Pros and Cons of Different Types of Real Estate Funds
October 9, 2023
When investing in real estate funds, especially amid a volatile macroeconomic landscape, it is imperative to know the differences between the various types of funds. To ensure that you’re maximizing your investment dollars, you must understand the intricacies of the most notable types of real estate funds: real estate investment trusts (REITs), open-end funds and closed-end funds. Whether you prioritize high returns, low fees, tax benefits, predictable timelines, fund flexibility or other factors, each type of real estate fund has its positive and negative consequences to consider.
Real Estate Investment Trusts (REITs)
Real Estate Investment Trusts (REITs) are companies that own or finance and operate income-producing real estate across various property sectors. REITs can be privately held or publicly traded on major stock exchanges.
Pros and Cons of REITs
| Pros of REITs | Cons of REITs |
| High Dividend Yield – Law requires REITs to pay at least 90% of their income in dividends. | Interest Rate Sensitivity – REITs use mortgages and other financing arrangements to purchase assets, so they are sensitive to interest rate movements. |
| Tax Advantages – REITs do not have to pay a corporate tax, so there is a higher available payout for investors. | Macroeconomic Trend Sensitivity – Overarching consumer and financial trends can heavily influence REITs. |
| Pass-Through Deduction – 2017 tax reforms allow REIT investors to deduct up to 20% of combined qualified income, including qualified REIT dividends from income tax. | Long-Term Investments – REIT investors will not see an immediate return in their investments. |
| Depreciation – REITs can use depreciation to reduce their ordinary income and reclassify it as return of capital. | Expensive Fees – Non-traded REITs may have high up-front fees, sales commissions and operating expenses, such as management and legal fees. |
| Value Appreciation – REITs are investments in physical pieces of property, which allow investors to see what they invest in and for the assets to appreciate. | Taxed Dividends – While there is no corporate income tax, individual REIT investors must still pay taxes when they receive REIT dividends. |
| Portfolio Diversification – REITs diversify investor portfolios with real estate assets and divert away from the traditional stock market. | |
| High Rate of Return – All REITs in the FTSE Nareit REIT index have returned 9.09% annually between 1972 and 2022. |
Open-End Funds
An open-ended fund has an indefinite life and can issue an unlimited number of shares to its investors. Investors have the flexibility to purchase and redeem shares at their convenience, in accordance with the fund terms.
| Pros of Open-End Funds | Cons of Open-End Funds |
| No Fixed Term – Open-end funds enable investors to enter the fund and redeem interest periodically. | Unpredictable Timeline – Because open-end funds have an unlimited life, it may be more difficult to predict realized returns. |
| Additional Investors – Open-end funds allow fund managers to add additional investors into existing investment vehicles, whereas new closed-end funds would be launched every few years. | Incentive Fees – Open-end fund managers earn incentive fees on unrealized investments, so there may be no incentive to sell assets. |
| Fund Flexibility – Open-end fund managers have more power over timing of acquisitions and dispositions, and increased navigation through an ever-changing economic landscape. | Redemption Requests – Open-end fund managers deal with redemption requests, which can be challenging to fulfill and create potential liquidity issues. |
| DRIPs – Open-end funds offer an attractive option to investors to reinvest distribution via distribution reinvestment plans (DRIPs). | Scrutinized Valuations – Open-end funds receive much higher scrutiny on the accuracy of valuations because investors can redeem capital, including unrealized gains and losses. |
| Lower Fees – Open-end fund management fees are typically lower than close-ended funds, and are generally charged on contributed capital instead of committed capital. | Complex Structuring – Open-end funds can have more complex structures, including side pockets, gates and lock-ups, to manage liquidity risks and redemptions. |
| Profits and Loss Visibility – New open-end fund investors participate in profits and loss on existing investments and can assess vehicles’ track records. | Administrative Burden – Open-end fund managers typically spend more time on administrative efforts because of more frequent reporting and management of fund inflows and outflows. |
| Lack of Capital Gains – Open-end fund managers may not receive the benefit of capital gains treatment on the performance fees because they are structured as fees, rather than carried interest distributions. |
Closed-End Funds
Closed-end funds use pooled money to invest in real estate. They have a predetermined life that is set by the manager at the fund’s beginning during the capital raise period. These funds normally add value and are driven by capital gains, where more of the expected return is earned from the asset sales rather than the income stream.
