While real estate was once regarded as an alternative investment—well out of the mainstream categories of stocks, bonds, commodities, and other forms of trade—the sector has performed so well as a risk-adjusted investment class that it is no longer considered an alternative by many.
This legitimacy flooded the market with buyers eager for profitable real estate deals, which gave rise to real estate investment funds.
Funds have provided buyers with many benefits, including:
1. Reduced risk—With a variety of entities putting skin in the game, and funds required to comply with regulatory statutes like Dodd-Frank, individual investor risk can be minimized.
2. Diversification—Funds that purchase real estate across a variety of property sectors allow investors to diversify their portfolios, which is a hedge against a downturn in any one asset class.
3. Time savings—Fund managers vet and research each transaction the fund invests in, saving individual buyers the time and headaches of doing this themselves.
4. Exposure to more opportunities—Funds provide investors with exposure to a much wider variety of transactions, potentially allowing them to reach their investment goals faster.
There are some basic elements of real estate funds that investors should be aware of, including its phases, fees, and lifespan. Understanding the below elements will help investors determine which type of fund works best for them:
Real estate investment funds work in several phases: formation, launching, fundraising, closing, investment, and distribution of profits.
During formation, fund managers create the foundation for the fund, including its scope and goals, and following the regulatory process that allows for its formation.
The launching phase involves announcing that the fund has been established and is now “open for business.”
Next comes the fundraising phase, during which investors actually place their money in the fund. The initial closing occurs once the target raise amount has been reached.
The investment period commences when the fund purchases its first asset following the initial closing and continues for a period of up to 24 months. Note that the fund is not committed to investing if the market does not present opportunities.
Profits are generated from selling assets in the fund’s portfolio and from rental income. A portion of those profits is then distributed to investors and other stakeholders.
Most real estate investment funds charge investors fees that go toward services including negotiating the price of assets purchased, creating marketing materials and legal documents, raising equity, managing the day-to-day operations at the property, formulating and executing a business plan, reporting to investors, selling the assets, and distributing the proceeds.
While it’s tempting to choose funds with low fees, remember that you get what you pay for. On the other hand, excessive fees can eat into distributions, reducing the return on investment (ROI)—something potential investors should consider before deciding on a fund in which to invest.
Private equity funds typically have a lifespan of about 10 years, but keep in mind that that period usually doesn’t start until the fund’s investment team has raised substantial capital, and it doesn’t end until all of the fund’s assets are sold. Because of this, the lifespan of a private equity fund could extend to as long as 15 years. The lifespan of a fund could affect how investors choose to invest.
Understanding the benefits and basics of funds introduces investors to how funds work and why some funds might be better choices for them than others. Choosing the right fund canmake the difference between a smart real estate investment and a less profitable one.