Real estate funds are a type of investment vehicle that is composed of a pool of capital raised from a group of investors for the purpose of investing in real estate. These funds seek to generate income and/or capital gains for the fund’s investors through a variety of investment strategies. Real Estate Funds are structured either as a limited partnership (LP) or as a limited liability company (LLC) and are larger than DSTs but smaller than REITs. These types of funds seek to raise $100 million or more in capital, which is used to purchase income-producing real estate assets. Beyond the capital raised through investor participation, many funds make use of leverage to increase their purchasing power and projected returns. An investment into a real estate fund is not considered to be an interest in real estate, thus this type of investment is not eligible for 1031 exchange but can be an excellent addition to a diversified investment portfolio.
Real Estate Funds are illiquid investments offered to accredited investors, or other suitable investors, and are often put forth as a private placement security. The accreditation standards for funds limits who may invest in the fund, which is similar to the standards for DSTs and other private placement offerings. For an individual, an accredited investor is any investor with a net worth of $1,000,000 or more, not including the equity in the investor’s primary residence. Alternatively, the individual investor must have an income level of $200,000 ($300,000 if married) for the prior two years, and an expectation of the same for the current year. Real estate funds focus on four main types of investment opportunities—distressed assets, property improvement, development, oil and gas, and debt. Within these investment opportunities, real estate funds offer asset classes such as multifamily properties, single family homes (built to rent), agricultural farm properties, offices (including bio-life offices), and warehouses. The variety of asset classes available over multiple real estate funds provides the investor with excellent diversification potential. Most funds have minimum investments limits of $50,000 and investors can r diversify over multiple funds each with multiple properties in various locations.
Income from a real estate fund in most cases qualifies for the 20 percent qualified business income deduction per the 2017 Tax Cuts and Jobs Act. In addition, the investor’s share of rental income is sheltered by depreciation which flows through to the investor as a separate line item on a Form K-1. If the real estate fund owns properties in various income tax states, the investor is required to file a tax return for those states. However, most larger funds provide an election for the fund to file a composite return on behalf of the individual investors to help save on tax compliance costs.
With lower minimum investment requirements, multiple properties in each fund, and numerous funds with different investment strategies and asset classes, the real estate fund is an excellent opportunity for diversification. Investment in funds for distressed assets, property improvement, and development have a higher return potential and provide tax sheltered income during the hold. However, real estate funds are not for every investor and there are significant elements of risk that should be evaluated prior to an investment. Because there is not a strong secondary market for these types of interests, these funds should be considered illiquid investments.
We all know the risk of placing all our eggs in one basket. A properly balanced investment portfolio combines aggressive investment strategies with more secure investment strategies. Real estate funds should be used in concert with more stabilized DST properties and larger private REITs. These funds provide investors with the potential to receive much higher returns and greater tax advantages as compared to other investment options, and as such play an important role in providing additional diversification to an alternative real estate investment portfolio. If one were to list the best investment strategy for investors to follow in only one word, that one word would be diversification.