Real Estate Investment Fund
A Guide to Real Estate Investment Funds
Real estate is an important “alternative” asset class that offers attractive returns and diversification benefits for all types of investors. While owning real estate directly, including finding, acquiring, managing and maintaining individual properties, is not right for everyone, there are a number of ways to invest in real estate. We explain the different approaches in this guide to investing in real estate funds.
What Is A Real Estate Investment Fund?
Real Estate Investment Fund Defined: In a real estate investment fund, the sponsor (manager) combines capital from many investors and chooses properties in which to invest. When a real estate fund is involved in improving or renovating properties, the sponsor also manages those activities. Real estate investment funds generate passive income and appeal to investors who want to include real estate in their portfolios but do not want the responsibilities of direct ownership. Some are open to all types of investors, while others are available only to accredited investors.
There are various types of real estate investment funds. Some own shares of other entities that develop and own real estate, and may also own shares of Real Estate Investment Trusts (REITs). Some funds specialize in a specific type of real estate, such as office buildings or data centers, while others hold a wide variety of property types. Many private equity real estate funds, which are available to accredited investors, directly own and develop real estate properties. They offer benefits not available through publicly traded funds such as REITs, mutual funds and exchange-traded funds (ETFs) that offer exposure to real estate with a fairly small investment.
Real Estate Private Equity Funds:
Private equity real estate funds provide accredited investors with a number of important benefits that are not readily available through other types of real estate funds, including preferred returns as well as tax advantages. For individuals who are seeking exposure to real estate and have at least $50,000+ to invest, this approach is compelling.
Here, we describe how private equity real estate funds are structured, the key benefits of investing in these funds and a summary of Regulation D Rule 506 that governs the types of investors that can participate in a private equity real estate fund. We then describe the different phases of developing properties a fund may undertake and provide a high-level summary of The Kona Estates Fund I, LLC, a private equity real estate fund available to accredited investors.
How Do Private Equity Real Estate Funds Work?
Private equity real estate funds sell limited partnership (LP) interests to raise capital for real estate investments. The fund’s general partner (GP), often referred to as the sponsor, uses investors’ capital and often borrowings from banks and other lenders to invest in real estate. The sponsor/GP provides some equity, identifies the real estate investment opportunities, manages the investments, and earns fees that are often (but not always) based on the fund’s performance. The LPs typically provide most of the equity capital. Buying LP units is a passive investment that offers a preferred return, including return of capital. LP investors typically receive distributions from the Fund before the sponsor does.
There are five categories of private equity real estate funds, distinguished by their risk/reward profiles:
1) Core – Offers the lowest risks/rewards, uses little or no leverage and focuses on stable, high-quality assets with high occupancy rates in prime locations. Income from the Fund’s properties produces a high proportion of the total return, while appreciation is a lesser component.
2) Core-plus – Owns high-quality assets in secondary locations, or slightly risky assets in prime locations. Uses moderate leverage – up to 50 percent – with the goal of increasing the fund’s internal rate of return (IRR).
3) Value-add – Acquires properties to improved or redevelop, thereby adding value; may also engage in new development. The location of the assets is less important than the opportunity to add value. Uses up to 70 percent leverage, and a large portion of investment returns comes from appreciation in property values.
4) Opportunity – Repositions and redevelops poorly run, outdated buildings or builds on vacant land. Location is secondary to the opportunity. Offers high risks/returns. Appreciation in property values is the primary source of returns, and much of that occurs at the end of the investment period.
5) Distressed debt/mezzanine – Buys senior and mezzanine loans, and unrated tranches of commercial mortgage-backed securities. May own defaulted loans with the expectation of recovering value. Leverage is used to increase investors’ IRR.
When evaluating a private equity real estate fund, investors should look for a sponsor that has clearly articulated the fund’s strategy, and makes investments that are consistent with that strategy.
The Benefits Of Real Estate Funds
Real estate investment funds offer a number of important benefits to investors, particularly those with substantial portfolios. Here are some of the key advantages of investing in real estate via a fund:
Diversification
Real estate as its own asset class offers the benefits of diversification to investors who often have most of their portfolios in stocks and bonds. Real estate fund returns are not strongly correlation to the ups and downs of the stock market, which can be volatile over short periods. Over time, the demand for real estate tends to increase with population growth and the overall economy.
Variety
Investors can choose from a wide range of real estate funds that focus on different geographic areas, property types and risk/reward profiles. This allows investors to customize their portfolios without having to buy individual assets directly.
