How Do I Start a Real Estate Fund?

A private real estate fund is managed investment fund that invests entirely in real estate. Generally, the fund allows investors to pool capital together for investment by a real estate developer who manages the fund. Like most investment funds, the structure and operations can be quite cumbersome. Fortunately, the real estate investment fund is generally capable of exemption for the onerous reporting requirements generally associated with Real Estate Investment Trusts.

In this article, we discuss the structure of the fund and the process necessary to make it operational.

Entity Types and Fund Structure

The investment fund is generally organized as a limited partnership (LP). The LP entity form allows for limited partners who are passive investors in the fund and general partners who actively manage the fund. Importantly, the limited partnership allows for pass-through taxation (profits and losses pass through directly to the partners). There are no entity-level taxes applicable to the entity. Generally, the limited partnership is either formed in Delaware or the state in which the real estate is held. In any event, the LP may be required to register as “carrying on business” in the state where the real estate is located.

The general partner or partners in the fund are the individuals or entities who raise the funds and who manage the funds. There are often two general partnership, one is the fund sponsor. This individual (or more commonly a business entity - an LLC) invests personal funds into the LP and raises funds from others. The second general partner is the fund managers. This may be an individual or a business entity who specializes in real estate and money management matters, such as property management, funding transactions, etc.

Investment Fund Model

The real estate sponsor for the trust is often the first investor. This signals to other potential investors (the limited partners) that the general partner has a personal stake in the success of the fund. The general partner must then convince the limited partners to invest. The partners will generally need to have confidence in the general partner(s) and understand the objectives and structure of the fund.

Real estate funds are highly illiquid (difficult to get your money out before the fund closes). This is because of the long duration associated with purchasing, developing, and selling real estate. A fund may be open-end or closed-end.

Open-End Fund - This type of fund allows investors to invest in and exit the funds subject to the discretion of the fund sponsor. The fund sponsor may delineate time periods, metrics, or transactional events that allow a limited partner to invest or withdraw her funds. Open-end funds are not popular structures for real estate funds. Allowing investors to enter and exit causes problems establishing a fair market value for the interests of the limited partnership being purchased or sold by the investors. At the beginning of the fund, everyone’s assets are equal in value. As the fund proceeds to invest, the underlying property gains or loses value. As such, each limited partner’s ownership percentage of fund rises or falls in value. Determining a value at which to sell additional interests is very difficult and expensive (the process would involve an detailed audit and valuation). The same goes for cashing out existing limited partners. Also, the fund is pretty illiquid. Allowing investors to cash out at will requires the fund to either liquidate assets (which can be very costly and time consuming) or to borrow against the fund assets (which creates a debt obligation that must be repaid). As such, the closed-fund model is a difficult (and fairly unpopular) model for running a real estate fund.

Note: Funds that use an open-end structure generally employ an investing technique known as “side pockets”. This is where early investors in the fund invest in specific real estate project. Later investors are not permitted to invest in the earlier real estate project. They can only take part in present or future real estate investments. This relieves the need for valuing real estate that has appreciate since being acquired by the fund.

Close-end Fund - A close-end fund generally requires all investors (limited partners) to join the fund at the beginning or formation of the fund. When the fund closes its funding drive, it is closed to new investors. The fund may be structured to allow distribution of capital at various intervals or upon the reaching certain metrics or undergoing specified transactions.

Initial Capital Contributions and Capital Calls

As previously discussed, the limited partners provide the initial investment of capital into the fund. Generally, the investors make an initial capital contribution at the inception of the fund. The investor also promises to invest addition funds at a later date in time. These are committed funds. When the fund is in need of the capital to make an investment, it will “call down” these funds from the investor.

The reason for this structure is to allow for closing of the fund without calling all of the capital up front. It generally takes time for the fund to allocate the capital into real estate investments. There are several reasons for this.

• It takes a while to identify approbate deals.
• After committing to purchase real estate assets, it may take a substantial amount of time to close the deal.
• If the underlying real estate is being developed, the fund will make periodic payments toward the property development - not all payments are made up front.

So, until the money is needed, the investor retains the funds to earn interest or deploy elsewhere in the meantime. Remember, the investors have an expected rate of return from investing in the real estate fund. Generally, the “preferred return” period begins to run when the investor actually transfers capital to the fund.

Rights and Interests of Limited Partners

This requires a number of considerations with regard to how handle revenue from holding or selling the fund’s portfolio assets. The fund may retain all of the revenue until the end of the fund’s life. Or, it may allocate the realized revenue periodically. This decision should be based upon the operational characteristics of the fund.

Regardless of when the profits are distributed, the fund will have to establish a method for compensating the limited and general partners of the fund. The compensation structure is generally known as the “waterfall”. The waterfall may be structured uniquely for any fund, but the general approach is as follows:

◦ Management Fees - Generally, the fund managers are paid a fee based upon the amount of capital under management (generally 1-3%). These funds are used to cover the costs of managing the fund. It may include research costs, transaction costs, development costs, property management costs, employee salaries, etc.

◦ Return of Capital Contribution - Investors receive a return of their capital contribution before any other proceeds from sale of assets is distributed.

◦ Preferred Return - Investors will then receive a preferred return based upon the amount of their capital contributions from the time that capital is transferred into the fund.

◦ Sponsor Catch Up - The fund sponsor then receives a preferred return (a specific percentage of the preferred return allocated to investors). This amount is generally based upon or matches the profit split between the general partners and limited partners.

◦ Profit Split - After capital is returned and preferred returns paid to the investors and fund sponsor, any additional profits are split between the sponsor and the investors in some pre-determined percentage.

This allocation seems very simple at first glance. The difficulty arises when the fund distributes capital to investors at various stages of the fund life or upon sale of specific fund assets. If the manager makes an error in assuming future asset returns, it may be the case that she distributes capital to a sponsor before the investor has received her preferred return. In such an instance, the fund generally employs a “clawback”. Another situation that requires the fund sponsor to return any funds received if it somehow receives more over the life of the fund than is agree upon as a profit split. In either case, the sponsor must return the funds to be redistributed among the investors and sponsor.

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