Risks and Benefits of Starting a Real Estate Fund

Making an informed decision is crucial for any new investment decision. If you’re considering starting a real estate fund, you should carefully assess the benefits and risks.

Benefits of Real Estate Funds

Real estate investing has historically been a great way to build wealth. That’s because real estate funds, and real estate investment in general, have a wide range of benefits. As the saying goes, “Buy land—they aren’t making any more of it!”

Better Buying Opportunity

Raising capital from business partners allows you to break into real estate markets that would be out of reach on your own. As an individual, for example, you may only have the capital to purchase a small office or duplex multifamily property. Real estate funds can help you do so much more than buy and operate a single rental property. They can help you:

• Purchase a portfolio of single family homes for rent or short-term rental
• Invest in multifamily housing, like apartments and quadplexes
• Break into commercial real estate like storage facilities, strip malls, office spaces, industrial warehouses or manufacturing sites, hotels, etc.

Investment Gains

With better buying opportunities comes the potential for greater appreciation. Consider commercial real estate. Commercial property investment generally has a higher potential return on investment (ROI) than residential real estate, both in terms of appreciation and in terms of income.

According to the National Council of Real Estate Investment Fiduciaries Property Index, industrial real estate had an average annual return of nearly 14.55% in 2022 compared to the S&P 500’s average 20-year return of 7.6%.

With real estate funds, you have the capital to break into the commercial real estate market if you want to take advantage of these heftier gains.

More Income

Real estate funds can bring you more income than investing in real estate on your own, for several reasons.

• They allow you and your business partners invest in larger properties that bring economies of scale to your operations.
• Commercial lease terms tend to be longer than residential lease terms. This can reduce turnover costs and give you more predictable cash flows.
• Because commercial rents are longer, they are less tied to market fluctuations. This is particularly beneficial when markets drop.
• Many commercial leases are triple net leases. These leases pass many risks and costs of owning the property (like property taxes, insurance and some operating expenses) on to tenants.

Diversification

Your real estate fund can hold whatever type or types of property you want. For example, your real estate fund may:

• Focus on one type of asset, like purchasing a large portfolio of single-family homes
• Purchase properties that need renovations (known as a value-add acquisition)
• Buy property in only one geographical area, like purchasing both residential and commercial properties in an up-and-coming area of your city
• Purchase property in areas that are eligible for tax breaks (such as a qualified opportunity zone)
• Invest in property that has historically been resilient to market fluctuations, like vacation homes

Risks of Real Estate Funds

The benefits to real estate funds are undeniable. However, it’s important for you to consider both the pros and the cons before you make any investment decision.

Bad Investment and Risk to Reputation

Real estate funds tend to have lifespans of approximately five to 10 years (sometimes more, sometimes less). Although real estate has historically been a reliable long-term investment, market downturns can put property owners in a pickle. You’re always at risk that your investment won’t pan out like you had envisioned.

Unfortunately, the success (or lack of success) of your fund directly affects your reputation as a fund sponsor. If one of your real estate funds performs poorly, you may not be able to find investors willing to come on board for your next venture.

Credit Risk

Over leveraging yourself can be risky. Although debt in and of itself isn’t a bad thing, having too much debt can result in you defaulting on your loans if markets fall or the interest rate environment changes. And being underwater on real estate investment isn’t unheard of. In the 2008/2009 real estate crisis, many investors found that the value of their real estate holdings had declined significantly.

Personal guarantees of debt and collateral can also extend the losses beyond just what was invested in the fund.

Tenant Issues

As we discussed above, real estate funds allow you to more easily invest in commercial real estate. But those properties might have long lease terms, which makes it important for you to find high-quality tenants. A good tenant can add value to your property by making improvements or bringing visibility to the location.

A bad tenant, however, can bring value down if they don’t maintain the property, cause issues with nearby businesses or default on payments. Be cognizant of the impact your tenants have not only on your property values but also your reputation as an investor. You may do everything correctly, but if a tenant defaults on your lease, it could cause significant hardship to your fund.

Vacancy Risks

With larger properties, it may take time to find the right tenant. If one is unoccupied for long, your investment could quickly dip into the red. You might need to renovate your property periodically to make it more enticing to tenants.

Although it requires up-front costs, renovating a lobby, updating fixtures or rehabbing old landscaping can make properties more appealing and help justify higher rents. Finding that right balance between making needed renovations and managing cash flow is crucial.

Look at All Sides

Before you start a real estate fund, do your homework. Think about the property’s potential appreciation and income, the market’s performance, and the quality of investors you bring on board. Having a solid plan, one that is reflective of your risk tolerance, is key to your success. Make sure you understand everything that’s required of you as the fund sponsor, from managing accounting for your real estate fund to handling investor reporting.

If you want to talk investment strategy with an expert, reach out to our James Moore advisors. Our real estate CPAs have years of experience working with real estate fund managers, sponsors and investors. They can help you make an investment plan that accounts for all potential risks and benefits.

All content provided in this article is for informational purposes only. Matters discussed in this article are subject to change. For up-to-date information on this subject please contact a James Moore professional. James Moore will not be held responsible for any claim, loss, damage or inconvenience caused as a result of any information within these pages or any information accessed through this site.