The Benefits of Real Estate Funds and How they Work
Private real estate funds are fast becoming highly sought-after investment vehicles with passive investors but the concept of real estate funds has been around for quite some time. In fact, the concept of a real estate syndication and bringing individual investors together as a combined source of capital to purchase large-scale assets has been around since about 1800 B.C.
Because so many investors are learning about the many benefits of real estate it is the fourth main asset, with cash being king, followed by stocks and bonds. Investors have been particularly interested in such real estate investments as commercial property as a way to add stable returns and less potential risk to their investment portfolio.
Real estate funds are segmented into basically two different camps: REITs (Real Estate Investment Trusts) and private equity investments. Private equity real estate investment funds allow you as the passive investor to invest your capital with other real estate investors to purchase large real estate assets directly, whereas REITs (established by Congress in 1960) allow you to own publicly traded stocks that are comprised of an array of commercial assets across the globe.
Real Estate – An Alternative Investment
Commercial real estate investing has largely been deemed an “alternative investment”, but in recent years because of commercial real estate’s ability to be a powerful inflation hedge and its generally high returns based on past performance, commercial real estate is not just for institutional investors anymore. With the high cost of housing and the limited availability of cash-flowing rental units the strategy of owning rental properties just isn’t as appealing to passive investors anymore. So a majority of investors are looking at alternatives such as real estate syndications so that they can still be invested in real estate, with its many tax advantages, while still being able to maintain a “hands-off approach” to their investing style.
You can always buy apartment buildings or other large-scale commercial real estate properties on your own, but a more practical and affordable approach would be to explore real estate investment funds.
So, how this works is that potential Investors pool their funds to purchase the real estate asset that sits in the fund. The fund’s operator or sponsor is in charge of all of the fund’s operations such as asset management and professional management of the property. These private equity real estate funds appeal to the accredited investor who wants real estate holdings and passive monthly income but doesn’t want the day-to-day management that so many real estate investments require.
Let’s dig in as to what a real estate fund is and what are the benefits of investing in one.
What Is A Real Estate Fund?
A Real estate fund is an investment entity that allows potential investors to invest in a variety of properties that are within the fund, regardless of the property-to-capital ratio. An advantage here is that it diversifies the investor’s capital across a number of assets instead of deploying all of the capital into just one asset. With this investment strategy, investors buy into the investment in the form of shares.
There are funds that present similar to mutual funds in that they pay investors dividends. These funds utilize investor money to purchase a variety of commercial properties that are potentially located in varied, but solid, real estate markets. The fund may consist of different asset classes such as commercial residential real estate such as multifamily apartment buildings, office buildings, hotels, or data centers. Or a real estate fund may just have one type of asset class such as medical office buildings.
One of the key differences with funds is that they offer investors the opportunity to invest in real estate holdings that allow for liquidity since the investor receives shares that can be sold. And, of course, like most other types of real estate holdings, the investor receives their passive income in part from the rental income.
Types of Real Estate Funds
There are two main types of real estate funds: One type of fund is a private equity real estate fund. Private equity funds have restrictions on participation and are not open to the public. They are typically reserved for high-net-worth individuals or institutional investors.
Another type is the – Real Estate Investment Trust (REIT). Real estate investment trusts are publicly traded, unlike a private equity real estate fund. REITs offer liquidity and can provide diversification within your investment portfolio.
Real Estate Funds vs REITs
A real estate fund structure is somewhat like a mutual fund, except that it focuses on real estate securities that these companies offer. One of the different ways that real estate funds vary from real estate investment trusts or REITs is that real estate funds are exempt from registration with the Securities and Exchange Commission (SEC). These types of offerings are exempt from registration with the SEC under what is called Regulation D, Rule 506.
REITs are corporations that invest directly in commercial real estate, similar to a real estate fund. Investing in a REIT is similar to buying stocks because shares can be purchased and sold. REITs and other securities have to be registered with the SEC.
How To Invest In Private Equity Real Estate Funds
Once you have decided to invest in a private equity real estate fund and have identified a sponsor/operator you would like to work with, you have a couple of options on how to proceed. You can invest with cash or you can invest with retirement savings from a self-directed IRA.
If you have liquidity in a savings account or other bank account, you can simply wire the investment amount to the operator. The operator then purchases shares of the fund on your behalf. A transfer agent then maintains the records of the shareholder accounts.
Self-Directed IRA Funds
One of the best ways to access real estate investment funds is by utilizing a self-directed IRA. Self-directed IRAs are frequently used because potential investors have a wider array of assets they can invest in such as real estate investment funds.
