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How Do Real Estate Hedge Funds Work?


Oct 10, 2020 by Liz Brumer

There are a number of different ways to passively invest in real estate. A real estate investment trust (REIT) or real estate crowdfunding opportunity are some of the more popular methods, but investors also have the option to invest in real estate hedge funds. Real estate hedge funds are a type of pooled investment fund that raises capital from multiple investors to acquire and manage real estate. Real estate hedge funds are actually quite popular, making them an appealing option for a growing investor to scale their real estate portfolio or for a passive investor looking for a competitive return.

Learn what a real estate hedge fund is, how they work, what it's like to invest in or start a real estate hedge fund, what to look for in a hedge fund, and the pros and cons of this method of real estate investing.

What is a real estate hedge fund?

A real estate hedge fund pools money from multiple investors to purchase, manage, and invest in real estate assets providing a specified return to the participating investors monthly, quarterly, or upon completion of the fund. Real estate hedge funds are a part of the private market, meaning each individual fund sets its parameters for returns or investment requirements, which can include the requirement of being an accredited investor or a minimum investment amount.

There are real estate hedge funds in every sector of real estate, including residential real estate, commercial real estate (CRE), and debt markets where the fund buys and sells performing and nonperforming mortgage loans. It's fairly common, especially among small real estate hedge funds to have a specialized investment strategy, like multifamily housing, self-storage investments, or residential rental properties. Larger funds, which manage several hundred million to potentially billions of dollars in real estate, often take a multistrategy approach, having several successive real estate funds under one parent hedge fund that each specialize in their own real estate sector.

How do real estate hedge funds work?

Real estate hedge funds don't have to invest in physical assets; some choose to invest in REITs or other real estate-related stocks, but the majority choose to focus on investing and managing multiple real estate assets, most commonly distressed assets or value-add opportunities. By purchasing underperforming assets, the fund has the opportunity for increased revenues and asset value and provides an easy structure to profit upon disposition.

A real estate hedge fund structure is a bit more simplistic than that of REITs, which are required to pay at least 90% of their income as dividends to gain certain preferential tax benefits. While they may not fall under REIT tax status, real estate hedge funds are still able to bypass a lot of the securities laws and reporting requirements that are related to a single investment capital raise, or syndication, making them an ideal investment vehicle for investors who want to own and manage multiple real estate assets over a period of time.

Most real estate hedge funds, unlike REITs, are closed-end structured, meaning the fund is established for a designated period of time, such as three to five years or more. At the end of the fund timeline, the fund is closed and all eligible returns or capital is returned to the investors. During the fund's holding period, investors are unable to contribute additional money into the fund, remove their capital, or reinvest any returns.

Real estate hedge funds are run and managed by a hedge fund manager. Depending on the size of the private fund, this could be one or several hedge fund managers who help oversee the various facets of managing their real estate portfolio. They are responsible for overseeing the success of the fund and day-to-day management of the assets in the portfolio as well as reporting and payment to their investors. Many funds choose to offer their investors a preferred return, which can be paid quarterly, accrue annually, or be paid upon the occurrence of a capital event (such as the sale of the assets in the fund or refinancing of the assets).

For example, let's say a sponsor establishes a five-year real estate hedge fund focusing on multifamily real estate. After raising capital for a period of five months, the investment period closes and the raised money is placed into three different apartment complexes in two Florida submarkets. The acquired apartments were underperforming, with below-average rents, deferred maintenance, and high vacancy. The fund improves the property, increases rents to match the market, and improves occupancy, increasing the asset value over the next four years. Before the fund's official end date, the asset is sold on the retail market for much higher than it was originally purchased for. The profit earned, in addition to the revenue that was collected during management and ownership of the asset, allows investors to be paid their preferred return of 7% each quarter during the duration of the fund, while earning a nice return for the sponsor and partners of the fund.

What to look for in a real estate hedge fund

There are hundreds of different private real estate funds to potentially invest in, making it difficult to know which right real estate investment hedge fund is the right match. Start by determining what real estate investment strategies or sectors you want to participate in. Search for the top performing funds in those sectors and do your due diligence on how long they've operated, performance of past funds that have closed, and availability for current fund participation.

It's important to find a fund that has a strong reputation in its targeted investment avenue. The hedge fund manager or sponsor should have experience and expertise in the investment strategy of the fund and be able to provide documentation on the structure of the fund, including capital structure and investor payouts, plan of execution for the fund, and information about the management team. Past performance is always a helpful metric but isn't indicative of future performance. Unknown factors, including market fluctuations (the current global pandemic is a perfect example of this) and natural disasters, can affect the profitability of the fund.

How to invest in a real estate hedge fund

Since real estate hedge funds are private, it's important to find a fund that has a strong reputation in the targeted investment avenue. The hedge fund manager or sponsor should have experience and expertise in the investment strategy of the fund and be able to provide documentation on the structure of the fund, including capital structure and investor payouts, plan of execution for the fund, and information about the management team.

After completing your due diligence on the fund and management team, you'lll enter into a capital commitment agreement with the fund, which will outline the exact protocol for paying returns, including what constitutes as a capital call, or the amount of capital investment being made by the investors and the corresponding return based on the amount being invested.

How to start a real estate hedge fund

Starting a real estate hedge fund can be expensive and time-intensive, which is why nearly all fund managers use an experienced attorney to help with the foundation of the company. There are various structures available for the fund manager to choose from, which will offer certain advantages, particularly tax advantages, based on the fund's goals.

For this reason, starting a real estate hedge fund is really best for those who have extensive experience in a specific sector of real estate and are looking to scale their portfolio to own multiple assets over the next few years and want to benefit from the simplicity of having multiple investors for multiple investments rather than having to syndicate for each investment.

Those who feel a real estate hedge fund makes sense for their investment goals and experience level should expect to spend tens of thousands of dollars on the establishment of the fund and should have a specific investment plan and strategy for not just the acquisition, management, and disposition of the assets, but also for how they'll raise capital for the fund.

Pros and cons of real estate hedge funds

The biggest benefit of participating in a real estate hedge fund is the potential return, which can range from 6% - 12% on average. This beats out most REIT returns while still giving exposure to the real estate market. Since most real estate funds focus on value-add opportunities, the fund has a larger margin for error and room for potential growth. With that being said, distressed investments also inherently have more risk with them. If they do pay off, they often pay off big, but there are also many times they don't. That risk is carried over to investors. Depending on the fund structure, the investor may have additional security in the position of their investment, but returns are never guaranteed. A fund's performance could fall below initially expected, and a portion of capital could be lost.

Investors considering either starting a real estate hedge fund or investing in one should make sure they do their due diligence on the process and are comfortable with the requirements and risks involved. In most cases, with the right investment strategy, sponsor, and firm, this can be a worthwhile method of real estate investing.

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