Fractional real estate investing may seem like a new concept, but in reality, it has been a vibrant part of real estate investing, from rental properties to construction and development, for longer that you might imagine. Beyond real estate, fractional ownership has been utilized to finance and own private jets, yachts and even high-end motor coaches.
As you can infer from the name, fractional ownership involves dividing a high-value asset into several parts, each sold to different owners/investors. Segmenting the ownership creates more affordably priced investments for each of the various owners. Fractional ownership can be used with real estate that a group of owners might use personally (Pacaso currently offers this with second homes, also handling management and scheduling among owners). Fractional ownership can also be used by investors who are taking a more passive approach, by simply renting out a property (either on a short-term or longer-term basis) and splitting the return. It is fairly common for larger real estate deals, including new construction and development, to involve a group of investors who underwrite the 'equity' in the deal, before the deal sponsor, then, obtains one or more types of debt financing to complete the deal.
How Does Fractional Real Estate Investing Work?
Essentially, fractional real estate provides greater flexibility for investors, diversifying their portfolios and risk with other investors. Fractional investing is a way to invest with others and not take on the entire financial risk or operating burden on yourself. To enable multiple owners to purchase a single property, a special purpose vehicle (or "SPV") is established. This is usually an LLC, but can be an LLP or LLLP or other form of partnership vehicle. Once the SPV is established, the owners each invest their 'stake' in the property in return for ownership or membership units in the SPV. This initial investment in the SPV provides the 'equity' part of the financing. If additional financing will be required, often a mortgage will also be obtained, using the initial SPV equity investment as the equity in the property (bringing down the loan to value ratio financed by the SPV).
While the property is owned by a pass-through vehicle, such as an LLC, the equity owners share in the gains and losses generated by the property. If the property delivers positive cashflow, the owners can receive that benefit. The depreciation deductions are also passed-through to the investors. The benefits to the equity owners of the SPV that owns the property are typically passed-through based on each owner's fractional share. Fractional structures for real estate also frequently relies on property management by professional third-party property management that is paid by the SPV as an operating expense.
Why Is Fractional Real Estate Investing Better for Rental Investing?
Investors in rental real estate must consider many factors. What region, state, city will they invest in? What property type are they seeking: multi-family, commercial, single-family, long-term/short-term? Once they have settled on a given property, they must put down a substantial cash amount in equity, often 20%-35% or more. Beyond that initial cash contribution, they will likely, then, obtain mortgage financing. Additional funds will likely be spent to renovate, rehab or improve the property before marketing will then consume time and capital to fill the rental. In addition to substantial cash investment, the investor will spend considerable time in financing and management of the investment.
As the cost of real estate has increased (with rapid appreciation across nearly all asset classes) and with interest rates increasing rapidly, purchasing rental properties can become more difficult. It can be harder to get the down payment for more expensive properties and qualifying for the increased cost financing can also put a burden on individual investors.
When multiple investors are in a fractional ownership group, multiple investors are pooling the equity capital and the SPV will take on the financing, insurance, management and will generally hire a manager to oversee the investment. In this way, fractionally investing can be truly 'passive', or 'hands-off' for the investors, reducing time and stress while increasing success.
Additionally, once the property is purchased, cost segregation studies can be conducted and accelerated depreciation can be passed-through to the owners on a proportional basis. As the rental produces income and cashflow, fractional investors also proportionally benefit. Of course, ongoing depreciation reduces the income tax impact and, when the property is sold, capital gains also flow through to the fractional investors. Since the mortgage will have also been paid down, cash is also distributed at liquidity.
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Does Fractional Real Estate Investing Offer Any Other Benefits?
Flexibility is another important benefit of fractional ownership. Because the SPV owns the property and each of the fractional owners owns a proportionate interest in the SPV, their ownership interests can be more easily transferred. Whether it is for estate planning (transferring the interest to a trust or family member), or selling your interest in the property before the other owners elect to sell the property, each fractional owner has options. Usually, those options will be more well defined in the operating agreement of the SPV, but frequently improved liquidity for each of the fractional investors is an powerful incentive for fractional real estate investing.
Summarizing the Benefits of Fractional Real Estate Investing
- You can invest without requiring a huge down payment;
- You don't need a high credit score;
- You don't need to do it all yourself;
- You don't need experience;
- You won't spend days, weeks or months supporting the process (finding the property, inspections, financing, renovating, renting);
- You can more easily and quickly diversify among multiple properties, markets and strategies;
- Your investment can more easily be transferred or sold;
- Relying on professional management, you save time and headaches and will likely earn a better return;
- You are not taking single-property risk on your own.
Fractional real estate investing has been around for a long time, but has recently become more widely utilized by real estate investors in all sectors and the development of more sophisticated entity structures and financing has enabled this more effective investing strategy to flourish. As costs for both properties and financing have continued to increase, fractional ownership will be an important tool allowing investors to remain active in profitable investments.