When diversifying your investment portfolio, you might have come across real estate debt funds. If this is new territory for you, these funds might feel like a lot to decode, but they’re actually a fairly simple concept. Like any type of investment, it’s important to understand how these funds work and the potential risks to determine whether they’re the right fit for you. Take a look at this quick guide to understand the fundamentals.
A real estate debt fund essentially acts as a private lender for people looking to purchase or improve real estate. The fund gets capital from an investor pool and invests in loans secured by real estate.
Borrowers make monthly loan payments to the fund just as they would with any type of mortgage or bank loan. That interest income is used to cover the expenses of managing the fund, and the remainder goes back to investors in the form of regular returns on a monthly or quarterly basis, creating predictable cash flow.
If you’re looking to diversify your portfolio and expand beyond the traditional options of stocks, bonds, and cash, there are several benefits of debt investments.
As an alternative investment in the real estate sector, real estate debt funds or mortgage real estate investment trusts (REITs) can come with lower risk than purchasing real estate directly or investing in an equity REIT that purchases and manages properties. Key factors to consider are the underwriting criteria for making loans and whether the debt fund/mortgage REIT uses any leverage. Having a large, diverse portfolio of debt secured by a variety of properties while carefully vetting borrowers creates a non-correlated income stream.
Mortgage debt funds typically come with a range of lockup periods, typically from six months to two years, although it depends on the fund manager. The operating agreement will also spell out the liquidity provisions so that you know what the process is if there is an emergency and you need to extract your capital. Be sure to be mindful of limits on investor redemptions, also known as “gates.”
Much like bonds, this type of investment can have predictable recurring monthly revenue, allowing you to build reliable cash flow—provided the fund is managed appropriately.
In addition to having no diversity, direct property ownership also requires you to manage the property. Debt funds allow you to see the benefits of a historically reliable real estate sector without having to manage property directly. The fund manages the loans, and there is a fee to cover this management, but you don’t have the kind of exposure that you have through direct ownership.
As you explore your options, consider these factors to determine whether real estate debt funds are right for your portfolio.
Some, but not all, funds require you to be an accredited investor, which means individuals must meet minimum criteria for net worth or annual income. Aside from this, there are no additional legal requirements, making this asset class relatively accessible to a range of investors.
Each fund has a minimum investment. Consider how much you’re willing to invest and look at funds within your range. Know your limitations, and don’t invest money that you don’t think you’ll need in the near term
Always ask if there’s a lockup period and how long it is so you don’t have any surprises down the line. Understand the process for requesting to exit the fund or take money out so you’re prepared if the need arises.
In most cases, you will have the option to collect monthly interest or roll it over and compound it. Think about your investment strategy and whether you want the cash flow or the appreciating income. Optimize your capital in a tax-efficient way. Investing in debt funds with your retirement capital while you invest in equities with taxable capital can generate tax-efficient returns with a lower tax bill.
Real estate debt funds can be structured in a few ways, including as a mortgage REIT, which generates cash flow the same way as a debt fund that gets distributed to investors. The REIT structure comes with certain tax benefits and simplification of tax returns. Alternatively, a real estate crowdfunding platform may not come with the same benefits.
Understand where the fund is investing and what types of loans it targets. For example, some funds focus on residential construction loans, and others may focus on small-balance commercial loans or Small Business Administration loans. If you have a particular asset class of interest, such as single-family houses, multifamily, industrial, self-storage, marinas, or offices, you can probably find a fund that caters to it.
Review historical fluctuations and weigh them against your risk profile. Perform your own due diligence and carefully consider the offering documents before you capitalize on an investment opportunity.
If you’ve had an eye on the California real estate market but aren’t sure how to get in on it as an investor, Herzer may be the entry you need. We offer a range of financing types to borrowers, including construction, fix-and-flip, commercial, and consumer bridge loans. The interest generated from these loans goes to our investor pool, delivering regular yields that you can use to supplement your income or roll it over to compound your earnings.
The process to become an investor starts by completing a quick form on our website. Once approved, you’ll have access to all of the information you need to make an informed decision about your investments.