By Dan Miller, WCI Contributor
There are many different ways to invest in real estate. Each way comes with its own pros and cons, and choosing the right way to invest will depend on your unique personal and financial situation. Today, we'll talk about private real estate funds and if they're the right choice for when you want more of a passive investment journey into real estate.
What Are Private Real Estate Funds?
Private real estate funds are one way to passively invest in real estate. One way to think about a private real estate fund is simply a group of people pooling their money together to invest in real estate. Investing in a private real estate fund typically means that you are using your money to acquire, finance, and own a specific property or properties. Investing in a private real estate fund allows you to purchase much larger projects than you could probably buy on your own.
Accredited Investor vs. Qualified Client vs. Qualified Purchaser
Some private real estate funds are limited only to certain types of high net-worth individuals. There are three main types of investors, which are typically defined as follows:
- Accredited Investor: Someone with an income of $200,000 for each of the last two years and an expected income of $200,000+ this year for an individual OR an income of $300,000 for each of the last two years and an expected income of $300,000+ this year for a couple OR investable assets of $1 million or more.
- Qualified Client: Someone that has $2.2 million investable assets OR has $1.1 million invested with that advisor OR is considered a “qualified purchaser” OR is an officer or director of the fund manager or an employee who participates in the investment activities of the investment advisor.
- Qualified Purchaser: An individual (or family-owned business not formed just to buy into this fund) that owns $5 million or more in investments OR a trust not formed for the specific purpose of acquiring the interest in the fund which is sponsored by and managed by qualified purchasers OR an individual (or any entity not formed just to buy into this fund) which owns and invests at least $25 million in investments (or someone who is acting on account of such a person) OR an entity, of which each beneficial owner is a qualified purchaser.
For more information on these definitions, see how we compare an accredited investor vs. a qualified client vs. a qualified purchaser.
How Do Private Equity Real Estate Funds Work?
At its simplest, a private equity real estate fund is a group of people pooling their money together to buy a piece of real estate. One simple example might be 10 people each putting down $100,000 to buy an apartment building worth $1 million. In practice, most private real estate funds are more complicated. Most funds have more investors and a specific minimum amount that each investor must contribute.
Most private real estate funds have someone like a manager or controlling partner that handles the day-to-day operations of the fund and any properties they control. As we'll see below, a good private real estate manager is one of the most important factors in choosing a private real estate fund.
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Who Should Consider Investing in Private Real Estate Funds?
There are a few different types of people who should consider investing in real estate funds. One is people with very high net worths. The higher your net worth, the more sense it can make to diversify your investments. Real estate can serve as a useful hedge against the volatility of the stock market since the two classes of investment are not highly correlated. Investors looking to invest in real estate without being actively involved—where they might have to fix up a house or where they might get a 3am phone call about a running toilet—might consider private real estate funds for a much more passive experience. Private real estate funds are for people who are looking to passively invest but want lower correlation with their stocks than is offered by publicly traded real estate, such as REITs. Private equity real estate funds pass through their depreciation via a K-1. Private funds are also an excellent way to gain access to the private real estate debt markets, an asset class with high returns and low correlation to stocks and bonds.
Private Real Estate Managers
One of the most important things you can do when considering investing in a private real estate investment fund is to choose a good manager. A good manager can make up for a bad deal, at least enough to turn lemons into lemonade. A good manager is less likely to get into a bad deal in the first place. And there is no real estate deal good enough to make up for an incompetent or criminal manager.
How to Choose the Right Fund Manager
There are five things that you want to look for when choosing a fund manager:
- Philosophy: Match your investing philosophy and strategy with that of the manager
- Communication: Make sure they’re communicating enough to keep you happy
- Trustworthiness: Absolute integrity is non-negotiable
- Competence: You want someone who is experienced and good at their job
- Discipline: Look for someone who knows when to invest and when to walk away (from a bad deal)
Doing Due Diligence on the Fund Manager
Now that you know what criteria you want to use to find the right fund manager for you, you have a couple of ways to find that information. You can start with the company website, the Private Practice Memorandum (PPM), or a due-diligence site like CrowdDD.com. Talking to the management team itself, current and former investors, and people you trust is another step in doing due diligence. Depending on how much you are planning to invest, you might want to pay for and run a full background check on each of the principals.
Learn as much as you can about the sponsor before investing and even while investing. Some of the highest quality due diligence that you can do is done with the first investment. One strategy might be to invest the bare minimum investment with a new sponsor and then just watch for a year or two before deciding whether to invest more with them. If things go well, you can consider investing more, and if it is not a good fit, you can end your investment. Either way, you can learn a lot about them without having too much money committed.
How Much Do Private Real Estate Funds Usually Return?
Unlike investing in an index fund, it's a bit more complicated to calculate how much a private real estate fund returns. Usually, there isn't a specific amount or percentage that a fund returns. Instead, it will depend on several different factors. Here is an example of how a typical private real estate fund might pay out returns to its investors:
- First, the operator typically gets a 1% fee per year.
- Then, the limited partners (the people, like you, who invested in the fund in the first place) get their principal back.
- Then the limited partners get a preferred return. This might be 6%, 8%, or even 10% a year.
- After that, the limited and general partners (the people who are running the fund) split the remainder of any returns above and beyond the preferred return, perhaps 80/20, although this can range anywhere from 60/40 to 90/10.
And of course, fee and payout structures vary widely from fund to fund. Make sure that you understand these structures before investing any of your money.
REIT vs. Private Equity Real Estate Fund
A Real Estate Investment Trust (REIT) shares a lot of similarities to a private equity real estate fund, but there are also a few key differences to be aware of, primarily with their taxation. REITs are eligible for the 199A deduction and send only a 1099 tax form, and they will never require you to file in multiple states. Depreciation is passed through via “return of capital” distributions. A fund is not eligible for the 199A deduction, sends a K-1 that may require you to file in multiple states, and passes depreciation through to you where it may be used against income from other investments. REITs can also be publicly traded and offer a lot of liquidity, although not all do. REITs often have much lower minimum investment minimums. While you might have to invest at least $50,000-$200,000 in a private fund, a private REIT might only require you to invest a minimum of $5,000-$25,000.
Best Private Real Estate Funds
There isn't a single “best” private real estate fund, since the right fund for you might not match the investing style or philosophy of someone else. At The White Coat Investor, we maintain a list of recommended real estate investing company partners. That list can serve as a starting spot for you as you do your own due diligence to find the best private real estate investment fund for your specific situation. Here's other information from some of our partners.
Featured Real Estate Partners
Platform / REIT
Self-Storage / Mobile Homes
Fund / Turnkey
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