Preferred Returns
Returns from real estate investment funds are usually used to provide a profit and return of capital to investors before the fund sponsor earns a profit. This motivates the sponsor to manage the fund to achieve its profit target and helps to keep the interests of the investors and the sponsor aligned.
Tax Efficiency
Most real estate investment funds are designed to generate returns over a number of years. Unless fund assets are sold within a year of the fund’s inception, returns will be taxed at the long-term capital gains rate rather than the short-term capital gains rate. In addition, investors in real estate funds may benefit from pass-through depreciation.
What is Reg. D 506(b)?
Regulation D (part of the Securities and Exchange Act) allows companies to sell securities that are not registered with the SEC, thereby reducing issuance costs. Reg. D also defines the term “accredited investor”. Reg. D’s Rule 506(b) allows real estate funds and developers to raise capital from an unlimited number of accredited investors and up to 35 non-accredited investors. Non-accredited investors must still be “sophisticated investors” who are knowledgeable about investing in general, and are familiar with the type of investment being offered.
Companies issuing securities under Rule 506(b) are not required to make disclosures to accredited investors, but anything they disclose must also be provided to non-accredited investors. Companies must make certain disclosures to their non-accredited investors. Importantly, entities offering securities under Rule 506(b) can only sell to investors with whom they have had a substantive relationship prior to the offering.
What is Reg. D 506(c)?
Rule 506(c) was added to Regulation D through the Jumpstart Our Business Startups Act (JOBS Act) in 2012 to provide more ways for businesses and real estate funds to raise capital. It allows sponsors to solicit participation from all accredited investors, not just those with whom the company had a previous relationship. The sponsor must verify that investors are “accredited” by verifying their income or net worth.
Phases of Developing Projects in Real Estate Funds
There are three major phases of investing in real estate that we describe here:
Phase 1 – Acquire and develop
This phase can span from two to five years, as extensive planning is necessary, and ground-up construction takes time. However, the potential gains are much greater than acquiring Value-add or Stabilized properties that have already been developed.
Phase 2 – Add value
This phase involves renovating and remodeling to improve a property with the goal of commanding higher rents, leases or rates (for hotels) after the renovation is completed. The amount of time is usually less than for Phase 1.
Phase 3 – Stabilize
In this type of project, the developer is seeking to greatly improve the appeal of a property, which may have high vacancies, to attract better, more stable tenants and thus significantly increase revenues.
Invest In Kona
The Kona Estates Fund I, LLC is a private equity real estate fund that will use investors’ capital, along with the Manager’s equity, to acquire and develop The Kona Estates at Opihihale, on the South Kona Coast in the Big Island of Hawaii. Returns will be generated through cash proceeds from the sale of each residence or estate home-site sale, and will be distributed to investors pro rata, creating a gradual exit over the investment cycle. Since the Fund does not expect to use leverage, there is less risk to investors than in many other real estate projects, while still preserving the strong upside potential associated with ground-up development of luxury property. This is one of the more exciting accredited investor opportunities that is a passive investment and is available only to accredited investors. Benefits, as described above, include the ability to take advantage of long-term capital gains, favorable taxation, and depreciation. The principals have a 40-year track record in destination real estate development, marketing, and sales and have a vertically integrated four-stage process of taking projects from conception to completion.
Stage 1
Fundraising. Using its own capital and raising all other necessary capital for acquisition and infrastructure development through its own Reg. D 506(c) private equity fund created specifically for the project.
Stage 2
Development. Completing all underground and surface infrastructure and amenities without using leverage/debt. Therefore significantly de-risking the project while preserving upside potential for its partners.
Stage 3
Real Estate Marketing. While the principals are well versed in all stages of project development, its the complex and multifaceted destination real estate marketing programs that is their expertise.
Stage 4
Sales. The Kona Estates at Opihihale project will take the company over the $1B mark in real estate sales. The highly effective real estate marketing programs will fuel the success of a specialized sales team.
Other Types Of Real Estate Investment Funds
A real estate exchange-traded fund
A real estate exchange-traded fund holds shares of real estate companies and may also hold REITs. These ETFs offer the opportunity to gain exposure to real estate with a fairly small investment. Real estate ETFs may focus on a specific segment of commercial real estate, or a broad range of property types, and typically offer greater diversification than what is available from holding a single REIT. ETFs hold a group of investments designed to track a chosen index; they do not actively select real estate properties based on their potential to deliver superior value. Since these ETFs do not involve active management, they tend to charge low fees. Like all ETFs, they trade on a stock exchange and can be bought and sold throughout the day.
