JF2248: Passive Investing In A Fund vs Individual Apartment Deals | Syndication School with Theo Hicks
In today’s Syndication School episode, Theo Hicks, compares two ways to invest, one by passively investing into a fund which you have probably heard of in the past on previous episodes versus the opportunity to invest in individual apartment deals.
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Joe Fairless: There needed to be a resource on apartment syndication that not only talked about each aspect of the syndication process, but how to actually do each of the things, and go into it in detail… And we thought “Hey, why not make it free, too?” That’s why we launched Syndication School.
Theo Hicks will go through a particular aspect of apartment syndication on today’s episode, and get into the details of how to do that particular thing. Enjoy this episode, and for more on apartment syndication and how to do things, go to apartmentsyndication.com, or to learn more about the Apartment Syndication School, go to syndicationschool.com, so you can listen to all the previous episodes.
Theo Hicks: Hello, Best Ever listeners, and welcome back to another episode of the Syndication School series, a free resource focused on the how-to’s of apartment syndications. As always, I am your host, Theo Hicks. Each week we air a podcast episode that focuses on a specific aspect of the apartment syndication investment strategy. For a lot of these episodes you will find a free resource to download. So make sure you check out the past episodes for those documents at SyndicationSchool.com.
In this episode I want to talk about the differences between investing into individual deals and investing into a fund. We’ve talked before about the types of passive investments – there’s the equity investments, which is the most common, and then there are the debt investments, which are less common, but they’re out there. Typically, you see debt investments for smaller deals, like a hard money lender, for example. When you hear someone is a private lender, that would be a debt investor.
One distinction that needs to be made for the equity side, which means that you actually own shares in the LLC that owns the property, is that as a passive investor, I can invest into one deal at a time, or I can invest into funds, where I invest into a fund that owns multiple deals. So as an apartment syndicator, those are your two methods of raising capital to fund your deals… So understanding the differences between the two, and the pros and cons for the passive investor will help you decide which one you should use. So again, the two are going to be the individual deals, and a fund.
For the individual deals – this is what most syndicators do, especially when they first start off, is they will raise money for a single deal at a time. So as a syndicator, we always recommend having verbal commitments equal to about 150% (at least) of the total project cost before you put the deal under contract. So if you can raise a million dollars, then you want to look for deals that are less than 30 million dollars. That way you know you can cover it assuming that a portion of those people actually end up investing.
Say you go out and you find your deal, and then you’ll send that deal out to your list of investors, and then people will commit to the deal, send the PPM, submit their funds, and then they’ll be an investor in that particular deal alone. So with that deal, the syndicator follows a business plan, and then obviously that one deal is in a single market. So everything is very unique to one specific deal.
A fund is kind of the opposite, where it’s a private partnership that rather than buying a single deal, it buys at least two, most likely more pieces of real estate, or for our cases, apartments. So if I’m raising money in a fund, I’ll have numerous investors send in their commitments, and then I will use their capital to buy a bunch of apartment communities.
So the GP of the fund – unlike the single deal – might do multiple business plans… Or they might just do one business plan. So maybe I just do value-add deals in my fund. Or maybe I just do turnkey properties in my fund. But it is possible to do a fund where it’s a mixture of business plans. I think it’s ideal to focus your energy on one, because they are different, and I think you’ll have economies of scale if you focus on one, as opposed to multiples. But I’m sure there’s people out there that do focus on multiple business plans. So if you’ve got multiple business plans potentially, obviously multiple deals, and then also it could be in multiple markets or it can be in one market. So there’s more diversity across the deals for sure, and then potentially diversity across business plans and the market.
So let’s talk about the funds. There’s two different types of funds that you can create. The commonly referred to as close-ended funds, or just like a regular fund… And then an open-ended fund, also known as the evergreen fund. For the close-ended fund – pretty self-explanatory by the name… It has a specific end date. So the investors would commit a certain amount of money to invest, and then the syndicator would continue to accept commitments until they’ve hit that desired fund goal. So maybe they wanna create a ten-million-dollar fund, so they’ll keep taking commitments until they reach ten million dollars. And maybe they’ll do a waiting list after that, up to, say, five million dollars, or something.
And then once they’ve achieved that desired goal – or maybe before – they will start to buy apartment communities over a certain period of time. So depending on how long the fund is – let’s say it’s a ten-year fund – it’ll be probably around three to five years maybe. So the fund starts, and then for the first five years they’re continuously buying deals. And then these deals are held, depending on the business plan, for 3 to 7 years. So again, the buy time, and then once you buy that last deal, however long that hold period is is typically gonna be how long that fund will be.
