Navigating The World Of Passive Real Estate Investments
Real estate investing has a tremendous record for creating wealth. Millionaires are created every day from investments in real estate but the options available can sometimes be overwhelming. As a seasoned mortgage fund manager, I want to help you navigate the world of passive real estate investments. Of course, I am a big believer in active investments as well but if you don’t want to deal with toilets, tenants, and tantrums, investing passively may be the best way to get involved. Whether you’re an experienced passive investor with investments in multiple projects and funds or just dipping your toes into the market, understanding the various investment options is crucial. In this article, we’ll explore four passive real estate investment choices: REITs, private real estate funds, syndications, and mortgage funds. I want to give you honest advantages and disadvantages to each so you can make a comparison and decide on the best option for you.
REITs (Real Estate Investment Trusts)
This is the most popular way to get started. These are typically very large funds with shares traded on public exchanges. You can add these to a stock portfolio to get some exposure to real estate without the effort of located or vesting deals. Historically returns have been very good with REITs but there is no promise or guarantee and they will go up and down in value quickly. Here are some advantages and disadvantages of REITs:
-
Liquidity:
REITs are highly liquid investments because they are traded on stock exchanges, allowing investors to buy or sell shares at any time they want. This liquidity provides flexibility, as you can adjust your real estate exposure quickly in response to changing market conditions or personal financial needs.
-
Legal Oversight:
REITs are subject to extensive regulatory oversight, including reporting requirements and compliance with certain income distribution rules. This level of regulation provides transparency and investor protection, making it a relatively safe option to avoid fraud or untrustworthy operators.
-
Higher Returns:
Historically, REITs have delivered competitive returns, often comparable to or even surpassing those of stocks and bonds. They can offer an attractive income stream through dividends, making them appealing for income-oriented investors.
-
Tax Advantages:
REITs are structured to be tax-efficient. As an entity, they are exempt from federal income taxes as long as they distribute at least 90% of their taxable income to shareholders. This can result in potentially higher returns and favorable tax treatment for investors.
-
Risky Commercial Assets:
While REITs can provide diversification, many invest in commercial properties, which can be vulnerable to economic downturns and market fluctuations. This is especially true today with the number of defaulting commercial property loans and loan maturities. For instance, office and multifamily REITs could be facing significant turbulence in the coming year with elevated interest rates and reduced demand for the asset. I have said many times the next opportunity is likely commercial real estate because those are the assets that have the most room to fall.
Private Real Estate Funds
These are funds normally set aside for high-net-worth investors. You will never hear about these unless you know someone who knows someone who is involved. Similar to a REIT, these are pools of money used to buy real estate. Here are some advantages and disadvantages of a private real estate fund:
-
Higher Returns:
Private real estate funds can potentially deliver higher returns compared to publicly traded REITs, and other options, because they have the flexibility to invest directly in properties with the aim of maximizing profits. They are much smaller than a REIT so they can do smaller deals with larger upsides.
-
Diversification:
Investing in a private fund grants you access to a diversified portfolio of real estate assets. This diversification can help spread risk across different property types and geographic locations. There are many real estate funds that either focus on residential real estate or have residential real estate as part of the overall portfolio. This helps reduce or eliminate the risk that comes with commercial real estate.
-
Professional Management:
Fund managers are typically experts in the real estate industry. They make informed investment decisions, conduct due diligence, and actively manage the assets within the fund to optimize returns. Because they do this full time, they are able to locate better deals than most part-time active investors. Typically, the manager of the fund will take a fee for their effort, but they also outsource the management at the asset level creating further separation between you and the underlying properties. This separation has some cost and creates some additional risk. The more layers you put between you and the underlying asset, the more people that need to get paid and the higher the risk of mistakes and fraud.
-
Lack of Liquidity:
Private real estate funds often come with lock-up periods, meaning your investment may be illiquid for several years. This can limit your ability to access your capital when needed, making it unsuitable for those requiring liquidity.