Because investors are not allowed to invest in “non-traditional” investments such as real estate with traditional IRAs or 401k’s, they may need to roll funds into a self-directed IRA with an IRA custodian that allows for self-directed investments.
Investors should keep in mind, however, that self-directed IRAs are just that – self-directed, which means that you will want to conduct thorough due diligence prior to investing in any real estate funds or other alternative investment types.
Who Qualifies to Invest In A Real Estate Fund?
There are investment qualifications that you should be aware of before exploring these investment strategies.
There are different qualifications that the fund managers will require. Real estate funds may have a requirement that you have a minimum net worth and that you contribute an initial investment minimum, which can range from a low entry point of a few thousand to hundreds of thousands of dollars. These varying differences are dependent on the size and structure of the real estate fund. Most real estate funds have a maximum investment amount to participate while others are open-ended.
Minimum investment periods are generally one year or longer. An important distinction with real estate is that it is typically an illiquid investment because of the time it takes to sell the asset. Investors need to be prepared to have their investment capital tied up for a specified period of time.
REITs are typically more accessible because they require much lower investment minimums. Additionally, they are listed on public markets and can be invested in utilizing most types of retirement savings accounts.
Sponsor Roles & Qualifications
As an investor, you are able to capitalize on the efforts, experience, skill, and connections that the sponsor or fund manager is bringing to the table in real estate fund. The sponsor is an expert in acquiring and managing assets in those sectors of the fund. The fund manager will have already done the due diligence on the properties in the fund such as real estate market analysis and selection, financial underwriting and projections, as well as an understanding of absorption rates, level of demand, and competitive assets in the marketplace.
One of the roles of the sponsors is to provide the business plan and the fund’s strategy to potential investors as well as in-depth financials so that investors can make an educated calculation as to whether they want to invest or not.
Sponsors often host webinars and other types of presentations regarding the logistics of the fund. But they are also available for one-on-one meetings with investors if you have further questions or you want to get to know the team better.
The fund manager is responsible for the day-to-day operations of the fund so that investors can have a truly passive investment strategy while building their real estate portfolios with a fund model.
Benefits of Investing in Real Estate Funds
Real estate funds are often independent of stock market gyrations and so as a result can provide investors with consistent, higher than average returns. Real estate has also proved to be a viable investment strategy because of the diversification it gives investors that stock market investments alone cannot provide.
These real estate investment opportunities allow you to invest in a variety of real estate assets without the hassles of being a landlord.
You combine your money with other investors to purchase similarly rated assets in a variety of locations using real estate funds. You can also diversify your investment holdings by purchasing shares in multiple funds. You can even diversify across asset types, markets, and appreciation profiles by buying shares in different funds. Diversification lowers risk for investors while increasing the potential for greater returns.
Most real estate investment funds are structured in such a way that provides for investors to be paid back before the fund’s sponsor is paid anything at all. This ensures that the sponsor works especially hard to meet or exceed goals so that they can be compensated. The structure of the fund should ensure that the sponsor’s and the investor’s goals are aligned.
The investment into a real estate fund is usually more than one year, which would make it a long-term investment and as such would be taxed advantageously as long-term capital gains for the investor.
Tax benefits such as pass-through depreciation are contingent on the investor’s situation and whether they can take advantage of that or not. Investors can defer taxes on their share of received income and the capital gains until their shares are sold.
A preferred return or “pref” means that the investor will be paid first before the sponsor or fund manager. In this case, the investors will continue to receive their allotted cash flow distributions for the duration of the investment. A preferred return is more desirable, especially with assets that are at higher risk.
Will Your Next Real Estate Investment Be In A Fund?
There are a variety of reasons people choose to invest in real estate funds and real estate in general. Real estate funds can be an excellent way to diversify your investment portfolio without the hassles associated with the direct ownership of real estate.
Some of the investors’ responsibilities are researching the investment property, conducting due diligence, exploring the market conditions where the potential investment is, and, of course vetting the fund’s sponsor and the property management team’s track record. Be sure to scrutinize the projected returns and the timeline that the fund is targeting and decide if you agree with those targets.
The more you understand about the fund, the fund’s sponsor and the management team, the assets in the fund, and the projections being presented, the more likely you are to make a truly informed decision. You know that with any investment opportunity you must research everything thoroughly. No investment comes without risk, but the more educated you are about the opportunity, the more comfortable you will be that you made the right investment decision.
Note: We are not financial advisors or tax professionals, nor are we giving tax or financial advice of any kind. Please seek professional or legal advice before making any investment decision.
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