JF2459: The Three Different Types of Commercial Real Estate Funds | Actively Passive Investing Show With Theo Hicks & Travis Watts
Today Theo and Travis share the three different types of commercial real estate funds that you could possibly invest in today instead of focusing on apartment syndication deals.
We also have a Syndication School series about the “How To’s” of apartment syndications and be sure to download your FREE document by visiting SyndicationSchool.com. Thank you for listening and I will talk to you tomorrow.
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Theo Hicks: Hello Best Ever listeners and welcome to another episode of The Actively Passive Investing Show. As always, I’m Theo Hicks, here with Travis Watts. Travis, how are you doing today?
Travis Watts: Hey, Theo. I’m doing great, man.
Theo Hicks: Today we are going to talk about funds. We’re going to talk about the three different types of commercial real estate funds. Of course, as a passive investor, you could invest in one deal at a time, so individually, or you could invest into a fund that buys multiple assets, potentially across multiple asset classes, multiple markets, really depending on what the investment strategy is. So we’re going to focus on that, and the three different types of funds that you could possibly invest in, as well as some of the pros and cons of each. I might have stolen some of Travis’s thunder there, but Travis, why are we talking about this topic today?
Travis Watts: No, not at all. We simplify, we use a lot of terms on this show, like private placements or syndications, but we rarely go into depth about the different types of funds, to your point. So in this episode, it’s about going into depth, defining the different types of funds for people out there wanting to know those subtle differences… So it’s important for passive investors, obviously, to know what you’re investing in. It’s important for active investors to know what your options are on how you could structure your deals… So we’re going to cover closed-end funds, open-end funds, and evergreen funds in this episode, and how these pertain to private placement investing. All of these fund types could be applied to the stock market as well, you could be invested in a publicly traded, closed-end, open-end, evergreen fund, but we’re talking about private placements because most of our episodes are centralized around multifamily investing that way. With that, I’ll let you start off, I guess, with closed-end funds and I’ll take it from there and see where we go.
Theo Hicks: I want to mention one more thing that I forgot to mention in the intro. We’re just focusing on the funds today. If you want to know what the differences are between investing into a fund as opposed to investing into one deal at a time, if you just go to joefairless.com, just type in Individual Deals Versus Funds. I have a very detailed blog post that goes into the major differences between those two from the perspective of a passive investor. But we’re just going to talk about the funds today.
As Travis mentioned, the first fund is the close-ended fund. Probably the most common type of fund, and as the title or the name of it implies, it has a beginning and an end. The sponsor is going to raise equity for a fixed amount of time, or up to a set amount; they might say, “We’re going to raise money for two years, or we’re going to raise money until we achieve 10 million dollars, 20 million dollars, 100 million dollars, whatever.” Once that capital amount is raised or that equity raising period ends, then no new equity comes into the fund, so it’s closed. There’s a closed end to the actual fund.
It also has an overall term. So maybe it’s going to be two years of raising capital, then the term of the fund is going to be five years, and then it’s going to be closed; or it could be 10 years, depending on the operator. But 5 to 10 years is going to be the most common life of one of these closed-ended funds. Once the portfolio of assets is acquired, that’s kind of set in stone.
If they’re going to raise 100 million dollars to buy 10 properties, then they’re just going to buy 10 properties, hold on to them, and as those properties are sold at the end of whatever the hold period is, those proceeds are not going to be reinvested to buy more deals. They’re most likely going to be distributed back to the passive investors until all 10 of those deals are sold, and that 5 or 10 year period is reached, and then the fund is over. You have your money back, all the properties are sold, and that’s it.
Now, as I mentioned, most are going to distribute those proceeds once it’s sold. Sometimes they might hold all those funds, they might hold a portion of those funds, and not distribute them until the very end of the fund, so at year 10 or year 5; again, it kind of depends on how it’s structured. Like all things, the answer is it kind of depends. When am I getting my money back? Well, it depends on what the operator is doing. But bottom line, overall, the closed-ended fund is going to have a set timeline and a fixed portfolio.
But what are some of the pros and cons? Closed-ended funds are going to be pretty much all liquid. You’re not going to be able to pull money in and out like some of the other funds we’re going to talk about. As we mentioned, you’re not going to get your money back until either the end of the fund or until a deal is sold. They’re most likely going to focus on a similar asset type, so it’s not going to invest in a diverse type of assets; it might just invest in class B value-add multifamily, for example. It’s not going to be multifamily and self-storage and medical and a bunch of other things.
