What is a real estate investment fund?

The short version

• Real estate investment funds are types of mutual funds that allow retail investors to access real estate that may otherwise have been too expensive to invest in.
• There are four types of funds, each with its own pros and cons: real estate mutual funds, REITs, real estate private equity funds, and real estate debt funds.
• If you're an investor and want to diversify your portfolio but don't want to buy a property directly, a real estate investment fund could be worth considering.

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What is a real estate investment fund?

There are four general types of investments that are referred to as a “real estate investment fund.”

• Real estate mutual funds
• REITs (real estate investment trusts)
• Real estate private equity funds
• Real estate debt funds

Essentially each is a type of mutual fund that invests in securities that are offered by public real estate companies established just for the fund. And the companies often manage the property listings. The companies either actively or passively manage the funds. These funds make it easy for the average investor to diversify their portfolio by investing in real estate.

Real estate mutual fund

The most common fund is a real estate mutual fund. This type of professionally managed and SEC-regulated fund invests in stocks and bonds of established real estate companies and/or directly in properties.

Real estate mutual funds offer an alternative way to invest in real estate passively. You simply buy shares of a mutual fund instead of putting a large chunk of funds into buying real property. Owning and managing one property in one location requires active involvement — a risky proposition if you're not an expert. But the fund holds investments diversified into many asset types and real estate sectors. Buying and selling a specific property takes time and is an involved process. But as a real estate mutual fund investor, you can buy and sell your shares easily and quickly.

You get all the benefits of a stock mutual fund investor.

• The minimum investment is low.
• Your involvement is passive.
• Diversification is built in.
• Your investment is highly liquid.

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Real estate investment trust (REIT)

A real estate investment trust (REIT) is a trust entity or corporation that invests directly in real estate by buying, holding and selling properties or mortgages. REITs are structurally different from real estate mutual funds in several ways.

• They are required by the IRS to pay out 90% of their taxable profits to shareholders each year.
• At least 75% of a REIT's assets must be invested in real estate.
• At least 75% of the REIT's gross income must come from rents, mortgage interest or gains from the sale of properties held by the REIT.

There are three basic types of REITs:

Equity REITs* own and manage commercial properties. These include apartments, office buildings, hotels and shopping malls. These REITs collect rents and leasing fees. And this provides stable and easy-to-forecast rental income that tends to increase over time.

Mortgage REITs* lend money for mortgages, purchase existing mortgages or purchase mortgage-backed securities. They receive income from interest as the mortgages are paid off.

Hybrid REITs* invest in a combination of both equity and mortgages. Hybrid REITs profit whether interest rates rise or fall. Equity-only and mortgage-only REITs can be subject to fluctuations during times of interest rate volatility.

Real estate mutual funds and REITs are a convenient and passive way for individual investors to diversify their investments into a segment of the real estate market. By owning shares, investors benefit from several of the unique benefits of owning real estate without personally buying and holding real properties.

One REIT we like here at InvestorJunkie is Fundrise. You don't need to be an accredited investor to invest with Fundrise and can start investing in real estate with as little as $500. Find out more in our Fundrise Review.

Real estate private equity funds

Real estate private equity funds* pool funds from individual investors and invest directly in pre-vetted and specific opportunities. These firms serve as what's referred to as a “general partner” (GP). They raise money from private investors, known as “limited partners” (LPs). The general partner identifies and acquires or finances real estate investments. And it manages the portfolio to provide a return on investment to the limited partners.

Shares of real estate private equity funds are not sold on the major market exchanges and are typically available only to accredited investors.

Primary investors include pension funds, insurance companies, university endowments, institutional investors and high net worth individuals. These often-local firms invest in a mix of smaller and carefully selected residential and commercial real estate ventures. Investors consider these funds to be more speculative than real estate mutual funds. The funds pay dividends regularly to investors.

