Building a portfolio of a variety of real estate deals or participating in real estate funds are the two choices available to those wishing to invest passively in private real estate. Each option has benefits and drawbacks.
The ability to select which transactions to engage in is advantageous for investors who choose specific deals, but it also takes a lot of time and may not produce the best-diversified portfolio. Investing in a real estate fund implies handing over control of specific deals to seasoned management in response to significant time savings and, ideally, acquiring a well-diversified portfolio of real estate assets.
To decide if investing in certain real estate transactions or funds is ideal, you should consider the following five elements.
1. Time Commitment
Individuals that invest in real estate funds are committing, and it is the fund manager’s job to create a diverse portfolio for those investors. To put it another way, the investor chooses the manager, who then chooses each contract and assembles the portfolio. To the degree of their commitment, the person is legally required to invest in each deal the manager purchases. The fund manager may only make calls up to the amount of an investor’s $100,000 commitment. Only a wire transfer from the investor is necessary to fund each transaction, and it normally takes a fund manager 2–3 years to invest the whole fund’s cash.
An investor would need to source several deals and assess each deal’s potential if they used a deal-by-deal method. The investor merely has to choose solid, reliable management if investing in a fund, which is not always simply growing. As the majority of managers in the portfolio grow, the likelihood of investing with fraudulent management increases as well. Returns and problems have a strong relationship with the manager’s abilities.
2. Reporting
Fund owners typically receive a single, aggregated quarterly performance report rather than hundreds of individual performance assessments on their entire portfolio. Each update will have a consistent format and show both the performance of the individual agreements in the portfolio as well as the overall success of the investments made by the fund.
A person who creates a portfolio out of 20 different agreements with different managers will receive 20 distinct reports, all of which may appear quite different. Investors can manually aggregate performance data if they want to measure the success of their investments.
In addition, year-end tax reporting is significantly simpler in a fund structure since K-1s, which are tax documents provided to partners outlining their share of revenue and loss for the year, are combined into one document for reporting tax purposes. The management of 20 K-1 forms and the related fees for submitting them would, however, likely fall on the shoulders of an investor in 20 separate acquisitions.
3. Diversification
One of the simplest strategies for lowering risk is diversification. In the real estate market, investors must be careful to avoid being fully exposed to any single deal, area, or industry.
Diversified Sources of Funding
A great way to decrease risk is to spread our money out over several varying investments. Stocks, bonds, and real estate all fall under the category of severely concentrated portfolios, as do any portfolio with less than ten assets. Although other programs have lower minimums than $100,000, their funding is often divided among 15 to 20 projects.
However, the greater investment opportunities often have minimums larger than $10,000 and frequently more than $50,000. Although participation in particular offers can occasionally be gained for as low as $500. A single property could easily account for 30% or more of the portfolio if $100,000 were invested in deals individually. With $100,000 invested in deals individually, a portfolio of four to six properties might be created.
Geographic Distinction
Depending on their approach, funds can either be regionally dispersed or concentrated. Some fund managers concentrate their efforts in only one city or one specific area. A limited-capital investor would choose to participate in many funds or locate a fund with extensive regional diversity. Downturns in the real estate market are frequently confined to a particular city or region and concentrating too much activity there might increase the danger of unforeseen events. A portfolio’s regional diversification might be improved by using a deal-by-deal approach.
Diversification of Industries
An investor seeking exposure to several asset classes would want to think about developing their portfolio as funds often focus on one or two asset classes. It is probably not a problem for someone with high amounts of money to invest because they can simply distribute their money over several funds to acquire exposure to real estate loans, apartments, offices, retail, and industrial buildings. Although they are unusual, funds that invest across several asset classes might offer investors the necessary diversification.
4. “Fees”
The intricate business of real estate investing necessitates a large number of people. Experts are required to identify prospects, negotiate prices, create marketing materials and legal papers, attract investor funds, monitor daily operations at the property, establish and carry out business plans, report to investors, file K-1s, sell the asset, and distribute revenues. Fees aid managers in attracting and retaining top-tier employees, as building a good team is not cheap. Understanding the management charges is an important component of screening them, whether it’s a fund structure or a specific contract.
When everything is said and done, the fee that an investor pays for fund management and the fee that a manager syndicating individual trades receives will be practically similar. Although the navigation of each option’s pricing structure might be challenging, they are all only alternative routes to the same destination. In this article, I go into “Comparing Private Equity Real Estate Fund Fees to Individual Deal Fees.”
The performance cost for a fund is determined by the fund’s overall performance, which is the most critical concept to comprehend. On the other hand, managers of certain agreements are paid according to how well each contract works. It is important because the manager will be entitled to an incentive charge on the successful contract if one agreement generates a 20 annualized return while another agreement results in a 20 annualized loss. Since they have got a lower liability of being compensated when operating under a deal-by-deal structure, operations may be more prone to concentrate on the agreements that are succeeding and ignore the ones that are failing. On the other hand, fund management has a strong incentive to save on underperforming investments.
5. “Manager Perks”
The benefits and drawbacks of funds versus individual agreements for investors have been discussed, but what about managers? Proof of funds is among the first things a seller of real estate requests from potential buyers. To consummate a contract, they want to be sure that the buyer has the necessary funds on hand. When management finds a favorable opportunity, a fund gives them a basis of stable cash that they may use to produce evidence of funds and move promptly. Funds are obtained in a deal-by-deal format after the sale has been negotiated and many sellers are reluctant to give deals to syndicators unless the management can persuade them of their capacity to finish the deal.
The manager may use the funds to pay their staff and fulfill their overhead responsibilities thanks to a consistent source of recurring revenue. Managers who purchase individual transactions have less predictable revenue and are not paid unless a deal is completed. A manager who is struggling to pay their employees may be enticed to conduct agreements just to earn fee money.
When weighing the pros and downsides, investing in a real estate fund tends to outperform investing in individual projects. However, for many, selecting transactions is more of a learning process, and knowledge, which is critical in real estate investment, is more likely to be achieved by poring over innumerable paperwork to analyze particular opportunities.
Fund investment is perhaps a better option for individuals who lack time to give each transaction great thought. Additionally, there is still room for learning because a skillful fund manager will update their clients about portfolio performance and plan specifics. Furthermore, with little effort, it lets one obtain all the advantages of owning real estate. It is far simpler to evaluate a single manager who will be in charge of creating a complete portfolio than it is to devote the necessary time to assessing 20 agreements and the individuals involved.
It’s not always an either-or choice, though, since some investors may favor a combination of the two approaches. Making an informed choice and profitable investments requires an understanding of the subtle differences between each strategy.
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