Broadly, potential commercial real estate investment opportunities can be divided into two categories, deals and funds. Each has their own strengths and weaknesses and it is important for investors to be aware of them to determine which is a better fit for their investment objectives.
In this article, commercial real estate funds are discussed in detail. By the end of the article, readers will be familiar with what they are, how they work, their strengths and weaknesses, and how they compare to a “deal.”
At First National Realty Partners, we do not offer investments in funds. Instead, we partner with investors to source capital for individual deals. For more information on our current single deal investment opportunities, click here.
What is a Real Estate Investment Fund?
A commercial real estate investment fund is any type of investment vehicle that “pools” investor capital for the purpose of deploying it into commercial properties. While the structure and specifics may vary from one fund to another, they generally have several things in common:
- Management: Commercial real estate fund managers make the ultimate decision about how capital is deployed. They source investment funds from many individual investors with no specific asset in mind, just an investment strategy. As cash flows into the fund, they pair it with debt and use it to purchase real estate properties. In other words, when real estate investors commit capital to a fund, they do not know which properties it is going to be used to purchase. They place their trust in the manager to find the best opportunities that are consistent with the stated strategy of the fund.
- Diversification: The money in a commercial real estate fund is spread over many different properties, which creates a diverse portfolio. The portfolio could be diversified by property type, asset classes, location, real estate market, and tenants. On the whole, this type of diversification helps to reduce the risk of investment.
- Liquidity: When compared with single deals, funds tend to offer a higher degree of liquidity. In fact, some types of funds can be bought and sold like stocks, which provides a significant degree of short-term liquidity not normally found in commercial real estate investing.
- Access: Certain types of funds are available to any individual who wishes to invest. Other types are only available to “Accredited Investors” who are individuals that meet certain income and net worth requirements, as defined by the Securities and Exchange Commission.
- Minimum Investment: Certain types of funds have no minimum investment because their shares can be bought and sold freely on major stock exchanges. Other types of funds may require a significant minimum investment of $50,000 or $100,000.
- Income: Most funds pay a healthy dividend that is derived from the income produced by the rents for the underlying properties. This provides fund investors with passive income in return for their initial investment.
With these attributes in mind, commercial real estate investment funds can be broken down into four types.
Four Types Of Commercial Real Estate Investment Funds
There are four types of commercial real estate investment funds. They are discussed in detail below.
Real Estate Investment Trusts
A real estate investment trust – or REIT for short – is a type of commercial real estate investment fund that is distinguished by its high dividend yield and certain tax advantages. According to Internal Revenue Service (IRS) rules, the bulk of a REIT’s income and assets must come from real estate and they must pay out 90% of their taxable income to investors in order to maintain their tax advantaged status. The key tax advantage is that REITs are not taxed at the corporate level. Instead, taxes are paid by individual unit holders.
REITs can be privately held, which means that they are only accessible to accredited investors. Or, they can be publicly traded, which means that their shares can be bought and sold in the stock market. In addition, REITs tend to specialize in a specific property type like multifamily apartment buildings, office buildings, healthcare, data centers, or shopping centers. For example, Camden Property Trust is a large multifamily REIT or Simon Property Group is a large shopping center REIT. This type of specialization allows investors to pursue a specific investment strategy, even if they have no say in the specific properties bought and sold.
Finally, there are three types of commercial real estate REITs:
- Equity REITs invest in real estate and derive their income from rent, dividends, and capital gains on profitable sales. They tend to be the most popular.
- Mortgage REITs invest in mortgages and mortgage backed securities that are secured by commercial real estate assets. Their income is derived from interest, which makes them sensitive to changes in interest rates.
- Hybrid REITs invest in both property and mortgages.
REITs tend to be a good fit for individual investors with a moderate risk tolerance and a desire for a passive income stream.
Mutual Funds
Mutual Funds and REITs are very similar in purpose, but, the main difference between a REIT and a mutual fund is that REITs invest in properties directly. Mutual funds invest in the equity securities of companies that invest in properties. For example, the Vanguard Real Estate Index Fund invests in REITs like Prologis, American Tower, and Simon Property Group. In addition, mutual funds are not required to pay out a high percentage of their taxable income as dividends and they tend to be offered directly through their management companies (Vanguard, Fidelity, etc).
Mutual Funds tend to be a good fit for investors with a moderate risk tolerance and a desire for passive income and capital appreciation.
Exchange Traded Funds
An Exchange Traded Fund – or ETF for short – is very similar to a mutual fund. However, the key difference lies in the “exchange traded” portion of the name. ETFs are essentially mutual funds, but traded on major stock exchanges. This makes them easier to buy and sell and and they usually come with lower transaction and management fees.
For example, examples of large real estate ETFs include the Vanguard Real Estate ETF and the Schwab US REIT ETF.
