In its simplest form, a real estate fund is a structure established to raise equity for real estate projects. It can be set up as a debt or equity investment vehicle with multiple investors who jointly contribute capital to the fund in exchange for limited liability company (LLC) interests or as a limited partnership (LP) with a single general partner and several usually passive limited partners. In some cases, the fund may be established as an additional layer of ownership, but not a separate legal entity, where investors contribute capital directly to the underlying properties.
Real estate funds have been growing rapidly in recent years as investors are looking for uncorrelated asset classes offering handsome returns. The increase in availability started with the JOBS Act for small business, but the structure also allowed real estate investors to use the strategy to get into bigger deals and provide a safe vehicle to protect their investors.
Essentially, a real estate fund is a partnership, established by experienced investors, to raise money (also known as “equity”) for real estate projects. Similar to other pooled investments such as mutual funds and exchange-traded funds, private real estate funds provide investors with the opportunity to spread their risk by investing in a variety of different real estate assets rather than single properties. However, unlike investing in publicly traded securities, private equity funds are not required to disclose their holdings or financial performance so long as they raise under a specific amount of capital. These types of funds are focused on marketing to accredited investors.
How does one go about creating a structure, blessed by the Securities and Exchange Commission (SEC) to raise equity for ongoing real estate investment?
Funds are a reality in the world of real estate investing for those who find the right people to work with and to legally structure and file or register the structure. In its simplest form, a fund is a legal entity formed by people coming together with the desire to earn money through real estate investments. The purpose of this post is to go over some of the key strategies and structures you can use when forming a partnership to fundraise or raise equity for ongoing deals.
Private equity or debt real estate funds are investment vehicles that are created and organized to invest in a single specific sector or industry. The two most common private equity real estate funds and the structures that they utilize include a limited liability company (LLC) or a limited partnership (LP). Only IRS regulations can accurately dictate which structure is required by your specific situation, but in both cases, it is best to work with a CPA who can guide you through the entities that are best for you. A proper fund is also filed or registered with the SEC, and the sponsor or fund manager is responsible to follow strict guidelines enforced by the SEC. These rules and regulations protect the investor, the fund manager and the investment itself.
A private equity/debt real estate fund can be structured as a portfolio of income-producing real estate that is owned by a fund OR it can be structured for one project at a time. The purpose of these funds is to yield returns for investors, typically through the purchase of distressed properties, affordable housing or other income-producing properties, like stand alone commercial buildings, land or even industrial. When establishing a private equity/debt real estate fund, there are several strategies and structures to consider before making a final decision.
Admission and Withdrawal of Investors
One of the basic considerations with private real estate funds is whether the fund should be an open- or closed-end fund structure. Both of these structures have their advantages, and the right choice will depend on multiple factors (such as liquidity needed, investor base, etc.).
The open-end structure of a real estate fund allows investors to enter and exit the fund at regular intervals which also allows the sponsor to raise capital from a broad base of investors. It doesn’t allow investors to reimburse the fund or invest additional funds if they want to increase their exposure. it also exposes investors to greater tax risk.
The closed-end structure, on the other hand, allows investors to increase their exposure by reinvesting distributions as well as receive returns of capital, which reduces an investor’s overall equity in the fund, which is a tax advantage.
The third option is to create “side pockets” for the fund. This structure can also help manage some of the conflicts investors may have with one another by allowing them to participate in investments according to their preferences for risk or return.
What is the difference between General Partners and Limited Partners?
A general partner (GP), often called “Sponsor” limited partners (LPs) referred to as “Investors”. General Partners are responsible for managing and controlling the risks, taking care of day-to-day matters and approving decisions while Limited Partners make all investment decisions but usually have no responsibility for the management of the partnership.
What roles do sponsors and investors play in the real estate private fund?
The first step in forming a real estate private equity/debt fund is identifying the key roles to be played by all the participants involved. These include the sponsors or fund managers and their investors. You can structure your real estate fund as complicated or as simple as you like.
Sponsors: The sponsor is a person/company that provides the legal structure of the fund, hiring an investment manager to run it, raising capital from investors, and providing ongoing support and project management. Investors: Investors provide capital to the fund, expecting that they will get their money back (plus interest) when they sell their shares.
The sponsor is a firm/or individual which set up the fund. It is also known as an investment adviser, or a fund manager. The sponsor looks for potential deals and performs due diligence on them to determine if they are worth investing in. The sponsor has the responsibility of gathering money from a number of investors, which will then be used to finance the acquisition of new assets. He/she/or the group of fund managers may also help to manage the assets once they are acquired.
Investors come into play after the sponsor has put together the initial capital for the fund, meaning the legal fees to get the legal work done by a Securities Attorney who is licensed and the fees to file Form D with the SEC.. These investors are typically wealthy individuals who have an interest in real estate as a way to diversify their portfolios. We call these people accredited or sophisticated. Depending on the type of fund you chose, you are regulated to only accept money from accredited investors and/or sophisticated investors. Investors will have one or more different reasons for wanting to get involved in your fund, so be sure to ask them about their goals before taking their investment.
(We can review the different real estate funds and how you qualify an accredited investor later in the conversation. This is important information.)
Benefits of private equity real estate funds
Private equity real estate funds offer several advantages to investors who want to gain exposure to real estate assets without the complications surrounding direct ownership. Some of these advantages include:
1. Potential for Higher Returns – As a general rule, public equity markets do not offer the same returns on investment as private ones. In fact, according to PwC, the average return reported on public equities was 5% during 2016-2021, while that on private equities was 10%.
