For investors who wish to allocate capital to commercial real estate assets, there are two options for an investment vehicle: individually syndicated deals and pooled investment funds. The key difference between the two is how investment capital is deployed.
In an individually syndicated deal, investment capital is raised and deployed into one specific real estate asset. The primary benefit of this approach is that investors know exactly where their money is going. With this knowledge, they can perform their own due diligence on the property, location, and market. For example, we recently completed a capital raise for the purchase of the Penn Hills Shopping Center in Pittsburgh, PA. In the marketing materials, potential investors knew exactly what property was being purchased, what the site plan looked like, who the tenants were, and where it was located.
In a pooled fund structure, investors do not have this luxury. Instead, they commit a certain amount of capital to a fund manager who deploys it on their behalf. In lieu of knowing which properties are being purchased, the investor’s capital is deployed according to a pre-planned investment strategy that may focus on certain asset classes or investment objectives. For example, the fund’s prospectus may describe a value-add investment strategy focused on properties in New York and the greater Northeast.
In general, a pooled fund offers greater diversification and more liquidity than an individually syndicated deal. But their fee structure and price volatility are the primary drawbacks.
For investors who prefer the pooled fund structure, investment options can be further sub-divided into open-end funds or closed-end funds. The differences between the two are the subject of this article.
What is an Open-End Fund?
An Open-End Fund is one that does not have a termination date. They allow for continuous solicitation of capital and periodic subscriptions and redemptions.
There are a number of benefits to this structure:
- Liquidity: Open-end funds typically allow for quarterly subscriptions and redemptions, which make them more liquid than their closed-end alternative. However, there may be an initial lockup period of 2-5 years during which time an investor’s funds are not available.
- Cash Flow: Because there is no end date, open-end fund managers tend to focus on properties that produce strong, recurring cash flow that can be held for long periods of time.
- Stability: The general strategy of an open-end fund is a “buy and hold” approach. Fund managers seek to maximize cash flow over the long term rather than chase capital appreciation over the short term. As a result, open-end funds tend to have less price volatility.
- Flexibility: Open-end fund managers are free to sell assets at a time that will maximize returns for their investors, not because they have to due to time constraints. This provides the opportunity to capture capital gains to go along with property income.
Like any investment, the benefits of an open-end fund are offset by some risks. They include:
- Returns: Prioritization of cash flow and stability over appreciation can reduce the property’s total income. As a result, total returns for open-end funds tend to be lower than their closed-end counterparts.
- Administration: Because they are constantly raising capital, the administration of an open-end fund may require more administrative support than their closed-end counterparts. As a result, they may have higher fees to support the extra staff.
Examples of open-end funds can include mutual funds, some Real Estate Investment Trusts (REITs), and ETFs.
What is a Closed-End Fund?
Closed-end funds have a predetermined end date, usually 10-12 years from the date of inception. On occasion, the term can be extended for several years at the discretion of the investment manager and upon approval by investors. Unlike open-end funds, closed-end funds have a predetermined subscription period. This means that they can only capital during a certain window of time – usually 12-18 months. After that, they are closed to new capital.
The closed-end structure offers several benefits:
- Returns: Because there is an “expiration date,” closed-end fund managers are incentivized to maximize returns in the short term. In general, this leads to higher total returns.
- Return Mix: Due to their need to maximize short term profits, closed-end fund managers actively seek to sell assets when the market price or valuation is ripe for a significant profit. Again, this can drive higher returns.
- Valuations: A closed-end fund’s return is calculated based on the market value when an investment is sold. As such, returns and fees tend to be calculated in a more objective manner than an open-end fund.
There are also several drawbacks to the closed-end structure:
- Liquidity: Capital invested in a closed-end fund is locked up for the entirety of the term. Generally, investors are unable to re-allocate invested capital until the fund has matured, which tends to make a closed-end fund less liquid than an open-end fund.
- Diversification: Typically, closed-end fund managers are only able to purchase assets in a predetermined time period – usually the first four to six years of the fund’s life. As such, there is a tendency to “rush” the deployment of capital, which can result in suboptimal portfolio diversification.
- Transparency: When an investor is allowed into a closed-end fund, they may have little or no information about the properties in the fund’s portfolio.
When comparing the two options, it is only natural to wonder, which is better?
Closed-End Funds vs. Open-End Funds – Which is Better?
Given the risks and benefits of each, it is tempting to point to one of the above options and say that it is an objectively better investment. This logic is flawed.
One isn’t necessarily better than the other, but one may be a better fit for an individual’s personal investment objectives, risk tolerance, and time horizon. If an investor is looking for stability, cash flow, and a higher degree of liquidity, an open-end fund may be the right option. Conversely, if an investor is willing to take more risk in pursuit of higher returns and can afford to lock up their capital for an extended period of time, a closed-end fund may be the better option.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We leverage our decades of expertise and our available liquidity to find world-class, multi-tenanted assets below intrinsic value. In doing so, 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 Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.