Most close-ended funds you’ll see are gonna be about ten years. But as a syndicator, you also have the opportunity to close the fund early, or you can extend the fund by multiple years too, depending on how you made the contract.
Now, for a close-ended fund the passive investors are not gonna get their initial equity back until the end of the fund. But as I mentioned, some funds might end early, also some close-ended funds might distribute large lump sum profits to the passive investors once an apartment is sold or refinanced. The GP may also have some option to recycle proceeds from a sale refinance back into the fund if some criteria is met, like the deal was sold before two years, or something; or a refinance before two years. So very flexible… But it is possible to get some lump sum profit by investing into a fund, but the passive investor is not gonna get their full investment back until that fund ends, after ten years or so.
The other fund is the open-ended or the evergreen fund. The main difference between the open-ended and the close-ended – again, as the name implies – is that the open-ended fund does not have an expiration date or an end date. So rather than accepting commitments up until a certain limit, and then stopping, and then buying deals for only a certain period of time and then stopping – the money-raising and the deal buying is continuous.
An example would be I raised money up to a certain point, and then I’ll buy some deals, and I’ll raise more money, and I’ll buy some deals, and I’ll raise more money and I’ll buy some deals, I’ll raise more money and I’ll buy some deals… Or I’ll buy a bunch of deals, then I’ll raise a bunch of money, then I’ll buy a bunch of deals and I’ll raise more money. So it can be one at a time, two at a time, it really just depends on how available capital is and how available deals are.
So unlike the close-ended fund, where the initial equity is only received back at the end of the fund, for evergreen funds the passive investor can get their equity at any time by selling their shares. Of course, there might be some sort of lock-out period where you can’t sell your shares for a year without a penalty or something… Again, highly flexible.
So those are the types of funds. Now, how do these compare to the individual deals? So when is the passive investor’s money due to you as the syndicator? Well, when investing in individual deals, the passive investor commits, and then surely thereafter their funds are due, because generally, they’re gonna commit and the deal will be closed within 60-90 days, traditionally… So the money is due pretty quickly. Whereas for a fund, that’s not necessarily the case.
What happens to the fund is that – say I’m a passive investor, I commit a million dollars to the fund right at the very beginning, and then the syndicators are continuing to get commitments for let’s say a year, until they reach their fund limit of 100 million dollars. So for a year, I have not submitted any money; and then the syndicators identify a deal, and then they’ll send out an email to all of the people who committed and signed the documents of their commitment. It’ll say “Hey, we have a deal, and we need either all of your investment, or we need a portion of your investment to cover this deal.” This is referred to as a capital call. Again, this could be a portion or all of the capital you committed. And when the GP sends this formal capital call notification, the passive investor is legally obligated to fulfill that call based on whatever they’re committed amount was, and whatever percentage the GP is requesting.
And if the passive investor fails to meet that call, then the GP can force them into default, and then if this capital call happens after the passive investor has already invested some of their money, then they will forfeit their entire ownership in the deal, and then other passive investors can buy that ownership.
So depending on what point in the process you make your commitment… Or if it’s in the beginning, then you might not have to submit your capital or any capital at all for a year, or maybe less, or maybe more… Or maybe you’ll submit all of your capital gradually over three years or five years. Or if you jump right in in the middle, maybe you submit all of your capital right away. So it varies. There’s not a standard timing in which you will have to submit your money. It’ll depend on the fund for the passive investor.
The compensation structure for funds and individual deals are gonna be the same, and so the passive investor will be offered a preferred return, and/or a profit split. That profit split might change to be more favorable to the syndicator once a certain return threshold (like an IRR) is passed. And then the timing of the ongoing distributions are similar once the passive investors have submitted their capital, once a deal has been identified. But the time, as I mentioned, from commitment to receiving your first distribution has a potential to be longer for the fund, because again, you’re committing and then you’re only submitting capital at the capital calls.
So you might receive distributions pretty quickly, it might be a year… And even if you submit a portion of your investment, you’re not gonna get the full return based off of your entire committed amount until all of your money is in that fund.
Return of capital – we already talked about that for the fund. And then investing in an individual deal – passive investors get their money back when the deal was sold. So depending on the length of the fund, the length of the hold period for the individual deal, passive investors might get their money back earlier in a fund, they might get it back later in a fund, or they might get it back at the same time.