-
Lack of Oversight:
Private funds do not carry the same level of scrutiny that public funds have with audited financials, transparency, and government oversight.
-
Open to Accredited Investors:
In most cases these investments are limited to accredited investors only. The definition of an accredited investor is a bit broader than this but in general to be accredited you need to have a $1 million net worth, exclusive of your primary home, or make $200,000 as a single tax payer or $300,000 with a spouse or partner for the previous two years.
Syndications
Similar to a real estate fund where a manager raises private capital into a pooled account and uses that money to purchase real estate. The difference is a fund is typically invested in several projects while syndication is normally limited to one. Apartment syndications have been extremely popular in recent years. Here are some advantages and disadvantages of a syndication:
-
Ownership Control:
One of the primary advantages of many real estate syndications is that investors may have a say in the property’s management and decision-making. Not all syndications allow this, but this level of involvement can be appealing to those who want to play an active role in their investments.
-
Profit Potential:
Successful syndications can yield substantial profits, especially when the property appreciates in value or generates consistent rental income. Investors can benefit from the property’s financial performance. I have made returns of over 100% in some syndications I invested in.
-
Interest Rate Sensitivity:
Syndications can be highly sensitive to changes in interest rates. When interest rates rise, it can increase the cost of financing for the property, potentially affecting returns and the overall viability of the investment. Although I have made very high returns on some syndications, recently, I have lost money on others because my investment is tied directly to the property.
-
Operator Risk:
The success of a syndication heavily depends on the expertise and integrity of the operator or sponsor. Recent cases of fraud in the syndication space have raised concerns about the reliability of some operators. There are a handful of substantial examples but none smaller than the recent Grant Cardon allegations.
-
Lack of Liquidity:
Similar to private funds, syndications often lack liquidity. Exiting a syndication can be challenging if it is even possible. If it is allowed, it typically requires finding another investor to buy your stake otherwise you may be forced to wait until the property is sold or refinanced.
-
Accredited Investors Only:
With very rare exceptions, these investments are reserved for accredited investors only.
Mortgage Funds
I know I am biased but for many investors, this is the best option because it combines the best advantages of the other three options without the downside. This is investing in a pool of money that is used to make loans against real estate. Instead of owning the physical real estate and being subject to that potential downside, a mortgage fund only invests in the paper and uses the real estate to secure the investment in a worst-case scenario. Here are some advantages and disadvantages of a mortgage fund:
-
Stability:
Mortgage funds offer stability with steady returns backed by real estate assets. They generate income through interest payments on mortgages, providing a predictable cash flow to investors. Payments come in regardless of a tenant being in place or rental performance. The asset does not lose value if real estate values go down, assuming there is no default, because the asset is a note with a promise of repayment. It also generates income and distributes income monthly, so it is a great option for immediate cash flow.
-
Diversification:
Many mortgage funds invest in a diverse portfolio of mortgages, reducing risk. This diversification spreads the risk across multiple properties and borrowers, making it less susceptible to the performance of a single asset. This allows for steady monthly payments to the investors.
-
Liquidity:
Unlike private funds and syndications, mortgage funds often offer liquidity options. Investors can typically redeem their shares or interests periodically, providing access to their capital if needed. It is not as liquid as a REIT but you can get your investment back if needed.
-
Local Impact:
Maybe the biggest advantage to a mortgage fund is that it plays a crucial role in improving local neighborhoods. Mortgage funds do this by providing loans to real estate investors for property rehabilitation and development. Mortgage funds are a vital role in improving local neighborhoods.
-
Returns:
The one potential downside is that you may be giving up on potential returns by investing in a stable asset. If you are ok taking losses and want to gamble for the higher return, one of the other fund options may be a better fit. If you are looking for some stable diversification a mortgage fund may be a good addition to your portfolio.
Obviously, each of these real estate investment options has its merits but mortgage funds are the only choice that combines stability, diversification, liquidity, and a positive local impact making them an extremely attractive option for passive real estate investors.