7 Reasons Why Real Estate Funds Are Better Than Deals in a Volatile Market
As a private real estate fund manager, we often speak to individual investors about the advantages of investing in real estate funds versus deals. No time are these advantages clearer than the market environment we’re experiencing this year.
Many individuals steer away from funds because they want to select their deals and be in control of the investment process. But what is the likelihood that an individual, no matter their net worth and their access to resources, can do a better job than a full-time investment manager who dedicates hours each day to finding the best deals? Beyond this question, we’ve outlined below the top seven reasons why investing in real estate funds is a better choice than building your own portfolio on a deal by deal basis.
- Sponsor Risk. Ask anyone who has been investing in private real estate long enough and they will all say that it’s who you invest with that matters. Not all managers are created equal and spreading money across different deals exponentially increases your chances of investing with a mediocre to bad sponsor. Plus, a middleman who brought you a deal likely doesn’t understand it as well as the sponsor and may not have your best interest in mind. Middlemen get paid for getting the deal done, not getting it done well. Don’t fall for high advertised returns either because if one thing is for certain, it’s that projections are wrong. Every deal looks great in Excel and, in general, the higher the advertised return, the more skeptical you should be of a deal. An investment that pencils out to a 25% internal rate of return sometimes ends up losing 50%, while a deal that is marketed with 10% returns may produce 15% returns. Get to know the people who are managing your money. What motivates them? What is their track record? How do they underwrite? Who is their team? If you don’t get this right, nothing else matters.
- Diversification. A fund enables you to diversify across a multitude of assets instantly. In a closed end fund, the sponsor builds a portfolio over time and in open ended funds, like our IncomePlus Fund, new investors receive immediate diversification. A fund manager will take a thoughtful approach to construct a diversified portfolio across geography and asset types.
- Cross Collateralized Fees. Despite what some people think, fund structures are not more profitable to the manager than an individual deal strategy. In fact, it can be quite the opposite. In a fund, the performance fee is calculated across all assets and therefore places that revenue at risk as one bad deal in a fund can place the bulk of a manager’s compensation at risk. This structure benefits the investor at the expense of the sponsor, and it aligns interests so that a fund manager must be highly selective when choosing what assets to invest in. In a deal by deal strategy, the sponsor gets paid on every deal and it sets up a situation for heads you lose and tails they win. Fees destroy returns and the deal by deal structure tilts the fee scale heavily in favor of the sponsor.
- Liquidity. A fund’s cash flow is shared across all assets so if one gets in trouble, liquidity can be shared across all assets and provided from the fund-level. When you invest in an individual deal, if that deal goes bad, the sponsor doesn’t have a lot of choices and must either call the partners for more money, put money in themselves, or let the project go back to the bank. In times of crisis, there is no question that a fund structure has more staying power and will be able to weather a downturn far better.
- Cash Drag and Taxes. In an open ended fund, you can defer taxes by staying in as long as you’d like and enjoy the benefits of depreciation, which means you don’t pay taxes until you sell. When you invest in individual deals, you will pay taxes on every deal you sell. On top of that, you will have to figure out where to invest idle capital. It’s important for you to include the impact of idle capital and taxes on your overall investment returns.
- Organization. Keeping your finances meticulously organized can’t be underestimated. An investor with 25 individual deals will get 25 K-1’s at the end of the year and will have to track all of them on different systems, which can be a huge time drain. When you invest in a fund, you typically receive one report to read that covers all your assets and one K-1.
- Sidecar Opportunities. In the event you do want to round out your investment portfolio with additional individual deals, most fund managers raise additional sidecar capital from their investors when a deal is simply too big for the fund or doesn’t fit the fund strategy. With this option, you know the deal has already been thoroughly vetted if the sponsor is putting it into their fund.
The bottom line is that funds are better than acquiring individual deals for any investor, and that’s why we’ve chosen to invest through funds. I’ve been personally investing for more than twenty-five years across real estate, venture, private equity and other alternatives and I stopped looking at individual deals more than twenty years ago. With my personal capital, I heed my own advice and only invest with fund managers who have a seasoned track record and a significant amount of their net worth invested alongside of me. I might do the occasional sidecar opportunity, but I have the advantage of knowing the sponsor and knowing they looked at hundreds of deals and vetted it thoroughly.
To be fair, not every fund is created equal and many managers use a fund structure so they can take more risk. Funds can use more leverage if they guarantee debt, and subscription lines can be used to financially engineer returns. Make sure to thoroughly vet every fund manager to understand their motivations. At Origin, we create products that we want to invest in and inherently we want our money in the best products. An individual deal by deal structure would be far more profitable for a company like ours but our mission is to transform the way individuals invest in real estate – not maximize short-term profits. We hold our investor interests above all else because we believe this is the way to build a great company that will endure forever.