Individuals assessing alternative investment options look to private real estate funds due to their tax efficiency, risk-adjusted solid returns, and low correlation to the stock market. These pooled funds receive capital from investors and invest the combined wealth into properties as one actively managed portfolio.
Pooled real estate funds are split into two categories: open-end and closed-end funds. Moreover, private real estate funds are illiquid. Hence one must analyse the unique structure of each type before investing.
Open-end Funds Vs Closed-end Funds
Open-end Funds
- Open-end funds do not come with an expiration date.
- These funds might operate under a “buy-fix-hold” strategy where more anticipated returns are derived from the property’s income stream.
- The key benefit of open-end funds is flexibility. Without an end date, managers are not restricted to liquidating assets and focusing on investors’ long-term wealth appreciation.
Nevertheless, the requirement to provide robust and recurring cash flow may reduce the aggregate income stream, showing a lower total return than what may be accomplished by a closed fund. However, as immediate cash flow is part of the acquisition standards, open-end funds generally have a lower risk profile.
Closed-end Funds
These funds are typically capital gains driven where more of the anticipated return is realized from the sale of the asset instead of the income stream.
- Closed-end funds have a decided term, which is set by the manager at the fund’s onset.
- Closed-end funds might operate under a “buy-fix-sell” strategy, which typically involves repositioning, some level of construction, property management changes and recapitalization of current debts. Executing these strategies can take time, and thus, closed-end funds may give negative returns in the initial years.
Considering the value-add strategies are implemented successfully, the results can generate returns more than what can be accomplished by purchasing a wholly stabilized property. Since the capital’s returns are conditional on the performance of an underlying business plan, proper due diligence on the performance of the fund manager track record is imperative.
Additionally, the capital gains-driven method has specific tax implications that are essential to acknowledge when estimating the total return of an investment.
Which Option Is Right For You?
As mentioned above, both closed-end and open-end private real estate funds have their pros and cons. It is significant that you analyse your investment objectives and make an informed selection based on each type of fund’s approach, acquisition strategy, liquidity considerations and tax implications that may influence a project’s anticipated returns.
