responsibilities of direct ownership.
In this article, we take a look at everything you need to know about real estate investment funds, including their many benefits, how they are structured, and how profits are generated and returned to investors. Read on to learn more.
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What is a real estate investment fund?
An investment fund is a pool of capital that has been aggregated on behalf of multiple investors. There are many types of investment funds, such as mutual funds, money market funds, and hedge funds. A real estate investment fund is a specific subset of funds that is focused exclusively on investing in income-generating property.
A real estate investment fund is generally spearheaded by a sponsor who has years, if not decades, of experience in the real estate industry. The fund manager will carefully analyze all individual opportunities, and then these opportunities are executed on using capital from the fund.
Real estate investment funds can be structured in many ways. Some funds are open to the masses, whereas others are only available to accredited investors. Funds can focus on specific geographies, asset classes, asset types and more. Most real estate investment funds are closed-end funds that target risk-adjusted passive returns for their investors.
Benefits of Real Estate Funds
Flexibility
It is a common misconception that investing in a real estate fund requires an investor to sacrifice flexibility. In fact, the opposite is true. If you were to invest in a single asset, for example, you’ve put all your eggs in that basket – you’d better hope that the investment pays off the way you expected it to! However, investing in funds provides more control and flexibility.
For example, an investor who has $1 million to invest can choose to invest that in $250,000 tranches across four different funds. There are many funds focused on different geographies and asset classes, which allows the investor to choose which types of properties they want to purchase and where. This allows investors to truly customize their portfolios without having to buy individual assets directly.
Profitability
Real estate investment funds are generally structured to return profits to investors before any profit is earned by the fund’s sponsor. As a result, the sponsor is highly motivated to ensure the deal achieves its intended profit threshold. Funds are structured in this way as a means of keeping interests aligned between the sponsor and their investors.
Tax Efficiency
There are several benefits to investing in a real estate fund. For example, most funds are structured to last longer than one year, so unless one of the fund’s assets is sold within a one-year time period, it will be taxed at the long-term capital gains rate instead of the short-term capital gains rate.
Moreover, investors in a real estate fund may benefit from pass-through depreciation. As with all tax matters, the benefits that accrue to investors will be dependent on the advice that they receive from their own accountant and driven by their own unique circumstances.
Diversification
Funds can set a wide variety of investment parameters, broadening the reach of potential investments. For example, a fund may focus specifically on a single asset type but be open to different geographies (say, multifamily investments in core markets across the U.S.). Alternatively, a fund might invest in a range of product types in a single market (say, metro Los Angeles).
Another fund might only invest in opportunistic real estate investments that need moderate to heavy rehab on a mid- to long-term time horizon. Other funds will have few, if any, investment parameters. By investing in a real estate fund, individuals can diversify their portfolios, thereby mitigating the risk of having “all eggs in one basket.” This is one-way investors protect themselves in the event of an economic downturn.
Preferred Returns
Most private real estate funds offer investors a preferred return in addition to their pro rata share of the fund’s overall net profits. While no fund can ever guarantee payment of a preferred return, those who invest in a real estate fund are assured that they will receive the initial profits from the fund’s investment activities before the fund’s sponsor receives its share (called the “carried interest). This structure ensures that the fund’s sponsor is motivated to achieve their targeted returns; otherwise, the fund’s manager will not earn their share of the profits as anticipated.
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Absolute Returns
The absolute returns of a fund refer to the amount of profit the fund has earned. The absolute returns include any additional returns above and beyond the preferred return. Funds that perform exceptionally well will provide absolute returns significantly higher than the anticipated preferred return. However, investors beware: a fund’s previous performance does not guarantee its future performance. Always evaluate a real estate fund based on its current merits, not only past performance, and on the experience and track record of the sponsor.
Correlation to Other Asset Classes
Commercial real estate, in general, has a low correlation to other asset classes such as stocks and bonds. This is because of the highly illiquid nature of real estate, which cannot be purchased and sold on a moment’s notice. As such, many people will opt to invest in real estate investment funds as a way to diversify and protect their holdings. Consider, for example, an instance in which the stock market plummets overnight.
