Affluent investors often call themselves real estate investors. They may look at their own home, a vacation property, apartment building, property owned by their business, and/or commercial investment property as their real estate exposure, but is this the best way to invest in real estate?
Yes, these owners are receiving the benefits of appreciation, rental income, and tax benefits, but are they also taking on more risk and losing economies of scale by not investing in a private fund.
Much like the stock market, individual properties (stocks) experience greater volatility than a portfolio of properties (stock indexes). By investing in a Private Real Estate Fund, the manager will work to diversify hold times, use debt terms of varying maturities, invest across many different markets in the country, and lean on different property management companies all to generate higher quality returns than buying a single asset.
Many high-net-worth individuals (typically viewed as $1-$5MM of net worth) have direct real estate investments of owning a vacation home and/or smaller apartment buildings. The problem with this type of investment is a very concentrated bet on a specific set of tenants, at a single property, in a unique market, and this business is often operated as a side business by the owner.
If one tenant moves out, if the major employer in the market relocates, if there is a major physical issue with the property, such as a fire or flood, a massive property tax increase, or another major setback to the property’s operations, the ramifications on the owner’s investment can be catastrophic.
By investing in a Private Real Estate Fund, many of these property-specific risks can be spread out across different markets, property types, and business plans, thereby reducing volatility in the fund investment while generating alpha.
It is very common for a real estate fund to own hundreds, if not thousands of rental units. There are general rules of property management regarding staffing—typically, one property manager, one leasing agent, and one maintenance tech per 100 units is an optimal ratio. Many individual owners of rental never reach this many units, so they are paying a lot of additional hidden costs that real estate funds do not need to pay.
Sales commissions are inversely proportional to the gross sales price of a property. An investor selling a $1 million property may pay 5% commission, or $50k. Whereas an institutional product, typically greater than $20 million in gross sales, is usually around 1%, or around $200k. This dramatic spread in commissions can greatly decrease the proceeds a seller receives at sale and why larger properties inherently yield net proceeds when analyzing the cost of sales commissions.
The owner of a single apartment building often either self-manages the property or outsources property management and leasing to an off-site third-party manager. In both of these cases, a dedicated team is not solely focused on the success of the property.
Owners who self-manage tend to operate to maximize occupancy and not maximize revenue. This reduces cash flow and value as tenants are enticed to remain in place, knowing their rent is below market.
Off-site property managers often charge higher aggregate fees for management, leasing, and maintenance as the property manager bears the responsibility of the cost for keeping the staff on the manager’s payroll instead of the buildings. Additionally, tenant issues are addressed more slowly, leading to higher levels of dissatisfaction with the property, resulting in increased turnover.
Institutional property ownership utilizes on-site responsive teams who are compensated for maximizing rents and occupancy and ensuring the tenant experience top rate, but done at the lowest cost possible.
Owning real estate directly becomes a part-time job. Maybe it is only a couple of hours a month. Perhaps it is multiple hours a week. Unfortunately, property issues arise on their own schedule and often cannot wait for an owner to return from vacation to be managed.
By investing in a Private Real Estate Fund as a limited partner, other than signing documents and funding the investment, there are no property management responsibilities.
Many fund managers share limited information on property performance, often waiting for year-end when a K-1 is issued, accompanied by a brief letter describing general property conditions and market outlook.
Managers also control who manages the property, the level of debt put on each property, and the timing of the sale.
This aspect of real estate investing is often welcomed by Fund investors, but at times, investors may desire more transparency and decision-making in the process.
Private Fund investors receive all the tax benefits of owning property directly, such as being able to take advantage of cost segregation allowances for tax reporting, pass-through depreciation, use of passive losses, and long-term capital gain tax when applicable.
However, Private Fund investors cannot defer taxes on a sale by utilizing a 1031 Exchange or ensure an investment in the fund will be owned long enough to pass it to the investor’s heirs upon their death to take advantage of the step-up in valuation at the investor’s death.
Private real estate funds allow investors to access diversified, professionally managed property portfolios while enjoying many of the tax benefits of direct ownership—without the headaches of day-to-day management. Though investors relinquish some control and certain estate or 1031 exchange advantages, the benefits of risk mitigation, economies of scale, and time efficiency make private funds a smarter, more streamlined way to grow real estate wealth.
Important Information
This article is provided solely for educational and informational purposes. The views expressed reflect general observations regarding investment analysis, private markets, real estate investing, valuation methodologies, underwriting practices, due diligence considerations, and fund structures.
The information presented is not intended as investment advice or a recommendation regarding any specific investment, manager, property, fund, security, or strategy. Readers should conduct their own independent due diligence and consult their professional advisors before making investment decisions.
Investments in private funds and alternative investments involve substantial risks and are not suitable for all investors. Such investments are generally illiquid, may involve leverage, may have limited transparency, may be difficult to value, and may result in the partial or complete loss of invested capital.
Certain statements contained herein may constitute forward-looking statements. These statements reflect current assumptions and expectations regarding future events and market conditions.
Actual results may differ materially from those expressed or implied due to changes in economic conditions, capital markets, interest rates, tenant demand, property performance, financing availability, governmental actions, and other factors beyond the control of Valoran Capital Management.