2. Access to capital: Funds provide access to capital that might not be available from other sources, such as large institutional investors and insurance companies. For example, a small retail developer might not qualify for a bank loan because of insufficient collateral or personal guarantees; however, an experienced private equity fund manager can secure the necessary financing by assembling a group of investors with sufficient financial resources to provide the developer with greater assurance of repayment.
3. Diversify Holdings: Private equity funds have the ability to diversify holdings across different locations and property types. This allows the investor to reduce risk by spreading their capital over multiple properties. By diversifying holdings, an investor can limit exposure to any one particular investment and avoid losses that may be incurred if a single property underperforms or loses value.
4. Manageability: A fund allows you to manage a large portfolio of properties from afar, hiring competent management and agents to handle all aspects of ownership from rent collection and maintenance to property acquisition. This also relieves you of the responsibility of finding new tenants when leases expire and budgets are tight.
5. Returns: Your returns are more likely to match their expectations and remain stable over time. Plus, you have greater leverage when it comes to negotiating rental rates because your income is guaranteed by the larger investor pool.
6. Flexibility: Fund investors are typically focused on long-term growth rather than short-term profits; this allows for flexibility in how the properties are managed, enabling new approaches that might not work for individual owners. You may find that your investors actually invest themselves; therefore, with these structures you can make it simple for them to request a cash out. This is a bonus for many investors. Instead of holding their capital for 5+ years, you have the ability to cash them out faster. For example in the funds we consult on we write that an investor must give 12 months notice vs. many competitors who are at 3-5 years notice. This is very valuable to investors.
Five Key Considerations
The following five considerations can help you form your fund in an efficient manner, while minimizing risk and maximizing returns:
Purpose: The purpose of the fund will determine what kind of assets it will buy. A fund formed with the purpose of holding income producing assets will follow different criteria than a fund formed for capital appreciation. The former will want assets that are cash flow positive, while the latter might be willing to take on additional risk for the sake of higher returns. Working with an experienced consultant will give you the creativity to write in for BOTH types of assets.
Economic Objective: Most funds are structured as private investment limited partnerships or LLCs. If a specific tax exemption is needed, such as the ability to deduct losses against other income, then a purpose-built vehicle such as an REMIC (real estate mortgage investment conduit) or QPAM (qualified publicly traded partnership) may need to be created. We can discuss your goals for the short term and long term. Experienced investors know that the short term goals are where we live and breathe.
Fund Type: This refers to the type of investor that will participate in the fund; for example, high net worth individuals or institutional investors like pension funds, insurance companies or corporations. The choice can impact how you structure the fund and how much leverage is used in transactions. We also examine your Network. If you have a Network of 50+ people who have potential in investing with you, we may advise a Regd 506b. This type of fund allows you to take potential investors you have a pre-existing relationship into the fund, including 35 sophisticated. If you do not have a Network and need to raise capital quickly we may guide you to a Regd 506c so you can publicly solicit. With this type of fund you must only accept accredited investors.
Capital Allocation: This refers to the balance between debt and equity investments within a transaction; for example, purchasing a $5 million property with only $1 million in equity would result in more leverage.
Capitalization table: This is a critical document because it lays out the capital commitments of each investor and sets forth key lifecycle events such as lock-up periods, when investors are not able to withdraw their money from the fund, and distribution windows, when investors can request distributions from their capital accounts. Each investor must enter into an individual side letter with the manager that spells out its particular capital commitment and rights related to the timing of investments and distributions in the fund. For this key consideration we always advise to go with the simple route, but as discussed you can complicate things if you want. A debt fund, paid out twice a year with set interest will be easy to maintain, allow you to always meet the expectations of your investors and allow you to grow with less stress.
Real Estate Fund Structures
Forming a real estate fund requires legal counsel to set up the terms of the investment, including the fund’s strategy and the specific needs and objectives of the fund. You can always go online and buy a boilerplate template to make yourself legal to raise capital, but we can assure you that accredited and experienced investors WILL review your Offering and will expect it to be detailed. Always meet with a professional and always use a licensed and experienced Securities Attorney to create your fund and file/register it correctly with the SEC. If you are not willing to invest in your fund’s Private Placement memorandum (PPM), you will have a hard time raising capital and scaling your business.
It is important to understand that forming a real estate fund does not give a private investor tax benefits such as depreciation or loss carry-back. However, when investing in real estate, depreciation and loss carry-back can be achieved by purchasing the property through an entity such as an LLC or an S corporation.
When it comes to real estate investment structures, there are several common structures that investors can choose from. Some of these include the open-end structure, the closed-end structure and successive funds.
The open-end structure is one of the most common forms of funds, according to Investopedia. In this type of structure, investors are able to invest as much or as little as they want into the pool of capital at any time, but there’s no cap on the amount that can be raised. In this case, there’s no limit on how many investors can be involved in the fund.
A closed-end fund is just what it sounds like — a fund in which a maximum amount has been set for it and cannot be increased once it’s been reached. The minimum investment amount is also set in advance and cannot change.
A third structure is also possible and this is a successive fund. This is made up of two funds: the first being an open-ended vehicle and the second being a closed-end entity. This type of structure allows investors to have ongoing access to capital while still achieving liquidity.
We recommend Regd 506b or Regd 506c.
Need help setting up your own real estate fund? Schedule a Free One-On-One Strategy Session with Cherif Medawar and his team. Cherif has Cracked the Code on RE Funds and is ready and available to assist you in mapping out yours!