Many factors influence the probability of success for any private real estate investment, including the strength of the market, the quality of the deal operator, and the quality of the asset. However, deal structure is an oft neglected element of risk and return that can lead investors to make poorer decisions and leave money on the table.
We will discuss two common investment structures, individual deals and funds, to help you understand the pros and cons of each and determine which is a better fit for your portfolio.
For clarity, we define individual private deals as investments where a specific asset has been identified and put under contract by the operator, with an entity formed for the sole purpose of acquiring that asset. Private funds on the other hand are usually set up with a defined strategy of acquiring multiple assets within the same entity, though those assets haven’t been identified or put under contract yet.
There are multiple reasons one may choose to invest in a private real estate fund, including:
- Potential redemption options rather than having to wait until an individual asset is sold
- Built-in diversification due to the fund holding multiple assets
- Higher degree of passivity for investors as they delegate the responsibility to select which assets they’ll invest in entirely to the fund manager
The pros of investing in a fund are essentially the cons of investing in an individual deal, where redemption options are limited and there is little to no built-in diversification. While individual deals are usually quite passive once you decide to invest, some due diligence to understand the deal before going ahead is highly recommended, whether you do it yourself or rely on companies such as ours. So why might you decide to invest in individual deals and why is this our preferred structure for equity deals with our clients? It mainly comes down to three main benefits:
- Capital is used more efficiently, often generating higher risk-adjusted returns
Funds rarely have their cash fully invested, which drags down returns. This is for a few reasons. One is that since funds raise money prior to finding properties to invest in, that cash may be sitting for months or even years before being put to work. Another is that some funds offer redemption options, requiring sufficient cash to fund potential redemptions whether they materialize or not. For individual deals, cash is usually put to work quickly and no cash has to be set aside for potential redemptions. This more efficient use of capital results in higher returns, all else being equal.
It is also common for closed-ended funds to get commitments on investment amounts from investors and then only ask for the money as it is needed for deals. These funds often calculate annualized returns only from the time the cash call is made, not from the time of the commitment. This makes returns appear higher because of the shorter amount of time that the cash was with the manager. In practice though, most investors will keep any committed capital in highly liquid and lower risk investments to be ready for any cash calls, likely generating only a nominal return in the interim. As such, many closed-ended funds generate a lower annualized return in practice than in theory.
Another benefit of investing in a variety of individual deals is that there is no commingling of funds. This means that if a particular deal you have invested in performs poorly, there is no impact on your other deals since each deal is in a separate entity. As such, our goal becomes to pick and choose which individual deals have the best potential risk-adjusted returns.
- Greater control over the assets invested in
Perhaps the biggest benefit of investing in individual deals is we know exactly what we are investing in before doing so, allowing us and our investor group to do due diligence on a deal by deal basis before making the decision to invest. Investing on a deal by deal basis also allows our investors to create a bespoke portfolio of assets according to their individual strategies.
Furthermore, since each new individual deal requires a new investment decision, this strategy forces us and our investors to keep our fingers on the pulse of the market. Not only must we decide if a particular deal is worthwhile, we must also determine regularly whether the broader investment strategy continues to make sense in the current environment or whether we need to pivot. This constant review is something investors are less likely to do when investing in a fund since no new decisions need to be made other than whether to stay in the fund or not.
Something to keep in mind is that pivoting strategies is easy for you, the investor, who just has to change the operator or fund you send the cheque to. Pivoting strategies for operators and funds is much tougher though, as they have often built entire systems and teams around specific investment strategies. As a result, they may be more hesitant to change the strategies they employ, even when the evidence suggests they should.
The ability to pivot with ease can lead to better deal selection and higher risk-adjusted returns over the long run, which is our goal at Hawkeye Wealth.
Which strategy is better for you?
When deciding which structure is right for you, it usually comes down to two main questions. How badly do you need liquidity for your investment and is your portfolio large enough that you can achieve proper diversification across a number of individual deals?
Most individual deals are illiquid. As such, you must determine how much of your portfolio you would be comfortable not having access to for longer periods of time, usually at least three years, though often longer.
After determining an amount of capital that you would be comfortable having illiquid, the question is whether that illiquid portion is substantial enough to be able to diversify across a number of individual deals, each with varying minimum cheque sizes. For reference, most of our deals have minimum cheque sizes of $50,000 and $100,000.
If your portfolio is smaller, making you hesitant to take on concentration risk and liquidity risk, investing in public and private funds could be a great option for you. If your portfolio is large enough to achieve some diversification across individual private deals and you don’t require liquidity for this portion of your portfolio, you should consider looking more seriously at investing on a deal by deal basis to potentially earn a higher risk-adjusted return.
We hope you are enjoying the Bird’s Eye View. As always, please feel free to reply to this email or call us if there’s anything we can do to help or you would be interested in working with us on future deals.
