The Ultimate Guide To Investing In Real Estate Syndication Funds
Initially, the idea about replacing my dental income with passive income from real estate sounded very appealing. But then I realized I’d have to take 3am calls from tenants with problems. Who has time to manage real estate when trying to run a practice, raise kids, stay married and attempt to stay in shape?
Fortunately, I learned other ways to take a “hands off” approach to real estate to avoid these late night calls such as:
- REITS (real estate investment trusts)
- real estate funds
With REITs, you’re able to invest in publicly traded real estate while keeping your money liquid (similar to the stock market).
Real estate syndications allow you to pool money with other passive investors to invest directly into an asset and share in the benefits.
A real estate fund is similar to a syndication but spreads your investment throughout multiple assets mitigating risk by providing diversification.
In this article, we’ll discuss each investment strategy and help you decide on which is the best for you.
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What Are REITs?
A REIT is a real estate investment trust.
They can either be public or private. When investing, you’re buying stock in a company that owns, operates or finances income-producing real estate.
Publicly traded shares of REITS can be bought and sold on major stock exchanges by anyone with a brokerage account or with a financial advisor.
On the other hand, privately traded REITs are only available to accredited investors.
The Securities and Exchange Commission (SEC) defines the accredited investor status via Rule 501 of Regulation D of the Securities Act of 1933 as:
- A natural person with an annual income of at least $200,000 in each of the two most recent years or married couples making $300,000 joint income. There must be a reasonable expectation of the same income level in the current year; or
- A person or married couple with a net worth of at least $1 million which does NOT include a primary residence.
Examples of different properties REITs invest in include:
- data centers
- commercial real estate
- self storage
- office buildings
- retail centers
- apartments buildings
What Is A Real Estate Syndication?
A real estate syndication involves pooling money with other passive investors in order to purchase real estate properties more expensive than anyone can afford on their own.
These investment opportunities are governed by the Securities and Exchange Commission (SEC) and must file documentation such as a private placement memorandum.
The two main groups involved:
#1 General Partner (GPs)
Also known as the sponsor. Their roles are:
- find deals
- evaluate the numbers
- place under contract
- arrange inspections
- obtain financing
- keep fully leased
- provide individual investors financial information
#2 Limited Partner (LPs)
This group is made up of those that choose to invest passively with limited additional risks. They have no active responsibilities in managing the asset.
What Is A Real Estate Investment Fund?
It’s likely you’re familiar with investment funds such as:
- money market funds
- mutual funds
- private equity funds
- hedge funds
These are a pool of capital that’s been aggregated on behalf of multiple investors. A real estate investment fund is one that’s exclusively focused on investing in income-generating property.
Typically these funds are led by a sponsor that invest the combined capital into properties as one actively managed portfolio.
Real estate funds are broken down into three categories:
- open-end funds
- closed-end funds
- fund of funds
a. Closed end real estate funds
A closed end fund has a manager that sets the predetermined life of the fund, and most are value add in structure.
The majority of the syndication deals we’re invested in reside in the value-add class. This is where the sponsor acquires an asset (i.e. apartment complex) that needs TLC.
Many times, updates need to be made to both the exterior and interior of the buildings such as:
- upgraded fixtures
- new flooring/carpet
- granite countertops
- stainless steel appliances
- new cabinets
- painting units
- new lighting
- new signage
- update fitness center/pool
- parking lot
- update clubhouse
- new landscaping
- covered parking
- playground update
These funds are capital gains driven where the majority of the expected return is earned from the sale of the asset versus the income stream.
It normally takes several months to years to implement the rehab process therefore closed end funds may deliver negative returns in the initial years. It’s critical to perform your own due diligence on the sponsor’s track record as these funds are contingent on the execution of an underlying business plan.
b. Open end real estate funds
An open-end fund structure, unlike a closed end fund, has no termination date. Because of this, they’re mainly a employ a “buy-fix-hold” strategy as most of the expected return is derived from the property’s income stream.
The main advantage of this fund structure has to do with “flexibility“. Sponsors can focus on long-term capital appreciation for their investors and aren’t forced to liquidate assets.
But the need to produce strong, recurring cash flow may potentially reduce the aggregate income stream, resulting in a lower total return versus a closed end fund.
Something else to consider is that open end funds typically have a lower risk profile due to the fact that immediate cash flow is part of the acquisition criteria.
c. Fund of funds
A real estate fund of funds is a portfolio holding of other real estate funds rather than investing directly. By investing in a fund that invests in other funds, passive investors get the added protection of more than one fund manager plus increased diversity versus a single fund.Join the Passive Investors Circle
5 Benefits of Real Estate Funds
One of the questions members of my Passive Investors Circle ask has to do with investing in one or multiple syndications during the year. For instance, I’ll get asked about whether someone should invest $200k in one deal or $100k in two deals.
Investing in a fund solves this dilemma when it comes to becoming diversified in the syndication space.
Most of the funds that I invest in offer anywhere from 4-8 different assets. So you’ll get even MORE diversification vs a single syndication deal.
Real estate funds are structured like syndications as they look to return and investor’s profit before any profit is earned by the fund’s sponsor.
Most funds offer this preferred return model in addition to their pro rata share of the fund’s overall net profits. In this structure, passive investors are assured they’ll receive the initial profits from the fund’s investment activities before the fund’s sponsor receives its share (called the “carried interest).
This set up highly motivates the sponsor to ensure the deal achieves its intended profit threshold. This is great for the passive investors as it keeps the interests aligned between them and the sponsor.
#3. Tax advantages
With a real estate fund, like a syndication, you’re investing for the long term. Most are structured to last longer than a year. Because of this, it will be taxed at the long-term capital gains rate instead of the short-term capital gains rate.
Limited partners may also benefit from pass-through depreciation.
As with all tax matters, the benefits that accrue to the passive investors will be dependent on their accountant’s advice regarding their own unique circumstances.
Investing in a real estate fund provides more control and flexibility versus putting money in a single investment asset.
For example, an investor who wants to invest $400k can choose to invest that in $100k tranches across four different funds.
Investors also are able to choose the types of properties they want to invest in (asset classes) along with their different locations.
This allows customization in their portfolios without having to directly buy individual assets.
#5. Absolute returns
A fund’s absolute returns refer to the amount of profit the fund has earned. These include any additional returns above and beyond the preferred return. The funds that perform exceptionally well will provide absolute returns significantly higher than the anticipated preferred return.
As with any type of investing, a fund’s past or current performance does not guarantee its future performance.
We recommend that you base your real estate investment decisions on the experience and track record of the sponsor.
As a busy professional aspiring to reach “work optional” status in five years or less, I can’t think of a better investment tool than real estate.
Besides syndications, real estate investment funds are another option with a unique way to diversify a portfolio without the hassles of direct ownership. That’s the part I like most!
As previously mentioned, the most important part of investing in syndications or funds is vetting the sponsor and their track record.
If you need more help with this process, check out this article: 7 Ways To Evaluate a Real Estate Sponsor