Showdown: Investing in Real Estate Funds vs Individual Deals

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The following is a guest post from Michael Episcope, a co-founder of Origin Investments which was started to provide access to real estate investments and management expertise previously available only to institutions. Although this is not a sponsored post, Origin Investments is a paid advertiser on this site.]

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Individuals who want to passively invest in private real estate essentially have two choices: Invest in real estate funds or build their own portfolio by investing in individual real estate deals. This is akin to selecting their own stocks or investing in a mutual fund.  Websites like Fundrise, RealtymogulOrigin Investments and RealCrowd [Editor’s Note: Some of these are affiliate links] provide investors with more private real estate investment choices than ever before.  These sites allow you to invest with professional managers by selecting individual deals or investing through a fund structure.

There are pros and cons to each strategy. Investors looking for individual deals have the freedom to pick and choose what deals they invest in, but this is also the most time-consuming option and may not result in the most diversified portfolio. Investing in a real estate fund means investors give up the control of selecting deals but are able to save substantial time by outsourcing that function to a professional manager.

5 Factors to Determine Which Real Estate Investment Strategy is Right For You

1. Time Commitment

Advantage= Real Estate Funds

When an investor commits to a fund, they make a commitment to the fund and it’s the fund manager’s role to build them a portfolio.  In other words, the investor selects the manager and it’s the manager’s responsibility to select each deal and build the portfolio. The individual is obligated to invest in every deal the manager acquires, but only to the extent of their commitment. If an investor commits $100,000 to a fund, the manager can only call up to that amount. It typically takes a fund manager two to three years to invest all of the fund’s capital and the only requirement by the investor is to send a wire to fund each investment.  In a deal-by-deal strategy, an investor would have to source a large number of deals and evaluate every opportunity.  Additionally, investing with a dishonest manager increases as the number of managers in the portfolio increases. In a fund, there is one manager and anyone who has been in private real estate long enough understands that returns and headaches are highly correlated to the quality of the manager.

2. Reporting

Advantage= Real Estate Funds

In a fund, investors typically receive consolidated quarterly performance reports on their entire portfolio rather than dozens of individual reports. Each update will follow the same format and illustrate how the individual deals are doing and the overall investment performance at the fund level. An individual who assembles a portfolio made up of twenty individual deals with several managers will receive 20 individual reports that all may look very different. There is also no aggregation of performance and this is something an investor must do by hand if they want to better understand their portfolio’s performance.

Additionally, year-end tax reporting is much easier in a fund structure because k-1’s, a tax document sent to partners that lists out their share of income and loss for the year, are consolidated into a single document for tax reporting purposes. But an investor in twenty individual deals will likely have to manage twenty K-1’s and the costs associated with filing them.

3. Diversification

Advantage= Mixed

Diversification is one of the easiest ways to reduce risk.  In real estate, investors need to make sure they are not overexposed to any one deal, geographic region or sector.

Capital Diversification

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Advantage = Real Estate Funds

Diversifying your capital across a large number of investments is a great way to reduce risk. Generally, any portfolio, whether it be stocks, bonds, or real estate, that has less than ten assets, is considered highly concentrated. Often times, funds have minimums in excess of $100,000 but that capital will be spread across 15 to 20 deals.

Participation in individual deals can sometimes be obtained for as little as $500 but the higher-quality investment opportunities tend to have minimums greater than $10,000 and often times more than $50,000. Investing $100,000 on a deal by deal basis could easily lead to a portfolio of 4-6 deals and a single property could easily make up 30% or more of the portfolio.

Geographic Diversification

Advantage = Tie

Funds can be geographically concentrated or diversified, depending on their strategy. Some fund managers focus on a particular region or even one city. An investor with a limited amount of capital would want to find a fund with broad geographic diversification or invest in several funds. Real estate downturns can often be isolated to a single city or region and having too much concentration in one area can lead to unnecessary risk. For example, in the last five years, Houston real estate has suffered due to a decline in oil prices and lackluster economic growth, while real estate in Austin, TX has performed quite well. A deal by deal strategy could serve as a better way to geographically diversify a portfolio.

[Editor’s Note: I disagree with this one as a “tie.” Funds and individual syndicators are generally fairly geographically concentrated. If not in one place, usually in just a handful. If you’re buying the deals yourself, you can diversify as much as you like. Of course, once you start doing multiple state tax returns, you may not like all that diversification.]

Sector Diversification

Advantage = Individual Deals

Funds tend to be specialized in one or two asset classes so an investor looking to gain exposure to a handful of asset classes may want to consider building their own portfolio.  If you have millions of dollars to invest, this probably isn’t an issue. You could easily spread your capital across multiple funds to gain exposure in debt, apartments, office, retail and industrial buildings. That being said, it is not common but there are funds that invest in multiple asset classes that could provide the requisite diversification for an investor.