Unlike the stock market, which would immediately lose tremendous value, real estate portfolios tend to continue marching on. Rents continue to be paid and profits returned to investors. While the real estate portfolio may eventually take a hit, there is not the same correlation to other asset classes which can experience more drastic, momentary ebbs and flows.
Qualifications
When investing in real estate funds, individual investors benefit from the experience and qualifications of the fund sponsor. The sponsor is typically an industry professional (or team) that is highly qualified to oversee a fund that will be deployed in various commercial real estate projects. A high quality sponsor will be able to provide detailed financials for investors’ review, and will be happy to answer any questions about their strategy, assumptions, and how and why the fund structure they are building will prove to be successful.
Moreover, the fund manager oversees all day-to-day activities associated with the fund. This allows individuals to invest without being distracted by the nuances of each individual transaction carried out through the fund.
Types of Real Estate Funds
There are two primary types of real estate investment funds: real estate funds and real estate investment trusts.
Real Estate Fund Investments
A real estate fund is essentially just another form of mutual fund that is focused on investing in securities offered by public real estate companies. Real estate mutual funds are different from real estate investment trusts (REITs), which are corporations that invest directly in commercial real estate. Investing in a REIT is as easy as buying a stock, shares of which can be purchased or sold with just the click of a button. REITs, like other securities, must be registered with the Securities and Exchange Commission (SEC) or, alternatively, must seek an exemption from the SEC, a process that is complex, time consuming, and costly.
Conversely, most real estate mutual funds are exempt from registration through what’s known as “Regulation D, Rule 506”. There are two subcategories, Reg. D 506(b) and Reg. D 506(c) that real estate investors will want to understand.
Reg. D 506(b)
Reg. D 506(b) stipulates that a fund’s offering materials can only be shared with those who the fund’s sponsor has a “substantive, pre-existing relationship” with prior to soliciting interest in the fund (or, more broadly, the security being offered). Documenting this pre-existing relationship can be done using a simple questionnaire that the fund sponsor will generally provide. An investor can complete this on their own; it does not need to be certified by a CPA, lawyer or other investment professional. Nor does it need to be re-certified on an ongoing basis. While this limits the pool of potential investors, many fund sponsors prefer issuing securities under Reg D. 506(b) because it allows people to self-certify as an accredited investor, a process that can be completed quickly and therefore, allows those who qualify to invest in a fund more efficiently.
Reg. D 506(c)
Reg. D 506(c), on the other hand, still requires all investors to be accredited investors, but it allows the sponsor to broadly advertise the offering. Securities, in this case, the real estate mutual fund, can be advertised by email, digital ads, social and traditional media alike. The sponsor simply needs to take “reasonable steps” to ensure that each participant is an accredited investor. This confirmation is relatively easy and can be done via a statement from the investor’s CPA or lawyer that indicates the individual meets the criteria to be an accredited investor. The SEC requires individuals to be re-certified every three months prior to making any additional investments under Reg. D 506(c).
Self-Directed IRA Funds
Many investors will choose to invest in a real estate fund using a self-directed IRA. A self-directed IRA isn’t all that different from a traditional or Roth IRA. What makes these plans unique is the fact that they allow investors to choose from a broader range of investment alternatives, including real estate investment funds. Many traditional brokerages will not move funds from a traditional/Roth IRA or 401(k) to a non-traditional investment. Therefore, investors looking to pursue this strategy will need to direct the funds from their current brokerage account to an IRA custodian that allows for self-directed investment accounts.
One benefit to investing in a fund, instead of buying an individual investment property, is it allows an investor to diversify their portfolio while still taking a hands-off, passive approach. Self-directed IRAs are just that: self-directed, and therefore, investors should do their homework to ensure they’re investing with a high-quality sponsor. As with any investment, it is important to evaluate the real estate fund’s opportunities and risks.
Multifamily vs. Single Family
There are many kinds of real estate investment funds. Even those who are laser-focused on investing in residential real estate will find there are different ways to do so. For example, some funds focus on buying and flipping single family properties. Other funds are geared toward investing in, rehabbing and renting multifamily properties. Funds catering to both strategies are both perfectly legitimate, however, investors should be aware of the tax implications associated with investing in a fund that flips properties. Profits generated from these funds will be subject to short-term capital gains tax (a higher rate), unlike funds that buy, renovate and hold properties which are then subject to long-term capital gains tax (a lower rate).
