Entity Types

Private real estate funds are typically formed using an entity that is either a limited partnership or a limited liability company.  Both of these entity types are known as “pass-through” entities so that they are essentially disregarded for tax purposes and all gains and losses are directly attributed to the limited partners or members of the entity.  There has been a long standing tradition among private investment funds of using Delaware limited partnerships or limited liability companies as the entity of choice.  However, principals should be aware that the laws of many states may deem holding real estate for income producing purposes to be an activity that requires an entity to be qualified to do business in the state where the real estate is located.  In some states, qualifying an out-of-state entity, or a particular type of entity, to do business can be expensive in certain jurisdictions and might not be necessary if some advance planning is utilized.  More particularly, principals should carefully discuss their investment strategy and implementation plans with counsel and consider the benefits and drawbacks of using a particular entity type or jurisdiction for its formation.

Admission and Withdrawal of Investors

Since investments in real estate are illiquid, private real estate funds have many unique structural issues that must be addressed.  An initial consideration is whether to use an open-end or closed-end fund structure.  Many investors favor the open-end structure, which in the simplest form allows investors to enter and exit the fund at any time.  However, the illiquid nature of a private real estate fund’s investment assets tends to make this structure unworkable since it presents the fund with the dual problems of establishing an equitable net asset value each subsequent investor and satisfying withdrawal requests.  Closed-end funds, on the other hand, cause all investors to join the private real estate fund at the same time, removing the issues concerning the initial value of their investments, and restrictions can be crafted to match investor withdrawal rights with the fund’s liquidity profile. 

A private real estate fund’s investment assets are likely to appreciate over time and therefore many early investors would consider the participation of subsequent investors inequitable without some sort of compensation for that appreciation.  The difficulty comes in trying to determine the appropriate valuation for subsequent investors since formal real property appraisals may be the only way to properly assess the value of the fund’s investment assets.  The appraisal process is expensive, can be time consuming and in some circumstances may not be available at all.  One potential solution is for a fund to utilize what are called “side pockets.”  A “side pocket” refers to an internal accounting system where investors essentially participate in a private real estate fund’s investment assets on an investment by investment basis.  Therefore, the valuation of the private real estate fund’s earlier investment assets is not at issue for subsequent investors because they will not be permitted to participate in the profits and losses resulting from the earlier investment assets.

Meanwhile, giving investors withdrawal liberal rights causes very large problems for a private real estate fund.  It is very difficult to provide timely liquidity from investments in real estate assets because there are really only two ways to accomplish this objective.  One option is to arrange for the sale of the real property investment; however, (a) forced sales generally result in substantially reduced sale proceeds, (b) sales transaction can take a considerable amount of time to consummate, and (c) there may not be a ready buyer for the asset or the asset may not even be in salable condition (e.g. if the asset is a partially completed development project).  The second option is for a private real estate fund to leverage its real estate investments.  This option may not be particularly attractive or even available based upon the fund’s existing indebtedness and creditworthiness and whether the fund’s real estate investment are already encumbered.  Current market conditions have also made the availability of debt financing rather scarce in comparison to recent trends.  Additionally, both options can adversely impact both the performance and the risk profile of the fund for each investor that does not withdraw.  Principals should carefully match the liquidity of a private real estate fund’s investment assets with the withdraw rights offered to the fund’s investors.

Initial Capital Contributions and Capital Calls

Private real estate funds possess certain unique capital needs based on the nature of the fund’s investment assets.  Most funds utilize a capital call structure where investors are required to make an initial capital contribution at the time the fund accepts their investment subscriptions and then the remaining amount of each investor’s capital commitment is periodically “called” by the fund.  This structure recognizes that fact most private real estate funds will be unable to precisely time the closing of the fund and the full deployment of all of its capital.  The fund may also be making real estate investments where (a) a substantial amount of time is required between the fund’s commitment to purchase the investment and the consummation of the underlying transaction or (b) development activities are being undertaken and the fund is only required to make periodic progress payments on its investment asset.  Not only is the timing of investor’s capital contributions is critical to a private real estate fund’s ability to fund its investments, it more often than not starts the clock running on the preferred return to the fund has agreed to pay its investors.