Closed-end funds also generally have a buy/fix/rent/sell strategy that includes some level of construction, repositioning, recapitalization of existing debt and/or property management changes. Implementing these strategies can take time, and therefore closed-end funds may deliver negative returns in the initial years.
| Pros of Closed-End Funds | Cons of Closed-End Funds |
| Predictable Income – Closed-end funds have an anticipated general timeline for return of investment and growth due to their predetermined life. | Illiquidity – Closed-end funds have illiquid investment dollars locked in until the liquidation/sale event. |
| Set Contributions – Closed-end funds do not need large amounts of cash until the liquidity events or continued capital contributions, so more cash can be deployed for investment. | Lack of Control – Closed-end investors must exercise due diligence when determining the right fund to invest in. They are often dependent on the skill and acumen of fund managers for property acquisition and management. |
| Accelerated Depreciation – Closed-end funds can kick off tax losses during the initial years. | Delayed Returns – Closed-end funds do not have a consistent income stream, so fund managers and investors may not see any material returns until the sale or liquidity event. |
| Capital Gains – Most of the growth and return from closed-end funds will come in the form of capital gains, and some can be recaptured if there is an excess of accelerated depreciation. | Asset Divestiture – Closed-end fund assets must be sold as a part of the fund lifecycle, even if it is achieving greater than projected returns. |
| Short Hold Period – Closed-end funds have a shorter hold period than other funds, so property can be sold ahead of economic downturn. | Pressurized Asset Acquisition – Closed-end fund purchases can only occur during the investment timeline, so there is pressure to deploy funds, even if there are no optimal assets. Managers and investors cannot acquire prime assets that arise after cash is deployed. |
| Strategic Borrowing – Closed-end fund managers can employ leverage to gain greater investment exposure and amounts, so that the initial contribution can be lower. | Sponsor Obligations – Closed-end funds come with steep management fees and profit distributions that heavily benefit sponsors because they receive high portions of gains over set ROI. |
| Frequent Distributions – Closed-end funds potentially allow for monthly and quarterly distributions during the hold period. | Predetermined Lifecycle – Investors must find new investment funds if a closed-end fund is terminated, due to its shorter and predetermined lifecycle. |
Let Us Guide You Forward
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Sources
“Closed-End Real Estate Funds: What You Need to Know.” Realized (January 2022). https://www.realized1031.com/blog/closed-end-real-estate-funds-what-you-need-to-know
Dahle, Jim. “Open-Ended vs. Closed-Ended Private Real Estate Funds.” The White Coat Investor (July 2023). https://www.whitecoatinvestor.com/open-ended-vs-closed-ended-private-real-estate-funds/
Hunter, Cal, Lauren Hulme, Amy C. Johnson-Spina. “Open-Ended Funds Part 3: Pros and Cons for GPs.” Torys (Fall 2021). https://www.torys.com/en/our-latest-thinking/publications/2021/11/open-ended-funds-pros-and-cons-for-gps
Schoenberg, Debra, Chandeep Sodhi, Taylor Evans. “Open-Ended Funds in a Close-Ended Funds World.” EisnerAmper (June 2023). https://www.eisneramper.com/insights/real-estate/open-ended-funds-0623/
Spitz, Jonathan. “What are the Differences Between Open-End and Closed-End Real Estate Funds?” Origin Investments (May 2021). https://origininvestments.com/open-end-and-closed-end-real-estate-funds/#:~:text=Unlike%20closed%2Dend%20funds%2C%20an,open%2Dend%20funds%20is%20flexibility.