How to Invest in a Real Estate Fund
It’s important for any investor considering a real estate investment fund to understand how funds are established, structured, and how they distribute profits to investors. Below is a look at the different fund phases.
Formation
The first step is fund formation. During formation, the fund sponsor will establish the general parameters for investments. As noted above, some funds are structured to target investments in a specific product type, such as multifamily investments in core markets. Other funds may be more lenient with the product types and locations in which they invest. Sometimes, the fund will be created to have minimum threshold requirement. The formation phase helps to establish the fund’s “guardrails” and objectives.
Launching
After a real estate fund has been formed, it is then officially launched. The launching phase involves announcing to the world that the fund is “open for business” and ready to accept investments.
Most fund sponsors will quietly market the fund during the formation phase, letting potential investors know of their intentions to launch a fund and when. This allows the sponsor to get pre-launch soft commitments, which are non-binding commitments from potential investors. The success of a fund will often depend on the fund manager’s ability to garner a critical mass of these pre-launch commitments.
To be sure, fund managers are obligated to follow strict regulations around pre-formation communication. For example, any pitch decks and other materials must include disclaimers that the communication issued pre-launch is not a solicitation and that the fund has yet to launch. There are many third-party, independent firms who will assist fund managers with fund formation, pre-launch and launch activities.
Fundraising
The fundraising period is the time during which the fund manager actively solicits and accepts investments into the fund. By this point, the fund should have established capital requirements. This would include an estimate minimum amount of capital that the fund will need to raise in order to be successful. It is not uncommon for funds to raise $50 million or more with each offering. Fundraising efforts might also include minimum investment thresholds, which often depend on whether the fund is accepting investments from qualified investors.
Closing
Investors may see companies that announce they’ve “just closed a fund” or are “preparing to close a fund.” What this refers to is the closing of a fund once the fund has reached its fundraising target. For example, if a fund set out to raise $50 million, it would close upon achieving that final investment that helps the fund reach that threshold. This would pertain to “closed end” funds and contrast with “open ended” funds that will continue raising capital for a set period of time while it begins the active investment phase.
Investment
The investment phase begins upon the fund purchasing its first asset. Once the fund starts investing, its capital is deployed into investments as long as those investments are closely aligned with the fund’s objectives. Typically, funds will have 24 to 36 months following the initial closing to deploy the fund’s capital. Interestingly, a fund is not obligated to invest in any assets if the fund manager determines there are no opportunities that meet the fund’s objectives during that investment period.
Distribution of Profits
A fund’s final phase is distribution of profits to investors. Most private real estate funds will offer their investors a preferred return in addition to their pro rata share of the fund’s overall net profits. However, how funds are actually distributed really depends on the fund’s waterfall structure. Waterfalls can be complicated, often with multiple tiers depending on how the fund is structured.
Generally, a waterfall is structured to ensure investors receive a return of their capital contribute first, followed by a preferred return based on the total amount of their capital contribution. The fund’s manager then receives their allocation, equal to a portion of the total preferred return allocated to investors (usually in the same percentage split as the profit split). Any remaining profit is then generally split between the investors and the fund’s sponsor.
Which Real Estate Fund is Right for Me?
New Investors
Those who are investing in real estate for the first time will want to set aside extra time for their due diligence. It is important to fully vet not only the fund’s sponsor, but also the types of deals that that sponsor invests in. Newer investors typically have a lower risk tolerance, and therefore, will want to invest with a sponsor that has a proven track record of success. They may also want to look for “safer” funds that have potentially lower returns but are funds that invest in already stabilized properties.
Experienced Investors
Experienced investors may be willing to take on additional risk, and therefore, may want to look at funds that target more opportunistic investments. For example, a fund that specializes in acquiring Class C real estate in secondary or tertiary markets, and then renovates those properties to Class B condition may be attractive. Nevertheless, even the most adept investors will want to fully vet the fund’s sponsor to ensure they have the experience needed to execute on the fund’s strategy.
