Fractional Real Estate Investment: Everything You Need to Know
By Space Coast Daily // May 1, 2022
In order to understand the fractional ownership model, it is as simple as it sounds. You are investing in a fraction of a real estate property.
Investors can purchase a fractional share of an institutional-grade rental property.
In order to accomplish this outcome, a transaction sponsor (normally a private equity firm or REIT) establishes a limited liability company (LLC) and uses it to purchase an investment property in their selected asset class.
In order to raise the needed equity for the transaction, they sell shares in the LLC to investors, and in return for their share purchase, investors are entitled to their appropriate fraction of the rental income, cash flow, and profits.
For fractional real estate investment, there are both pros and cons to this approach.
Pros of Fractional Investing
There are several pros to a fractional investment, with the three biggest being:
■ Access to Institutional Quality Assets: Fractional investment lets individual investors gain access to institutional quality assets that they normally couldn’t afford by themselves. If an investor had $200,000 to invest, they could either purchase 100% of a single-family home that may be in an average or below average environment, or they could buy a fractional share of a Class A commercial multifamily property in an ideal living area.
■ Diversification: Sticking with the previous example of an investor with $200,000 to invest, that investor could purchase that same single-family home and tie up the entirety of their investment capital or buy five $40,000 interests in five different commercial properties to diversify their portfolio instead of putting all of their investment into one project.
■ Passive Income: In the framework of fractional property investment, the sponsor carries the responsibility of managing the regular upkeep of the property. Fractional owners get to collect passive income in an amount that is proportionate to their ownership share without having to put in that extra labor.
Cons of Fractional Investing
The potential downsides of a fractional investment include:
■ Liquidity: The particular terms of each deal are unique, but fractional ownership does not provide the same level of liquidity that would be available with a stock or bond. Quite often, the investment sponsor will require individuals to make a five or ten-year commitment, which means that during this agreed-upon time, they are unable to sell off their interest in the deal to pull their money out. This amount of time is needed to fully implement a property’s business plan but could be too long for some investors.
■ Property / Vacancy / Real Estate Market / Credit Risk: Commercial real estate investment is not without risk because rental rates could change, tenants may default on their lease payment, or the tenants could even end up moving out. One attempt at limiting these risks is to work with an experienced sponsor.
■ Fees: To finance the high startup costs that are involved in fractional real estate investment and the administrative effort that is needed to present a property to investors, sponsors generally charge fees. The type of fee and the amount may vary depending on the deal but can still make fractional investments more expensive than alternative investments.
Fractional Real Estate Options
Choosing between fractional real estate investing and private equity is not an either-or decision. Private equity investment is a type of fractional investment that is available to accredited investors. But there are other popular options that include:
■ Real Estate Investment Trust (REIT): REITs are real estate businesses that own, operate, or finance commercial real estate assets that they are invested in. Once an investor purchases a share of a REIT, they gain access to the income and profits that come with that portfolio of commercial properties. REITs can be privately held or publicly traded entities and can be available to accredited and non-accredited investors.
■ Delaware Statutory Trust: This is a company that is formed for the purpose of commercial real estate investment, with investors buying shares in the trust, opening them up to a proportionate share of the income and profits made by the underlying property.
REITs, private equity, and Delaware Statutory Trusts all offer fractional ownership opportunities, but the specific structure of each deal type should be investigated thoroughly before you commit your hard-earned capital to any of them.
Fractional ownership is a form of commercial real estate investment that gives individuals a fractional share of a property rather than purchasing it in its entirety.
This can offer investors access to institutional-level deals that they most likely couldn’t afford on their own.
Also, fractional investments give investors portfolio diversification and passive income.
Keep in mind that fractional investments can require long-term commitments of five to ten years, maybe more pricey than traditional approaches due to the fees involved, and still come with all of the risks associated with investments in commercial real estate.
Investing with private equity firms isn’t the only type of fractional investment.