Real estate mutual funds
Real estate mutual funds, like real estate ETFs, own shares of entities that develop and own real estate, as well as shares of REITs. These funds provide investors with exposure to real estate – either focused on a segment of commercial real estate, or a wide range – at a fairly small level of investment. As with other mutual funds, most real estate mutual funds are actively managed; in other words, the fund managers select the fund’s holdings based on their analyses and expectations for the returns their holdings will generate. In contrast, some real estate mutual funds are designed to track a specific real estate index (similar to ETFs); in this case, the real estate stocks in the fund are selected to closely match what is held in the index. Like all mutual funds, buy/sell orders for real estate mutual funds are completed at the end of the trading day, at the fund’s Net Asset Value (NAV). Real estate mutual funds can be open- or closed-end.
REIT vs Real Estate Funds: What’s The Difference?
A Real Estate Investment Trust, or REIT, is a publicly traded entity that invests in commercial real estate properties. Shares of REITs are traded like stocks, on an exchange, and are thus easy to buy and sell. Some REITs specialize in a particular type of real estate, such as office buildings, shopping malls, hotels, self-storage facilities, data centers, or apartment buildings; others invest in a diversified array of real estate types. Some REITs invest in the mortgages on commercial or residential properties and are therefore similar in some respects to bond funds. REIT income is derived mainly from rent generated by the properties, except for mortgage REITs, where income flows from payments on the mortgages held. At least 90% of a REIT’s income must be distributed to investors as dividends each year.
REITs vs Real Estate Funds – Key Differences:
The primary differences between REITs and Real Estate Funds are:
- Income – REITs must distribute at least 90% of the income from their properties to investors each year; thus, REITs are seen as income-generating investments. Real estate mutual funds usually pay a dividend, but also seek to provide returns from an increase in the value of the fund’s properties.
- Trading/Liquidity – REITs trade like stocks, and thus can be bought and sold throughout the day. Real estate mutual funds trade at the end of the day, but are still quite liquid. Private equity real estate funds are illiquid; investors commit to having their capital locked up for a number of years, which is one reason these funds may offer superior returns.
- Taxation – REITs distribute dividends that are taxed as ordinary income. Returns from owning real estate funds come primarily from an increase in value of the assets in the fund, which may be taxed as capital gains. For real estate funds that hold shares of REITs, income distributed from those REITs is eligible for a pass-through deduction called Qualified Business Income (QBI), lowering the taxes owed on that income.
What Are The Best Types of Real Estate Funds To Invest In?
For accredited investors, private equity real estate funds provide a number of important benefits that are not available from other types of real estate investment vehicles, including preferred returns and tax advantages. For individuals who are seeking exposure to real estate and have at least $50,000+ to invest, this is quite often the preferred approach to investing in real estate. Private equity real estate funds often specialize in particular types of real estate projects, so investors can compare various funds to find one that meets their goals and preferences.
For investors with less capital to invest that do not meet the accreditation standards, there are approximately 225 REITs traded on stock exchanges in North America, hundreds of real estate mutual funds and over 30 real estate ETFs. Some hold U.S. properties only, and others are international. Some specialize in a particular category of real estate while others invest in a broad range of property types. In choosing a REIT or fund, focusing on recent performance is not informative, as returns vary over time and real estate is cyclical in nature – while one sector may have done well in the past year, another will be stronger the following year. We offer these criteria to consider when evaluating publicly traded real estate investment vehicles.
(Note: Online fund screening tools, such as those available from Yahoo Finance, Fidelity, Morningstar, Charles Schwab and others, can be useful in gathering information investors need to evaluate REITs, real estate mutual funds and ETFs).
Key Criteria:
Primary investment objective: If current income is the priority, REITs are probably the best approach. Real estate investment funds or ETFs are more suitable when pursuing longer-term gains (key differences between them are discussed above).
Specialization versus diversification: Many real estate investment funds focus on a single property type, such as office buildings, retail shopping centers, hotels, etc. Others are diversified, investing in a range of real estate sectors. There are benefits to both approaches: investors with a view about the outlook for a particular segment can focus on funds and REITs that specialize in that area. For investors without a specific view on a particular market segment, or who wish to “hedge their bets”, a diversified fund would make sense.
Fees: All mutual funds, ETFs and REITs charge fees to cover the costs of managing the fund, and fees detract from investors’ returns. However, lower fees do not necessarily mean better performance. ETFs can charge low fees because they do not have to pay managers to analyze different real estate investments to find the best opportunities; they simply maintain holdings with the goal of tracking a particular real estate index. In contrast, real estate mutual funds select real estate entities and/or properties the fund will hold, and actively manage the fund’s holdings. Their managers have expertise that can contribute significantly to a fund’s performance, and can justify higher fees.