Profit upside is gonna be a pretty big difference. For the individual deals, the profit upside is going to be higher, because if I’m a passive investor investing in a deal that does really well, then the size of my equity and my distributions grow in proportion to that single deal. Whereas if I’m investing in a fund, then the passive investor’s return on investment is going to be an average of all the deals in that portfolio. So if a few deals in the portfolio perform exceptionally well, the performance of the other average or below average is going to flatten the overall return.
Now, on the flipside, when it comes to risk, that means that there’s more profit potential for individual deals, but there’s also the greater potential to lose more money in the individual deals, because if the one deal performs really bad, then the negative effect on the passive investor’s equity is going to be directly proportionate to the badness or the goodness of the deal. Whereas in a fund, if a few deals perform really badly, the performance of the average to above average deals will bring that return up and will dampen or entirely cover any of the passive investor’s losses.
Something else to consider about the fund is that the passive investor is putting a lot more trust in you, the syndicator, when they’re investing into a fund, especially when it’s early on in the fund and there aren’t any apartments, or only a few apartments. So as a passive investor, if I’m investing in an individual deal, I can analyze you (the GP) first and say “Okay, I really like this guy/girl.” And then once a deal comes in, I say “Okay, well I like them, but I don’t really like this market, or I don’t really like the business plan, or I don’t like this deal, so I’m gonna pass on this one.” Or “Okay, I really like this one. I’m gonna invest in this one, but I wanna invest all of my money into this one deal.”
Whereas for a fund, all the passive investor can do is vet the GP and their proposed usage of the funds. But once they make that commitment and a capital call comes in, the passive investor is not allowed to say “Well, I don’t wanna invest in this deal.” Or “Hey, I actually wanna invest all my money into this deal.” The GP gets to decide how much of your capital goes into that deal. So again, this could come with added risks to the fund from the perspective of the passive investor, because they’re putting a lot more trust in the syndicator, which is why the syndicator that opens a fund is most likely going to have a lot of experience. You’re not gonna start your syndication business by opening a fund. I’m sure it’s possible, but you’re more likely going to do individual deals, and then move to a fund, if ever, much later on.
From a tax perspective, the distributions to passive investors are taxed the same. Ongoing distributions are subject to income tax; that taxable income might be reduced if the depreciation is passed on to the passive investors. And then the profit at the conclusion of the individual deal or the fund are considered gains, and they’ll be subject to capital gains taxes. I’m not necessarily sure how 1031 exchanges work in funds.
And then the last thing would be feasibility for the passive investor. It’s gonna be easier and harder at the same time in the individual deal. The easy part is that the passive investor doesn’t have to be accredited to invest in your syndications if you’re raising using 506(b), whereas for the fund, the passive investor is gonna have to be accredited. So no sophisticated investors are allowed to invest in funds.
This is kind of minor, but it might be a deal-breaker for some passive investor… But when investing in a fund, the paperwork is less, because I’m only signing one set of documents when I’m making my commitment to your fund… Whereas for individual deals, I have to fill out paperwork for each deal. So that’s kind of like an upfront thing, but that is one difference.
So really overall, from the passive investor perspective, the major differences between investing in individual deals and investing in a fund is going to be the level of risk. Individual deals – a little bit more risky, but minor. It could be offset by a really good GP, a really good business plan, a really good market… So it could be riskier; but individual deals also have a greater profit upside, and it’s possible to receive the distribution sooner, and to receive the initial equity back sooner.
Whereas for funds, if they are diversified across multiple apartments, potentially in multiple markets, risks are reduced. But then because of that reduction in risk, the upside is also flattened… And it’s likely that the passive investor’s money is gonna be tied up a little bit longer, and that distributions will start a little bit later.
So that’s some of the characteristics, the pros and the cons of the individual deal investing versus the fund investing. This was inspired by an interview I did with Kris Benson, who does [unintelligible [00:20:17].15] the way he was explaining it in the show. I don’t think the episode has aired yet. All the information I’ve talked about today, he talked about in the episode, and I did some further research to bring more information to the table.
So yes, that concludes this episode on the differences between investing in individual deals and investing into a fund. Make sure you check out our other Syndication School series episodes, and those free documents I was talking about at the beginning of this show, at syndicationschool.com.
Thank you for listening, have a best ever day, and I will talk to you tomorrow.
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