Dr. Peter Kim is back with a Saturday Selection educating us on investing in real estate funds. As he explains below, these pooled funds can remain open to investors for a very long time, and the risk / benefit profile can change when you invest early versus late in the fund, the difference of which can be months or even years.
As an investor who has focused primarily in index funds, I’ve never had to contemplate such a question. You simply invest when you have the funds, and the risk profile doesn’t really change. One could argue that the higher the valuations (CAPE, CAPE10, etc…), the higher the risk, but I’m no market timer.
However, with real estate fund investing, timing matters. Is it better to get in early or wait until just before the fund closes to new investors? Let’s see what the good doctor has to say.
This post was originally published on Passive Income MD.
Is It Better to Invest Early or Late in Real Estate Funds?
Many of you already know that I regularly invest in real estate funds. In fact, in the past several years, I’ve invested in them a bit more heavily–mainly because of the amount of diversification it provides. And if you’ve read this blog at all, you know I love diversification.
Diversification helps to minimize risk and ultimately helps keep my returns stable. Since I’ve gone part-time as a physician, I rely more on these passive income streams for daily living. Needless to say, stable returns are very important.
That brings me back to real estate funds. They’re a great idea, but there can be some confusion as to the actual investing process. I’ve already talked about the life cycle of a real estate fund. Since then, I’ve often been asked about the timing of the investment.
Every fund is a bit different, but some funds have a finite time where they’re open for investment (for example 2 years). You might be able to jump in at any time. So…
Is it better to invest early or late in the fund’s capital-raising cycle?
But before we can discuss that question, it’s a good idea to give some background into what it takes to invest in a real estate fund.
What Is a Real Estate Fund?
A real estate fund manager pools capital from investors creating the fund. Then they go and purchase properties using those funds, manage them, and sells them later for a profit.
There are funds which are considered “open-ended,” meaning that investors can invest at any time, and (with some restrictions) move their money out of the fund.
Most funds in which I’ve invested in are considered “closed funds.” This is where the operators of the fund will have a specific time period during which they raise money. They then use that money to purchase investment properties. After that time period ends, they close the fund to any new investors, but continue to operate the business until some day they’ve sold all the properties in the fund.
Here’s an example:
MLG Fund IV has a two-year period during which they will raise money. After that point, no one can else enter the fund.
However, during that two year period, it’s possible someone invested at month one and another invested at month 23.
So in the case of a fund that is set up like this, is it better to invest in the beginning part of that two year period, or at the very end?
Well, here’s a quick summary of the pros and cons of each option.
Investing Early at the Beginning
- Your capital is put to work right away. You don’t have to sit and wait for the fund to do a capital call and only then give your capital. Your capital will be receiving returns from the beginning.
- You’re guaranteed to have the opportunity to invest in the fund. It is quite possible that a fund will close its fundraising once they reach their goal.
- You start receiving tax benefits right away. Depreciation often results in negative returns for investors. You’re able to use that right away to offset other passive income.
- You don’t get to see the properties that they’ve already purchased–or at least, not many of them. Often, you invest based on criteria they present, and it requires even more trust.
- You just don’t have much info such as to how the properties are running so far or how much money they think they will raise.
Investing Late at the End
- You’re able to see the properties they’ve already invested in. “Visibility” is the key word here. It allows you to see how well they’re finding properties that fit their criteria.
- You’re able to see how well their operations are running.
- It allows for a more tangible analysis of the sponsor, rather than just hypotheticals.
- Many times, you might commit to investing in the fund, but your capital may not be needed for a while because they’re still using capital that was committed earlier. So you have to hold on your fund for the day they’re going to want to use it. Since you want those funds relatively liquid, you’re probably not going to put it in anything but a high yield savings or money market account.
- You might not receive all the major tax benefits since some properties have already been bought and depreciation benefits may have already been taken.
Which Do I Prefer?
As with anything, there are pros and cons to both. When I invested in MLG Capital Fund III, it happened to be closer to the late end of the fundraising period. That wasn’t necessarily intentional. I hadn’t known them for very long and I took my time to vet them properly.
Once that fund ended, the question was whether I would also invest in MLG Fund IV right away. Well, I’ve been considering it. But like most people, life happened. I had to hold onto extra cash to possibly help my parents with the purchase of a home. However, we recently decided that this wasn’t the ideal time to buy a home for them.
That decision freed up some money, and now we’re getting closer to the midpoint of the money-raising period of the fund. In a way, I feel like it’s the best of both worlds. I’m able to get some information and visibility into what is already in the fund, but I also get my money working for me as soon as possible.
What Should You Do?
Well, if you run into a similar fund and want to invest, pay attention to the pros and cons of investing in a certain part of the cycle.
Investing early means likely better returns and benefits, but requires more trust in the fund. On the other hand, investing late allows for better vetting, but you stand to make less in returns.
Personally, I’ve invested early in a fund as well as late. The most important thing is ultimately making sure you invest with the right people. That takes time and experience to figure out and it’s definitely something you shouldn’t rush into.
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What about you? What’s the perfect timing for investing in a real estate fund?