I personally invest with a private equity firm, Trius Lending Partners. It lends money to local flippers. The firm's management vets the borrowers and properties/opportunities. It then provides short-term loans to qualified real estate investors/flippers. These people buy, rehab and resell the actual properties. Trius charges the flipper 12% interest and pays out 8% to investors like me. And Trius makes its money on the interest rate spread (the 4% difference) as well as loan initiation fees charged to the borrowers.

Real estate debt funds

A real estate debt fund is similar to a private equity fund, often on a larger scale. The fund typically raises money from larger institutional investors. And it invests in the development or redevelopment of substantial commercial properties that require large sums of cash. These include shopping malls, office building complexes and other longer-term projects.

Most debt funds specialize on a particular lending strategy. Banks provide one-size-fits-all, cookie cutter types of loans. But private debt lenders work with borrowers who have complex financial situations. And they offer loans and terms that traditional lenders cannot or will not provide. They offer financing to multifamily apartment builders, industrial developers, hotel/hospitality renovators, building companies and retail/shopping developers.

Both private equity funds and real estate debt funds are secured (or collateralized) by the property on which the loan is given. In case of a loan default, the fund has the option to take possession of the title of the property. That provides a great upside to investors. But more often than not, the lender modifies or restructures the loan to collect from borrowers. Like banks that are in the business of lending money rather than holding real estate, real estate debt funds focus on keeping their money churning and earning interest to pay out to investors.

What's the difference between a REIT and a real estate mutual fund?

The key difference is how the entity itself is structured since both are regulated by the SEC. A real estate mutual fund holds a mix of real property and related assets that are professionally managed to provide profits to shareholders.

A REIT is a tax-advantaged company that invests in real estate. REITs pay out 90% of their income as dividends to shareholders. As a result, REITs pay no corporate taxes.

Shares of both REITs and mutual funds trade on the popular market exchanges and can be bought and sold easily and quickly. And both pay out regular dividends to investors.

How to invest in a real estate investment fund

Real estate investment funds were initially developed to provide a convenient and easy-to-understand way for individuals to invest in real estate assets. In the case of REITs and real estate mutual funds, you can buy and sell shares through a broker much like you would buy and sell company stocks. Or check out our favorite real estate crowdfunding platforms, including ones that offer REITs.

Private equity funds and real estate debt funds are typically off-market and not advertised. So you must do a little digging and research to find and evaluate those options. And since most of these offerings are a little more sophisticated, the IRS often requires that you be an accredited investor.

The pros and cons of investing in a real estate investment fund

With each of these four types of real estate investment funds, the investor has a passive role and the funds pay periodic dividends.

Pros

• They are not directly correlated to the stock market. This provides portfolio diversification needed to achieve a properly balanced investment portfolio.
• These funds require a shorter-term investment than owning real estate outright.
• And they require a lower minimum investment than directly investing in real estate.
• But your investment is still typically backed by real, tangible property as collateral.
• The funds pay out regular dividends to investors.
• The funds provide easy diversification among real estate types and locations.

Cons

• You have no control over the decisions regarding the assets backing your investment. The fund managers make all those decisions. So your role is truly passive. If poor decisions are made by management, you can lose money.
• Your upside is limited. When you buy real estate directly, you benefit from capital appreciation of the property itself.

As an investor, it's important to diversify your investment among five asset classes that make up a balanced portfolio:

• fixed income
• equity
• real estate
• commodities
• cash

Wealth professionals typically recommend allocating 15–20% of your portfolio to real estate. And real estate investment funds provide the most convenient way to achieve this without the need to understand the ins and outs of owning real estate itself.

Real estate is its own market. And most real estate holdings are not closely correlated with the stock market ups and downs. So it's a good haven to diversify your portfolio by holding some assets in real estate.

Funds typically specialize in one or several strategies and types of assets. In the stock market you should understand the business behind any stock you're buying. And it's important that you have a basic understanding of the types of assets the real estate fund you choose is investing in. For example, funds investing solely in the development of new office space will not necessarily fare well if the trend toward working from home continues.

It's important to analyze the business prospects of the fund's investing strategy. And do your due diligence on the fund managers.