Common Real Estate Fund Questions
Can you get out of a fund early?
Although it is harder to pull your money out of a real estate fund than say, simply selling shares in a real estate investment trust, it can still be done. Most funds will have a provision that allows investors to exit a fund early, though it will come at a cost. Typically, early redemption necessitates a 1-3% exit fee. The earlier funds are withdrawn from the fund, the steeper the fee tends to be as a way of motivating investors to stay in the fund for its duration.
How does SEC oversight work?
There are many misconceptions around SEC oversight of real estate investment funds. In short, nearly all real estate investment funds are subject to SEC oversight. There are four triggers for SEC oversight:
(1) people are investing money
(2) the investment is expected to generate profit
(3) the transaction is structured as a common enterprise, meaning the sponsor and other investors “own” the investment alongside you
(4) the deal is offered from the efforts of another, meaning that other investors are passively engaged.
Real estate funds will almost always check these four boxes, which means the fund would be regulated by the SEC.
Now, there are some exemptions to SEC regulation. As noted above, Reg. D 506(b) and Reg. D 506(c) provide some exceptions to this rule. In either scenario, if the fund is targeting only accredited investors, SEC oversight may not apply. See above for additional information.
Real Estate Hedge Fund vs. REITs: What’s the Difference?
A hedge fund is a business structure that aggregates capital to be deployed in various investment opportunities. Typically, hedge funds invest in liquid assets, such as stocks and bonds. There’s a growing number of real estate hedge funds, however, that will invest in both liquid (REITs) and illiquid real estate assets.
The difference between a real estate hedge fund and a REIT is that a REIT is a publicly-traded stock of existing real estate companies. Hedge funds can invest in REITs, but REITs cannot invest in hedge funds. Real estate hedge funds are not limited to investing in REITs, however. Real estate hedge funds can also invest their money through the acquisition of actual properties.
How much leverage will a fund give you?
One of the benefits to investing in a real estate fund is that the fund, having aggregated capital from a variety of sources, can then leverage the equity investment by combining it with bank debt to build a more robust portfolio. For example, an individual investor may only contribute $50,000 to a real estate investment fund. That fund may have solicited $50,000 investments from another 30 individuals. The fund now has $1.5 million to invest in real estate. Assuming the fund buys properties at a 75% loan-to-value ratio, the fund will be able to invest in $6 million worth of real estate.
What are investment fees?
Most real estate investment funds charge investors fees that go toward services including negotiating the price of assets purchased, creating marketing materials and legal documents, raising equity, managing the day-to-day operations at the property, formulating and executing a business plan, reporting to investors, selling the assets, and distributing the proceeds.
While it’s tempting to choose funds with low fees, remember that you get what you pay for. On the other hand, excessive fees can eat into distributions, reducing the return on investment (ROI)—something potential investors should consider before deciding on a fund in which to invest.
What is a real estate fund lifespan?
Private equity real estate funds typically have a lifespan of about 10 years, but keep in mind that that period usually doesn’t start until the fund’s investment team has raised substantial capital, and it doesn’t end until all of the fund’s assets are sold. Because of this, the lifespan of a private equity fund could extend to as long as 15 years. The lifespan of a fund could affect how investors choose to invest.
Understanding the benefits and basics of funds introduces investors to how funds work and why some funds might be better choices for them than others. Choosing the right fund can make the difference between a smart real estate investment and a less profitable one.
Conclusion
There are many reasons to invest in real estate, generally, and other reasons to invest in a real estate fund more specifically. Real estate investment funds are a unique way to diversify one’s portfolio without having to take on the hassles of direct ownership.
Of course, not all funds are created equally. Any prospective investor is advised to do their homework before investing in a fund. Be sure to vet the fund’s sponsor, management, and track record. Look at the types of investments they make, including geography and product type. Evaluate the fund’s targeted returns and question how the fund intends to get there, and over what time horizon. As with any investment, it is critical to research the opportunity thoroughly. No investment is foolproof, but the more you know the ins-and-outs of how the fund is structured, the more likely you are to safeguard your hard-earned capital.
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