Passively Investing in Apartments – Fund or Individual Deals?
There are many ways to passively invest in apartment syndications. Knowledge of these different strategies is important to understand which is the best wealth generating vehicle for you.
In this blog post, I want to educate you on the differences between investing in individual apartment syndications and investing in an apartment syndication fund.
But first, we need to distinguish between the type types of passive apartment investments.
Passive apartment investments are either debt investments or equity investments.
For debt investments, the passive investor is acting as a lender to the apartment or the apartment syndicator. The loan is secured by the property and the passive investor receives a fixed interest rate as a return.
For equity investments, the passive investor is a shareholder in the entity that owns the apartment. Depending on the equity structure, the passive investment receives a preferred return and/or a share of the total profits.
Passive investors who prefer equity investments over debt investments will chose to invest in individual deals or into a fund.
The first option is to invest in a single deal at a time. One deal. One business plan. One market.
A fund (i.e., a private real estate fund) is a private partnership that owns more than one piece of real estate. For apartment investing, numerous passive investors commit an amount to invest and the apartment syndicator use the passive investors’ capital to purchase multiple apartment communities.
The apartment syndicator of the fund will either execute one or multiple of the apartment syndication business plans: value-add, turnkey, or distressed. And they may focus on investments in a single or in multiple markets.
What are the different types of funds?
Close-ended fund: For a closed-ended fund, you would commit to invest a certain amount of capital when the apartment syndicator is accepting investor capital. Usually when the apartment syndicator commences a fund, they will continue to accept commitments until they’ve achieved their desired funding goal. Then, the apartment syndicator will begin purchasing apartments over a specific period of time – usually 3 to 4 years after the start of the fund. The apartments are held for a specific period of time – generally 3 to 7 years, depending on the business plan. Therefore, most close-ended funds are 10 years. But apartment syndicators may have the option to extend a close-ended fund by one or more years.
Typically, your initial equity investment is not returned until the end of the fund. However, some close-ended funds will distribute lumpsum profits once an apartment is sold or refinanced. The apartment syndicator may also have the option to recycle proceeds from sales or refinances back into the fund if, for example, the apartment is sold or refinanced a certain number of years after acquisition or less.
Open-ended evergreen fund: The other fund option is an open-ended, or evergreen, fund. The main difference between evergreen and close-ended funds is that evergreen funds do not have a specific end date. Therefore, the apartment syndicator is continuously accepting investor commitments. To exit an evergreen fund, you would need to sell your shares in the partnership rather than having to wait until the end of a close-ended fund.
How does close-ended and open-ended funds compare to individual deal investing?
When passive investor money is due: When investing in individual deals, once you have committed to investing, funds are typically due in full shortly thereafter. Once you commit, you sign the deal documents and submit your funds.
When investing in a fund, once you have committed to investing, your funds may or may not be due shortly thereafter. The committed amount is submitted at a capital call. A capital call occurs when the apartment syndicator of the fund has identified an acquisition and requires a portion or all your committed capital to cover the purchase costs.
When the apartment syndicator sends a formal capital call notification, you are legally obligated to fulfill their call based on your committed capital investment amount. Typically, a capital call will only require a portion of your capital investment, but it is possible that they request the full committed amount. If you fail to meet the capital call, the apartment may force you into default and to forfeit your entire ownership share.
Compensation structure: The compensation structure for funds and individual deals are the similar. You are offered a preferred return and/or profit split. Oftentimes, the profit split will change and become more favorable to the apartment syndicator once a certain return threshold, like IRR, is passed.
The timing of the ongoing distributions after you’ve submitted funds are similar since you are actually submitting your capital once a deal/deals are identified.
However, the time from commitment to receiving your first distribution is longer when investing in a fund because of the gap between commitment and the first capital call. Additionally, you may not submit your full investment amount until one, two, three, or more years after committing, depending on the length of time over which apartment syndicators plan on acquiring apartments. Since you receive a return based on submitted funds and not committed funds, the ongoing distributions will be lower at first.
Return of Capital: When investing in individual deals, you will not receive your initial equity back until the asset is sold. When investing in a fund, you will not receive your initial equity back until the fund is closed. The exception would be an evergreen fund, where you can sell your shares at any time (or after a lock-out period).
The apartment syndicator of both approaches will provide you with a projected hold period (for individual deal) or fund length (for funds). Assuming you were to invest with apartment syndicators who follow the same business plan, you will typically receive your initial capital back sooner when investing in individual deals.
Profit upside: The overall return upside is lower for funds compared to individual deals. If you are investing in an individual deal that performs exceptionally well, your return increases in the same proportion. However, your return on investment in a fund is based on the average return of the entire portfolio. Therefore, if one or a few apartments perform exceptionally well, the performance of the other average or below average deals will flatten the overall return.
Risk: On the flip side, since by investing in a fund you are investing in multiple deals, the probability of losing a portion or all your initial capital investment is lower. If one or a few apartments perform poorly, the performance of the other apartments in the fund will cover (or at least reduce) your losses.
However, when investing in a fund, you place more trust in the apartment syndicator, especially early on in the fund when there are zero or a few apartments. When investing in an individual deal, you can qualify the GP and the deal. If you don’t like the syndicator, you can pass. If you don’t like the deal, you can pass. If you really like the deal, you can invest as much as you want.
When investing in a fund, you can only qualify the apartment syndicator. If you don’t like thm, you can pass. But at a capital call, if you don’t like the deal (if you even get to see the deal), you have no choice but to invest. Conversely, if you really like the deal, you cannot go all in. Therefore, qualifying the apartment syndicator is even more important prior to investing in a fund to minimize risk.
Taxes: From a tax perspective, distributions from an individual investment and a fund are the same. Ongoing cash flow payments are considered income and are subject to the income tax. Taxable income may be reduced if depreciation is passed on to the passive investors. Profit at the conclusion of the partnership are considered gains and are subject to capital gains tax.
Another minor advantage of funds to individual deals is the paperwork. When investing in a fund, you complete once set of documents at the beginning of the fund and then are invested into multiple apartments. Each individual deal you invest in outside of a fund come with its own set of paperwork.
Which is the ideal passive investment?
First, you need to determine if you are an accredited investor.
Assuming you are an accredited investor, all other things being equal (the GPs, market, and business plan) the only major differences between the two options are return and risk.
Investing in individual deals come with a higher level of risk, meaning both the profit upside and profit downside is greater.
Investing in funds diversifies your investment into multiple apartments and markets, reducing the risks and resulting in a more stable return.
If you want to maximize the chances of preserving your capital in return of a lower return, investing in a fund is the ideal option for you.
If you are more focused on growing your capital and potentially receiving a higher return, investing in individual deals is the ideal option for you.
Disclaimer: The views and opinions expressed in this blog post are provided for informational purposes only, and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.