This article is about the contemporary strategies and structures of real estate investment funds and how you can create and properly manage the fund. If you are interested in real estate investment management then likely you might be wondering how to start an investment fund for real estate. Simply said, the main purpose of a real estate investment fund is to raise funds for various real estate projects.
Starting a real estate fund is a bit different from setting up other types of funds. To set up a real estate investment fund, first, you have to decide, what amount of equity capital you need to be raised. The minimum fund size for a real estate investment fund is about $20 million and you also have to consider the organizational fees. Then you have to find some sponsors because they will be responsible for all aspects of the fund. Finally, you must have a clear investment fund strategy for real estate investment assessment.
What Is Real Estate Investment Fund?
An investment fund is an entity formed by a group of people who want to invest in development, property, or real estate investment trust. So, a real estate investment fund is a combined source of capital that is used for investing in various real estate projects. There are some similarities between real estate investment funds and REITs as they both are pooled sources of capital used to invest in real estate. However, there are also some key differences between these two fund types as REITs are corporations and they have to distribute 90% of their taxable income to shareholders. But, real estate funds don’t have to comply with those rules.
Types Of Real Estate Funds
There are four common types of real estate funds available. They are –
Real Estate Mutual Fund: This type of fund is a professionally managed investment and it mainly focuses on investing in a variety of asset classes in order to create a diversified portfolio. This type of fund invests in stocks and bonds of real estate companies and properties.
Real Estate Private Equity Fund: This type of fund is identical in concept to all other private equity funds but it only invests in real estate. It raises funds from private investors known as Limited Partners (“LPs”) and invests those funds in real estate.
Real Estate Debt Fund: This type of fund raises money from large investors to invest in real estate assets. Unlike any other funds, a real estate debt fund only invests in senior or mezzanine debt collateralized by real estate assets.
Real Estate Investment Trust: This type of fund is commonly known as REIT and it invests directly in real estate or the mortgages secured by real estate. Here, investors can buy shares of REITs and receive profits according to the income generated by the property and other investments.
Structure Of A Real Estate Investment Fund
A real estate investment fund is always formed as a corporation because this is the right structure to allow a group of people to gather money together for the investment. Most of the time, it is a limited liability corporation (LLC). Some real estate investment funds have an entity like a limited partnership. Having this type of investment structure allows the investors to collect funds without having any security registration process. So, if you form a limited liability corporation then you will have an easy taxation process which is a very important factor for property investment funds. You can divide the real estate investment funds into two types: one type has a set end date while the other type is an open one. Moreover, you have to understand that real estate investment fund is different from REITs and this type of fund won’t distribute profits quickly in the short-term like the REITs.
Admission And Withdrawal Of Investors
Real estate investment is illiquid, therefore; this type of fund has various issues that needed to be addressed as early as possible. One of the issues is whether to use an open-end or closed-end fund structure. An open-end structure allows investors to enter and exit the fund at regular intervals according to their wishes. The open-end structure is very simple and many investors prefer this type of structure. However, the illiquid nature of a real estate investment fund makes it difficult to work out the open-end structure because it becomes very difficult to establish a fair value for each contributing and withdrawing investor.
On the other hand, a closed-end fund structure doesn’t have much complicity. It’s a simple structure where all the investors join the private real estate fund at the same time. So, there won’t be any hassle of establishing a fair value for each contributing and withdrawing investor. Moreover, the above two structures can adversely impact the performance and risk profile of the investment fund. Therefore, you should choose the fund structure very carefully.
Types Of Risk-Adjusted Funds
While forming a real estate investment fund, you have to make clear the risk/return continuum of the fund and how to stay on the goal. For real estate investment funds, there are five types of risk-adjusted funds available. They are –
Core: This type of fund has the lowest risks/rewards compared to other types of risk-adjust funds. Usually, this type of fund offers 6 to 8 percent net equity IRR to LPs and its annual income return is also very high.
Core-Plus: This type of fund has slight risks and it also offers 8 to 12 percent net equity IRR to LPs. This type of fund has moderate leverage of up to 50 percent and over time the equity IRR also increases.
Value-Add: This type of fund has moderate leverage of up to 70 percent with features like re-leasing, operational efficiencies, redevelopment, etc.
Opportunity: This type of fund offers high risks/returns. You can expect more than 15 percent net equity IRR to LPs from this type of risk-adjust fund. Usually, the return occurs at the end of the holding period.
Distressed Debt/Mezzanine: This type of fund offers 8 to 12 percent net equity IRR to LPs. Usually, the investment is done in senior loans, mezzanine loans, nonrated commercial mortgage-backed securities (CMBS) tranches, etc.
How Real Estate Investment Funds Make Profit And Distributes
There are two common ways available in which a real estate investment fund makes money. One of the ways is property appreciation, and the other way is wise investing within the market. Though these two methods are related they are not always passive. For example, the appreciation might happen because of the change in real estate market conditions but sometimes it might happen if you invest in property development. One of the key structures of real estate investment is reinvesting the profits in various projects. Some investment funds give dividends but not as much as 90% of REITs. Usually, the structure of the fund determines how the profits will be distributed. So, the profit of the investor is calculated based on several factors and then paid to the investors. A part of the profit is reinvested again and then the remaining profits are split between the investors and the sponsor or manager.
Advantages And Disadvantages Of Real Estate Investment Fund
Starting or investing in a real estate investment fund has both advantages and disadvantages. Below are some of the benefits and risks of participating in a real estate investment fund.
Advantages Of Real Estate Investment Fund
1. Starting or investing in a real estate investment fund allows the investors to take the full benefits of the real estate market.
2. Real estate investment fund provides diversification for the investors.
3. This type of investment is very stable and provides good profit for long-time investment.
4. Real estate investment fund gives common people an opportunity to invest in real estate
5. This type of fund allows the investor to be paid first
6. If you invest in a real estate investment fund then you will be able to enjoy tax benefits
Disadvantages Of Real Estate Investment Fund
1. There are some real estate investment fund structures available where investors aren’t allowed to withdraw capital early, so if you want to keep your capital liquid then this type of investment is not a good option.
2. Real estate investment is a long-term investment, so if you are looking for short-term profit then this is not the investment option for you.
3. If you invest money in a real estate investment fund then capital gain tax will be applicable for you.
4. You will require high capital to form an investment fund for real estate.
5. Real estate investment is illiquid so a large amount of money will be stuck for a long time
6. There are many risks involved in this type of investment especially if the market condition is not stable.
A real estate investment fund allows you to collect funds to invest in real estate projects without the necessity of raising money on a deal-by-deal basis. Moreover, it also evades the complexities and substantial regulations related to a REIT. Establishing a real estate fund is a very big step and it will be very difficult if you won’t have any prior knowledge about the real estate industry. So, you can consult with the professionals before making the decision of starting a real estate investment fund.
Magalie D. is a Diploma holder in Public Administration & Management from McGill University of Canada. She shares management tips here in MGTBlog when she has nothing to do and gets some free time after working in a multinational company at Toronto.