[Editor’s Note: I’m going to add one more section to this, I’ll use the same format used above:

Manager/Platform Diversification

Advantage = Individual deals

With minimums often as low as $2-10K, you can buy properties from many different syndicators and through many different online platforms with a limited amount of capital. A significant risk in real estate investing is manager risk- the fund manager, the syndicator, and the online platform can all have something bad happen to them. You can’t get “Bernie Madoff’d” if your money is spread among many managers. The downside, of course, is that the more managers you hire, the harder it is to do real due diligence on them. ]

4. Fees

Advantage = Tie

Real estate investing is a complex people-intensive business. Everyone in the chain is crucial and fees are the way the team gets paid. Someone must find the property, negotiate the price, create marketing materials and legal documents, raise equity, manage the day-to-day activities at the property, formulate and execute the business plan, report to investors, provide K-1’s, sell the asset and distribute the proceeds.

The amount you pay to a fund manager versus a manager syndicating individual deals will be nearly identical when all is said and done. They each charge different fees but they are just different ways of getting to the same place.  A common list of fees and their purpose is outlined below:

  • Organizational and Set up Costs: Both fund managers and deal syndicators charge an upfront, one-time fee between .5% and 3% of invested equity. These fees pay for fund formation, legal, and capital raising. In a deal by deal structure, these fees are sometimes tough to identify as they are simply added to the overall cost of the deal.  They are always detailed out in the sources and uses of capital.
  • Acquisition Fee:  This is a fee charged by deal by deal syndicators that equates to between 1% and 2% of total deal size. This is a market rate fee to pay for the sponsor’s operational costs. Funds don’t typically charge this fee but instead start charging the asset management fee from the day the fund begins.
  • Annual Asset Management Fee:  The asset management fee is charged by both fund and deal by deal managers and are used to pay the manager’s overhead including the acquisition and asset management teams, accounting group, investor reporting, office rent and administrative staff. A typical management fee is around 1.5% of committed equity per year.
  • Annual Administrative Fees:  These fees cover fund administration, tax reporting, dead deal costs, and third-party software. They are variable costs found in both structures and typically range between .10% and .25% per year on invested equity.
  • Performance Fees:  In nearly all private real estate investments, managers receive between 20% and 30% of the upside when the deal goes well. This is meant to incentivize them and align their interests with those of the investor so that everyone wins and loses together. While the fees are similar in both a deal by deal and a fund structure, the mechanics are very different.

In a fund, the performance fee is paid based on the overall performance at the fund level. In contrast, managers of individual deals get paid based on the performance of each and every deal. This is important because if one deal generates a 20% annualized return and another deal generates a 20% annualized loss, the manager is entitled to an incentive fee on the deal that did well.  This is a ‘heads they win and tails you lose’ structure and, over time, will erode returns.  It doesn’t work that way in a fund structure.   Additionally, the manager operating in a deal-by-deal structure may be more incentivized to focus on the deals doing well and ignore those doing poorly where they are least likely to earn a fee.  The fund manager is highly incentivized to revive underperforming deals.

It is not uncommon for managers to have other fees embedded in their structure such as refinancing or disposition fees, and there are plenty of fund managers who attempt to charge every fee imaginable.  Make sure that the fee structure aligns interests because they can often tilt risk towards the investor.  Do you really want to pay a $300,000 disposition fee to the manager if your investment loses money?

5. Other Considerations: Manager Benefits

Advantage = Real Estate Funds

We’ve talked about the pros and cons to the investor, but what about to the manager?  One of the first items the seller of a property asks for when selecting a buyer is proof of capital. They want to know that the buyer has the capital on hand to be able to close a deal.  A fund provides a base of permanent capital that allows the manager the ability to show proof of funds and transact quickly when they find a good opportunity. In a deal-by-deal structure, capital is raised after the deal has been negotiated and many sellers are wary of awarding deals to syndicators, unless the manager can convince them of their ability to close the deal.

Funds also provide the manager with a steady stream of recurring revenue to pay employees and meet their overhead obligations. Managers who acquire individual deals tend to have less certain income and don’t get paid unless they do a deal. A manager struggling to pay their staff could be incentivized to do deals simply to generate fee income.

Overall Advantage

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Real Estate Fund Investing

From an investment standpoint, the advantages of investing in a fund tend to outweigh those of investing in individual deals.  But for many, picking deals is more of a learning process and education is more likely to be accomplished by evaluating individual deals and pouring over countless documents. For those who don’t have the time to evaluate each deal, fund investing is most likely the better route.  And there is still a great opportunity to learn as well, as a good fund manager will keep you apprised of portfolio performance and details of their strategy. It also allows one to gain all of the benefits of private real estate with very little effort. Evaluating a single manager, who will be responsible for building you an entire portfolio, is much easier than spending the time evaluating twenty deals and the people behind them. In many cases, it’s not an either or and an investor may prefer a hybrid of both strategies. Understanding the nuances of each approach is the key to making an informed decision and investing successfully.

[Editor’s Note: I am currently invested in both individual deals and funds. Fund investing is likely a better choice for me at this time as I would rather spend my time growing my own business than evaluating deals. I also appreciate the dramatically increased diversification between notes/deals particularly on the debt side. The main downside I worry about with that approach? Manager risk.]

What do you think? Are you using individual deals, real estate funds or have you chosen a hybrid of both to invest in real estate? What strategy would you recommend? Comment below!