Real estate debt funds have been gaining in popularity over the last decade. Since the 2008 global financial crisis, these types of funds have found a niche in the lending landscape.

For investors with a self-directed IRA or Solo 401(k) seeking an opportunity to diversify into a stable asset with solid returns and limited risk, real estate debt funds may be an alternative asset investment worth looking into.

What Are Real Estate Debt Funds?

Real Estate Debt Funds are pooled investment vehicles designed to accumulate capital for a targeted type of real estate backed lending.

These funds tend to focus on lending niches not well served by traditional banking following the 2008 economic downturn.  Most funds lend on a shorter-term basis of 1-3 years for construction financing, bridge loans, debt restructuring, or property redevelopment/rehab.

Loans in the range of $1M to $100M are common, and often fall in a range too big for smaller banks yet too small for direct institutional lenders.

Creating a pool of such loans provides diversification, minimizes risk, and generates predictable fixed-income returns.

Because fund managers tend to specialize, they can be more knowledgeable of the niche they operate in and may be willing to lend where a more conservative bank may not.

The lending process is also faster as there are fewer layers of decision making and regulatory hurdles than in the conventional banking world.

By providing the efficiencies of fast access to capital in specialty situations, debt funds can command a higher interest rate on the money lent.

Fund Structures

Most funds are setup as LLC entities where investors own a limited partner interest.  Limited partners are protected against liability but have minimal control over the operations of the fund.

The fund manager is responsible for creating and operating the fund and is compensated for doing so.  It is not uncommon to see startup fees for organizational and fundraising work.

Most funds have an asset management fee paid to the manager that covers their operational costs during the life of the fund. The range of 1-3% of invested capital is common.

Loan servicing may be outsourced or provided in-house.  Either way, this is a cost that will impact investment returns.

The profits of the fund are generally issued in the form of a preferred return to investors, with excess profits being split between the investors and the manager.  The benefit of this framework is that it incentivizes the manager to get capital deployed and productive quickly, which is aligned with the interest of fund investors.

Who Can Invest?

The majority of private real estate debt funds are limited to accredited investors.

Some funds are available on crowdfunding platforms and available to non-accredited investors.

Minimum investment amounts vary and can be as low as $1,000 – $5,000.  Minimums of $25-50K are more common.

Advantages of Debt Funds

There are several reasons that debt funds can be appealing to self-directed retirement plan investors.

Simplicity – This is a very hands-off and arm’s length type of investing, well suited to IRS rules.

Consistent Income – Real estate debt funds are designed to produce regular distributions of income to investors on a monthly, quarterly, or semi-annual basis.

Security – Fund-issued loans are secured by real property.  Most funds will target senior, first position debt with conservative loan to value ratios.  In the event a borrower defaults, the fund will takeover the property, and should have the equity to dispose of the property profitably.

Diversification – When a fund is allocated across a variety of notes, the risk of any single loan going bad is mitigated.

Real estate debt funds allow your IRA or 401(k) to participate in larger opportunities not available to individual investors and leverage the expertise of specialists familiar with managing this type of asset.

Disadvantages of Debt Funds

As is typical with any kind of fund investment, you have little control over the operations.  Performing due diligence on the fund in advance is therefore crucial.  You will want to review the private placement memorandum to ensure the operation of the fund aligns with your goals.

Fund investments are usually illiquid in nature, so your money may be locked up for several years before you can expect a return of the invested principal.  Be sure you understand in advance what limitations may be in place, and if there are any available exit options prior to fund termination.

Tax Considerations for IRA & 401(k) Investors

The interest income issued to fund investors is normally classified as ordinary income.  When investing using a tax-sheltered retirement plan, the income is not taxable when issued, and accrues to the plan either tax-deferred or tax free if a Roth account is used.  This can result in a significant tax savings.

Some funds use a combination of investor capital and borrowed capital to make loans.  If this is the case, then an IRA or Solo 401(k) investor will have a tax-liability on the Unrelated Debt-Financed Income that is produced.  Note that UDFI is taxable to a Solo 401(k) on debt-financed interest income.  A Solo 401(k) is only exempted from UDFI on debt used for the acquisition of real property.

Only the portion of income that the plan receives which is derived from non-plan (borrowed) capital is taxable.  Many funds have a small debt component that is purely used for rapid access to fund new opportunities.  That structure might not create much taxable income.  If the fund itself is largely leveraged, more of the income would be taxable and it may not be a particularly beneficial investment for a retirement plan.  You may want to consider non-leveraged funds as a result.

Speak with your licensed tax advisor for questions related to a specific analysis of debt usage and tax implications within a fund investment you may be considering.

In Summary

Real estate debt funds can be a good asset to hold within your retirement portfolio.

A self-directed IRA or Solo 401(k) gives you the flexibility to hold such note funds or other alternative assets as a means to diversify your portfolio.

Performance of note funds is decoupled from the stock market news cycle.

Note funds are a very passive form of investing well suited to busy investors who may not have the time or network to manage direct investment opportunities.

The income produced is consistent, with regular access to distributions.  Compared to other fixed-income investments such as bonds, the rates of return are generally superior, though there is a greater degree of risk.

Capturing interest income inside the tax sheltering environment of a retirement plan can be a more tax-efficient way to participate in these opportunities.