A version of this article was originally published on The White Coat Investor website.
Individuals who want to passively invest in private real estate can essentially choose between building their own portfolio of individual real estate deals and investing in real estate funds. There are pros and cons of each choice.
Investors who select individual deals have the freedom to pick and choose what deals they invest in, but this also requires a large amount of time and may not result in the most diversified portfolio. Investing in a real estate fund means giving up control of selecting individual deals to a disciplined manager, but also means saving substantial time and, ideally, receiving a well-diversified group of real estate investments.
There are five factors to consider when determining if investing in individual real estate deals or funds is best for you.
1. Time Commitment
When an individual invests in a real estate fund, they make a commitment and it is the responsibility of the fund manager to build a diversified portfolio for their investors. In other words, the investor selects the manager and then the manager selects each deal and builds the portfolio. The individual is contractually obligated to invest in every deal the manager acquires, but only to the extent of their commitment. If an investor commits $100,000 to a fund, the manager can only call up to that amount. It typically takes a fund manager two to three years to invest all of the fund’s capital and the only requirement by the investor is to send a wire to fund each investment.
With a deal-by-deal approach, an investor would have to source a large number of deals and evaluate every opportunity. Finding a good, trustworthy manager is not easy and the investor only has to find one if investing in a fund. The chances of investing with a dishonest manager increases as the number of managers in the portfolio increases. Returns and headaches are both highly correlated to the quality of the manager.
In a fund, investors typically receive consolidated quarterly performance reports on their entire portfolio, rather than dozens of individual reports. Each update will follow the same format and illustrate how the individual deals within the portfolio are performing and the overall investment performance at the fund level.
An individual who assembles a portfolio made up of 20 individual deals with several managers will receive 20 individual reports that all may look very different. Investors may do the performance aggregation by hand if they want to accurately gauge their portfolio’s performance.
Additionally, year-end tax reporting is much easier in a fund structure because K-1’s, a tax document sent to partners that lists out their share of income and loss for the year, are consolidated into a single document for tax reporting purposes. But an investor in 20 individual deals will likely have to manage 20 K-1’s and the costs associated with filing them.
Diversification is one of the easiest ways to reduce risk. In real estate, investors need to make sure they are not overexposed to any one deal, geographic region or sector.
Diversifying capital across a large number of investments is a great way to reduce risk. Generally, any portfolio, whether it be stocks, bonds, or real estate, that has less than ten assets, is considered highly concentrated. Often times, funds have minimums in excess of $100,000, but that capital will be spread across 15 to 20 deals.
Participation in individual deals can sometimes be obtained for as little as $500, but the higher-quality investment opportunities tend to have minimums greater than $10,000 and often times more than $50,000. Investing $100,000 on a deal-by-deal basis could easily lead to a portfolio of four to six deals and a single property could easily make up 30% or more of the portfolio.
Funds can be geographically concentrated or diversified, depending on their strategy. Some fund managers focus on a particular region or even one city. An investor with a limited amount of capital would want to find a fund with broad geographic diversification or invest in several funds. Real estate downturns can often be isolated to a single city or region and having too much concentration in one area can lead to unnecessary risk. A deal-by-deal strategy could serve as a better way to geographically diversify a portfolio.
Funds tend to be specialized in one or two asset classes, so an investor looking to gain exposure to a handful of asset classes may want to consider building their own portfolio. If one has millions of dollars to invest, this probably isn’t an issue, because the investor could then easily spread capital across multiple funds to gain exposure in real estate debt, apartments, office, retail and industrial buildings. It’s uncommon, but there are funds that invest in multiple asset classes that could provide the requisite diversification for an investor.
Real estate investing is a complicated business requiring many people. Experts are required to find the deals, negotiate the price, create marketing materials and legal documents, raise investor equity, manage the day-to-day activities at the property, formulate and execute the business plan, report to investors, provide K-1’s, sell the asset and distribute the proceeds. A great team does not come cheap, and fees help managers attract and retain high-quality employees. An important part of vetting a manager is understanding the fees they charge – regardless if it’s a fund structure or an individual deal.
The amount an investor pays to a fund manager versus a manager syndicating individual deals will be nearly identical when all is said and done. Each option charges different fees, which can be confusing to navigate, but they are just different ways of getting to the same place. I detail the differences between individual deal fees versus fund fees in this article and include real-life examples.
The main point to know is that in a fund, the performance fee is paid based on the overall performance at the fund level. In contrast, managers of individual deals get paid based on the performance of each and every deal. This is important because if one deal generates a 20% annualized return and another deal generates a 20% annualized loss, the manager is entitled to an incentive fee on the deal that did well. The manager operating in a deal-by-deal structure may be more incentivized to focus on the deals doing well and ignore those doing poorly where they are least likely to earn a fee. The fund manager, in contrast, is highly incentivized to revive underperforming deals.
5. Manager Benefits
We’ve talked about the pros and cons of funds versus individual deals to the investor, but what about to the manager? One of the first items the seller of a property asks for when selecting a buyer is proof of capital. They want to know that the buyer has the capital on hand to be able to close a deal. A fund provides a base of permanent capital that allows the manager the ability to show proof of funds and transact quickly when they find a good opportunity. In a deal-by-deal structure, capital is raised after the deal has been negotiated and many sellers are wary of awarding deals to syndicators, unless the manager can convince them of their ability to close the deal.
Funds also provide the manager with a steady stream of recurring revenue to pay employees and meet their overhead obligations. Managers who acquire individual deals tend to have less certain income and don’t get paid unless they do a deal. A manager struggling to pay their staff could be incentivized to do deals simply to generate fee income.
Looking at the pros and cons, the advantages of investing in a real estate fund tend to outweigh those of investing in individual deals. But for many, picking deals is more of a learning process and education, which is extremely important in real estate investing, is more likely to be accomplished by pouring over countless documents to evaluate individual deals.
For those who don’t have the time to evaluate each deal, fund investing is most likely the better route. And there is still a great opportunity to learn as well, as a good fund manager should educate their investors, keeping them apprised of portfolio performance and details of their strategy. It also allows one to gain all of the benefits of private real estate with very little effort. Evaluating a single manager, who will be responsible for building an entire portfolio, is clearly much easier than spending the time evaluating 20 deals and the people behind them.
However, in many cases, it’s not an either or and situation, as an investor may prefer a hybrid of both strategies. Understanding the nuances of each approach is the key to making an informed decision and investing successfully.