Allocation of Profits and Losses; Clawbacks; Return of Capital

Most private real estate funds offer their investors a preferred return together with a split of the fund’s overall net profits.  The structure that specifies the order in which a fund’s profits and losses are allocated among investors and its limited partner or manager is often referred to as a “waterfall.”  Waterfalls vary widely in their structure and operation depending upon a private real estate fund’s investment assets and overall investor profile.  Generally, profits are allocated in the following order: (a) investors will receive a return of their capital contributions, (b) investors then receive a preferred return calculated on the total amount of their capital contributions while such sums are held by the private real estate fund, (c) the fund’s limited partner or manager then often receives an allocation equal to a portion of the total preferred return allocated to investors (usually in the same percentage as the profit split and referred to as the “preferred return catch-up” or “preferred return make-up”) and (d) finally, the remaining profits are split between the investors and the fund’s general partner or manager. 

While no fund can ever guaranty the payment of a preferred return, investors are assured that they will receive the initial profits from the fund’s investment activities before the fund’s general partner or manager are entitled to any allocation of profits.  However, there are a variety of ways to specify the calculation of a preferred return based on the timing of capital contributions and/or fund’s investments.  The purpose of including a preferred return catch-up in a waterfall is to allow a private real estate fund’s general partner or manager to have some participation in the fund’s profits so long as the preferred return has been allocated to the investors.  This feature ensures that the profits resulting from a wildly successful private real estate fund are allocated exactly in accordance with the agreed upon profit split and, conversely, the profits from a marginally successful fund will be primarily allocated to investors rather than the fund’s general partner or manager.  Some funds will employ “clawback” features as a check and balance against any over allocation to a private real estate fund’s general partner or manager.  Clawback provisions take many different forms, but they generally serve as a contractual obligation of the fund’s general partner or manager to return any and all profit allocations it receives in the event that (a) any investor does not receive (i) all of its capital contributions and (ii) the its preferred return on such amounts or (b) the total amount allocated to the general partner or manager over the life of the fund is greater than the agreed upon profit split. 

Private real estate funds can also differ from other types of funds in how and when capital contributions are returned to investors.  Principals must closely consider their investment strategy when structuring for the return of capital.  For example, a fund that is focused on “fixing and flipping” real estate would likely prefer to retain the proceeds resulting from sale of investment asset for future investment activity.  On the other hand, there would be no reason for a private real estate fund focused on the development of a single project to retain investor capital.  Some funds also choose to treat current income generated from their investment assets differently than the proceeds from the sale of their investment assets such that the waterfall for current income does not include a return of capital and the profit/loss allocations are applied.  However, it is important to keep in mind that the preferred return generally continues to accrue on all unreturned capital contributions and it may make more sense for the private real estate fund to return capital to investors at its earliest opportunity.
 
Fees and Expenses and Related Conflicts of Interest

As an investment type, real estate is often susceptible to the imposition of many fees and costs, some of which can appear to be duplicative or improperly allocated to investors in a private real estate fund.  Funds generally charge their investors a percentage of capital under management as a management fee to cover the general partner’s or manager’s costs of operating the fund, but general fund expenses are also factored into the overall profit or loss available to investors.  For example, if a private real estate fund contracts with a third party to serve as the developer, general contractor or property manager for the fund’s investment assets, rather than have the general partner or manager serving in such roles, investors can question the purpose or amount of a management fee. 

However, there can be some resulting conflicts of interest when a fund’s general partner or manager does serve in such roles and care should be used to fully disclose all amounts that the fund may pay to the general partner or manager and their affiliates.  It is often helpful for a private real estate fund to consider more unique compensation system for its general partner or manager in order to better align the interests of all parties.  Such systems could include fully disclosed acquisition, development or disposition fees, fixed limitations on the total fees and expenses payable to a general partner or manager and their affiliates, and making such fees only payable from the fund’s cash flow when ultimately distributed to the investors.  In all events, investors should be provided with detailed disclosure of any system and all such amounts payable thereunder.

Operational Considerations

Private real estate funds, unlike certain other types of investment funds, more often than not contain most of the characteristics of a fully functioning business.  The principals must consider a multitude of operational aspects that simply do not apply in context of other investment funds.  For example, a private real estate fund must be able to provide for the development, improvement, property management and/or maintenance of its investment assets.  Real estate investments also encounter unique requirements for insurance, compliance with state and local codes and ordinances and will usually subject to property taxes and other ongoing taxes and assessments.  Private real estate funds are generally best served to plan for theses and other operational considerations so they can be properly addressed in the fund’s overall structure.