Once the fund is fully invested, then the returns are based on the full net asset value of the assets within the fund. Again, it’s not going to be like an individual deal, where your return based off of that one deal is going to be a blended average of all the properties that they own. As each property gets added, obviously, for the first property, I guess, technically it is one property. But then as each property is added, then you’re going to get an average of all those returns. So if one deal does really bad, that hopefully is offset by the other deals. On the flip side, if one deal does really, really well, it’s going to be offset by the average deals. That is the closed-ended fund.
Travis Watts: Let’s talk about open-end funds, as you probably can already imagine what that might represent. An open-end fund has no limit on the capital raised or necessarily a set time frame for how long this fund is going to be open. Capital can be raised and re-paid throughout the life of the fund. This allows investors for liquidity. More on that in just a second.
A couple of cons that come to mind, one in particular – investors may receive an overall lower return in exchange or a trade-off for that liquidity. Because there’s capital coming in and out of the fund, which means that the operator has to keep a large cash reserve for anybody wanting to do a redemption. That’s kind of a con to it, but most open-end funds, similar to closed-end funds that Theo talked about, will still distribute capital to the investors upon disposition or sale of the assets.
The bottom line is that these are great for folks that are looking for liquidity, because that’s one of the drawbacks to private placement investing; sometimes you put money in and it’s five, seven, ten years later before you get the money back. This is a nice feature – you may have a 90-day redemption, 180-day redemption, something like that where you could get some capital back out.
Like I talked about all the time, it comes down to your criteria. What’s important to you? Are you going to need the liquidity for putting your kids through college, or for retirement, or a possible unexpected medical event, or do you just not need the liquidity, because this deal represents an allocation in your portfolio that you could do without, you have liquidity elsewhere, stocks, bonds, mutual funds, etc. That’s open-end funds in a nutshell.
Theo Hicks: The third type of fund, which – I would consider this like a 2A or 2B, because they’re very, very similar to the open-ended funds. There’s no limit on capital raise, there’s no set time frame. The biggest difference here is that for the evergreen fund, so the 2A or the third fund, is that as deals are sold, rather than distributing the profits back to the investors, like in the open-ended fund and also the closed-ended fund, the operators have the ability to reinvest those funds back into another deal.
Once a deal is sold, rather than disturbing those profits, they’ll take the initial investment plus the profits and reinvest that back into another deal. The benefit here is that you can recycle your capital back into funds and kind of get that positive feedback loop of investing once, making that return, and then having a bigger chunk of capital invested into another deal, making higher returns, so on and so forth.
Now, the downside of this is that since there is no end to this thing, you keep your capital in there and whatever the sponsors want to do with that money, whatever types of deals they want to invest in, they can. They might invest in an asset that isn’t necessarily aligned with your goal. As Travis just mentioned, your goal or investment criteria is really the number one thing that’s going to dictate what you do. If you’re investing in an evergreen fund, they might start off by investing in deals that you like, and then they might end up investing in deals you don’t like, or maybe your investment criteria changes, the market changes, and you educate yourself and your idea of what’s a good investment changes. But of course, you are able to take your money out, but you might not get the full value of that equity at the time we pull it out. Again, this is depending on how the fund is structured. The bottom line, basically the exact same thing as an open-ended fund, except that at the sale, the funds can be recycled back into the fund to buy more deals.
Travis Watts: Exactly. Good reminder, too – there’s no right and wrong or good and bad here. It’s a good reminder that we’re all different. Different strokes for different folks. Which fund is the best? That’s up to you, depending on your risk tolerance, your goals, your needs, your liquidity needs, as we talked about. This episode’s just educational purposes only, to kind of open your mind to these possibilities that these different funds exist. Just because you see someone’s doing a fund versus an individual deal, it’s simply that – what kind of fund are they doing? This is all to help build your criteria, everybody listening. That’s all I got in recap.
Theo Hicks: Yeah, I don’t have anything else to add either; pretty straightforward. Basically, a closed-ended fund is when you invest a fund that’s kind of like an individual deal that has a set amount of money that’s going to be raised, and then you know when the fund is going to be over. “At the latest, I’m going to get my equity back in five or 10 years.” As opposed to the open-ended fund, which is you kind of decide when you want to leave. You decide when you want to invest more, when you want to invest less, when you want to pull out entirely. The evergreen fund – again, the opportunity to recycle those funds back into more deals.
That’s all I have, so if Travis, you don’t have anything else, we’ll go ahead and conclude the episode. Thank you for tuning in. Make sure you check out our other actively passive investing shows on YouTube. We’re also still doing our 60-second clips, those are also on YouTube. If you have any questions that you’d like us to answer, make sure you email me email@example.com and we will add those to the queue. Thank you for tuning in. Have a Best Ever day and we’ll talk to you tomorrow.
Travis Watts: Thanks Theo, thanks, everybody.
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