Private Equity Funds
Private Equity Real Estate Funds pool investor capital to invest in the “equity” portion of a commercial real estate deal. Private equity funds are set apart from other types of funds by two distinguishing characteristics:
- They are privately held, which means that they are only available to Accredited Investors; and
- They are less liquid. Private equity funds cater to investors with long term time horizons and often require minimum commitments of 5-10 years.
Given their long time horizons and accreditation requirements, private equity funds tend to be most suitable for wealthy investors who can afford to take a long term view of their investments.
While there are different types of funds, they all tend to offer the same benefits and risks.
Benefits and Risks of Real Estate Fund Investment
Like any investment opportunity, there are benefits and risks to consider before placing capital into a real estate fund.
Benefits
Real estate fund benefits include:
- Diversification: Because fund assets are spread over many different properties, locations, and tenants, investors benefit from a diverse portfolio of assets within a single share of the funds.
- Liquidity: For those types of funds that are publicly traded, shares can be bought and sold easily, which creates a high degree of liquidity for fund investors.
- Expertise: Fund investors benefit from the experience and expertise of the fund manager when selecting assets in which to invest. They are also able to leverage their professional networks and relationships to get access to deals that they would not be able to see on their own.
- Time: Because the fund manager does all of the work, investors get the benefit of real estate ownership, but without the hassle of actually managing it. This frees up a significant amount of time to devote to other pursuits.
- Asset Quality: Finally, the assets that tend to be held in funds are high quality, institutional grade assets like central business district office space, class A apartment buildings, and large-scale self-storage facilities.
But, these benefits must be balanced against the risks associated with fund investment.
Risks
Fund investment risks include:
- Control: In a fund investment, individual investors have no control over how their capital is deployed. In addition, they have no say in day to day property management decisions and no input on when to sell the property. Their role is strictly passive.
- Time: Some private REITs and Private Equity funds require significant time commitments, which means that an investor may not be able to access their capital for 5-10 years from the original investment date. This type of longer-term time horizon can expose an investor to increased market risk, which can result in some volatility of total returns.
- Fees: A manager does not perform their job for free. While publicly traded REITs and ETFs tend to have low transaction costs and management fees, this is not the case for some mutual funds and private equity funds. In these types of investments, the fees tend to be higher, which can also impact total returns.
Investors interested in a fund structure should perform their own due diligence on both the risks and the benefits to ensure it is suitable for their individual objectives. If it is, there are several ways that they could potentially invest.
How to Invest in a Commercial Real Estate Funds
The method used to invest in a commercial real estate fund depends on whether or not it is publicly or privately traded.
For a publicly traded ETF or REIT, the process is quite simple. Once an investor has completed their due diligence, all they need to do is decide upon an investment amount, identify the unique ticker symbol for the ETF or REIT, and use their brokerage account to place the trade. The trade request should be processed and executed fairly quickly (less than 10 minutes) and the shares will be placed in the investors account. Depending on the brokerage used, there may be a relatively small commission fee, but it is low compared to the fees in a mutual fund, private REIT, or private equity investment.
For privately traded investments in REITs and private equity funds, the process is a bit more complex. This is because the REIT or private equity firm is responsible for verifying that investors meet SEC accreditation requirements. Often this involves reviewing bank statements and/or tax returns, which can take some time. Once the process is complete, investors work directly with the firm to transfer the funds and finalize the investment. Because these investments aren’t publicly traded, the firm will usually provide some sort of regular update on the share price and/or investment value.
Commercial Real Estate Investment Fund Frequently Asked Questions
Question #1: What is the Lifespan of a Commercial Real Estate Investment Fund?
In short, it depends. It is unique to each individual investment. However, publicly traded funds are open-ended, which means they can be bought and sold at will so there is no defined investment period. In privately traded funds, these tend to be “closed-end” which means that they have a finite expiration date, at which point the fund’s assets will be liquidated. Again, it varies but it is usually 10-15 years from the completion of the fund raise. Investors should always read the fund’s offering documents carefully to understand the specific lifespan for that fund.
Question #2: Can You Get Out of a Real Estate Fund Early?
Again, it depends. Publicly traded funds can be bought or sold at will, so timing is not an issue. For privately held funds, there are stringent rules that dictate whether or not an investor has the ability to exit the fund early. They are outlined in the offering documents and should be studied carefully. In general, investors cannot exit a fund early unless there are extenuating circumstances. Even then, they may only be able to do so if another investor is willing to purchase their shares, which usually comes at a significant discount.
Question #3: What Are Investment Fees ?
Fees vary by fund and they are usually outlined in the offering documents. However, investors can typically count on some sort of upfront fee or “load” as well as an annual asset management fee. Other potential fees include things like: debt placement fees, sales fees, and admin fees.
With regard to questions, the key point is this. Before committing capital to a fund, investors should carefully read the offering documents. If they still have questions, they should arrange time to speak with the fund manager to get them answered.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Real Estate Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
