What is a Real Estate Fund?
Investing in real estate is often a very capital-intensive process, limiting the number of people with the ability to play in this industry. For most of human history, the wealthy were the only ones that were able to get enough capital together to invest in real estate. And for many years, Wall St. and large investment firms considered real estate to be an “alternative investment” outside of the “core investment” categories of stocks, bonds, etc. Thus, support for making real estate more accessible to smaller investors wasn’t a priority.
However, in the early 1990’s this started to change. The growth of Real Estate Investment Trusts and Commercial Mortgage Backed Securities began to offer more flexibility to potential investors and helped to open the real estate world to a larger investment base. In this article, we’ll explore a few types of funds that are available. Whether you’re looking to start a fund or invest in one, this article will give a high-level overview of what kind of mutual funds, private equity funds, debt funds, and real estate investment trusts are common in the real estate industry.
Types of Real Estate Funds
In this section we’ll describe four of the more common types of real estate funds.
Real Estate Mutual Fund
Real estate-focused mutual funds, like other mutual funds, are professionally-managed investments that invest in a variety of asset classes in order to create a diversified portfolio. Most real estate mutual funds invest in stocks and bonds of real estate companies (including REITs) and also invest directly in properties. Mutual funds are attractive to smaller investors or those who prefer a diversified and professionally managed passive income as well as a high level of liquidity.
Real Estate Private Equity Fund
Private equity funds that focus on real estate are identical in concept to all other private equity funds, with the exception that real estate private equity funds invest specifically in real estate. Real estate private equity (PE) firms serve as what’s known as a “General Partner” (“GP”) and raise money from private investors known as Limited Partners (“LPs”) and invest those funds in real estate. The general partner is responsible for identifying attractive investments and managing the portfolio in order to provide a return to the LP investors. Limited partners in PE funds are usually high net worth individuals, families, pension funds, insurance companies, university endowments, or corporations and serve as mostly passive investors in the fund. It should be noted that most investors in real estate PE funds are accredited investors. The United States Securities and Exchange Commission defines an accredited investor as one who has earned $200,000 or more for the past two years or who has a net worth of at least $1 million.
Real estate PE firms typically raise money for specific purposes, called “funds,” and are mandated to invest in the theme of the fund. A theme could be to invest specifically in multifamily properties in the southeast or to invest specifically in office properties in Los Angeles.
Real Estate Debt Fund
Similar to private equity firms, real estate debt funds raise money from large investors to invest in real estate assets. Unlike private equity firms, however, debt funds typically invest in senior or mezzanine debt collateralized by real estate assets. One of the main differences between equity and debt funds is the stability of cash flow in debt funds and the security provided by the property as collateral.
Real Estate Investment Trust
A real estate investment trust, commonly referred to as a “REIT,” is a legal entity that invests directly in real estate or the mortgages secured by real estate. Investors can purchase shares of REITs and participate in the income generated by the property and also in the appreciation of the properties in the REITs portfolio. There are many different types of REITs categorized by private vs. public, type of investment, geography, and asset type. This article won’t go into detail on each of the differences, but some short descriptions will be provided below.
Public vs. Private REITs
Although the basic structure of REITs is similar, there is a difference between who can purchase shares in a public REIT vs. a private REIT. The main difference between the two is that while anyone can purchase a share of a publicly traded REIT, private REITs require that investors qualify as “accredited” investors (described above).
REITs can also differentiate themselves by the type of investment they make, with equity, debt, and hybrid REITs being the most common.
- Equity REITs – Equity REITs focus specifically on owning and operating property and are the most common type of REIT. These companies can pursue a variety of activities such as acquiring stable assets, developing new properties, or renovating existing properties.
- Mortgage (debt) REITs – Mortgage REITs make loans or invest in debt on real estate. While an equity REIT generates income from operating a property, a mortgage REIT generates income from the interest paid on the debt they’ve provided.
- Hybrid REITs – Hybrid REITs are more flexible and pursue a variety of activities including both equity and debt investments.
Asset Type and Geography
A REIT can also focus on specific property types or a specific geography. According to the National Association of Real Estate Investment Trusts (NAREIT), there exist REITs that focus on the following asset classes: office, industrial, retail, lodging/resorts, residential, timberland, healthcare, self-storage, infrastructure, and data centers, among others. According to NAREIT, most REITs focus on one property type, but some are active in multiple property types.
Now that we’ve covered some of the major types of real estate funds, how should you think about which one is right for your desired outcome? There are a few issues that need to be considered.
- Liquidity – If liquidity is something that’s important for your investment strategy, then REITs and mutual funds are probably a better way to go than equity or debt funds, especially if the REIT is publicly traded with a decent volume.
- Active vs. passive – The distinction here is mostly between the GP role in private equity or debt funds. Investments in mutual funds, REITs, and serving as an LP in a private equity or debt fund are more passive investment roles. The GP in private equity or debt funds, however, is responsible for actively managing the funds in order to meet the objectives of each fund.
- Risk tolerance – As discussed in the section on real estate debt funds, some strategies offer more downside protection than others. Debt funds and mortgage REITs may provide more downside protection because of the collateral that underlies the investments. On the other hand, equity REITs and private equity firms could offer much higher returns than debt funds.
The rise of alternative ways to invest in real estate has opened the industry up to many different types and different levels of investors. Rather than investing directly in a real estate asset and having to actively manage that property, the funds discussed above have allowed those without a large amount of capital and those lacking the time (or experience) to manage properties a way to participate in the real estate industry. Each of the strategies above go much, much deeper on expertise, market knowledge, and legal compliance, so anyone interested in pursuing any kind of real estate fund should be very aware of those implications before starting.