Manager experience: Experience is important in the real estate industry, and a fund manager who has been in place through one or more business cycles has had the opportunity to learn from that experience. Note that a manager may only have had a few years of experience with a particular fund, but could have managed other funds in a previous position.
Long-term performance: Any fund can have a great year, or a bad year. While poor performance should be addressed in the fund’s yearly reporting, investors should look at 3-year, 5-year, and 10-year results before drawing conclusions. Note that investors tend to abandon funds that are consistently poor performers over the long run, so if the size of a fund has declined over time, that would be a red flag.
Turnover: As with any type of fund, the higher the turnover (the percentage of the fund’s holdings that change over the course of a year), the more likely the fund is to generate short-term gains/losses. Investors may wish to hold funds with a high turnover ratio in a tax-deferred account, such as a traditional IRA, or in a Roth IRA. Consult with a financial advisor or tax professional for details.
Benchmark comparison: There are many real estate benchmarks available when evaluating returns for real estate investment funds and REITs. Investors should assess whether a fund’s chosen benchmark is appropriate for that fund’s objective. For private real estate investment funds, the best-known benchmark is the National Council of Real Estate Investment Fiduciaries (NCREIF) Property Index, known as the NPI. The NPI measures changes in valuation for approximately 7,000 commercial real estate properties owned by institutional investors in the U.S.
Sharpe ratio: This commonly used investment metric shows the return per unit of risk a publicly traded fund, ETF or REIT generated over a given time horizon. It is a reminder that risk and return go hand-in-hand; while knowing a fund’s return is important, it is also important to know how volatile those returns have been. The Sharpe ratio captures this – a higher number is better.
Size: All funds start out small (with exceptions designed to “jump-start” a fund), so small is not necessarily bad; however, a fund that has existed for a number of years but has not grown could indicate that it is struggling to gain traction. Smaller funds often have relatively high fees to cover their fixed costs, and small ETFs and REITs are likely to have relatively low liquidity, which matters for investors who plan to actively trade them (mutual funds are not appropriate for active trading).
Real Estate Investment Fund FAQ’s
How to fund a real estate investment?
Investors can purchase shares in real estate mutual funds, real estate ETFs and REITs that are listed on a public stock exchange through an online or full-service brokerage account. These funds typically have a low minimum investment ranging from $1,000 - $2,500. Private real estate investment funds and private REITs typically have much higher minimum investments, often $100,000 or more. Accredited investors taking positions in Regulation D Rule 506 private equity funds may invests as an individual or through IRAs, 401Ks, trusts, brokerage accounts, and various entities.
How is The Kona Estates Fund I, LLC different than a REIT?
The Kona Estates Fund I, LLC (TKEF I) and REITs both generate returns through real estate investments. However, investing in TKEF I makes you a partner of the Fund and a partial owner of the entire project, with the potential for long-term capital gains, favorable taxation, and depreciation. In contrast, REIT investors do not directly own real estate assets, the interests of the REIT manager and the REITs investors are not always aligned, REIT management fees are often significant and not linked to performance, and returns are likely to be taxed at higher rates.
Can hedge funds invest in real estate?
Some hedge funds do invest in real estate, and may do so through REITs. While investors can buy REITs directly, hedge funds often use leverage and may actively trade their REIT holdings. Some real estate hedge funds invest directly in real estate, often focusing on distressed properties where valuations have declined significantly and the hedge fund sees an opportunity for a strong recovery.
Can IRA funds be invested in real estate?
Investors can hold real estate property in a self-directed IRA, i.e., an IRA that is not associated with any brokerage firm, bank, or investment company. The IRA custodian, or other entity responsible for record-keeping and IRS reporting, must accept alternative investments. The property must be held for investment purposes only; the investor/investor’s family members cannot use it. The investor must pay cash for the property, and all ownership expenses must be paid out of the IRA.
What is an Accredited Investor?
An Accredited Investor, in the context of a natural person, includes anyone who:
- earned income that exceeded $200,000 (or $300,000 together with a spouse) in each of the prior two years, and reasonably expects the same for the current year, OR
- has a net worth over $1 million, either alone or together with a spouse (excluding the value of the person’s primary residence less liabilities).
Should you invest in a private equity real estate fund or a real estate mutual fund?
Both offer advantages. For those with more to invest, private equity real estate investment funds are a compelling alternative, offering preferred returns, tax efficiencies and other benefits. Real estate mutual funds are a convenient way to gain exposure to this asset class, especially for investors with a limited amount of capital to invest.