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.
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
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.
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.
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.
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.
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.
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.
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.
If you loved the information above and want to learn more about the benefits of real estate funds, get in touch with us today to see how Voyager Pacific can help you build wealth with real estate,
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