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Private Real Estate Funds: Structuring for a Winning Deal

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Structuring Private Real Estate Funds

Forming a private real estate fund provides a means for the successful real estate developer to access a dedicated pool of capital to fund new investment deals without having to raise capital on a deal-by-deal basis. This article provides an overview of some of the key structural considerations related to the formation, launch, and operation of a private real estate fund.

Private real estate funds enable managers to pool capital without having to navigate the cumbersome securities registration process involved in launching an REIT (Real Estate Investment Trust) or other publicly-offered investment fund. Despite the relative ease of implementation, private real estate funds are structurally complex and sophisticated investors will expect to participate on terms that not only align interests between the investor and general partner/ sponsor, but that also reflect current market trends.

If you have questions about the process or costs to launch a private real estate fund, or are ready to start a fund, we invite you to contact us to schedule a complimentary consultation.

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 experienced 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 regular intervals determined by the fund’s sponsor. However, the illiquid nature of a private real estate fund’s investment assets often makes the open-end structure unworkable since it presents the fund with the dual problems of establishing a fair value for each contributing and withdrawing investor. 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.

If managed properly, a private real estate fund’s investment assets should 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 flexible withdrawal rights can cause significant 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, several problems arise with this option, including:

  • forced sales generally result in substantially reduced sale proceeds
  • sales transaction can take a considerable amount of time to consummate
  • 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 investments are already encumbered. Current market conditions have also made the availability of debt financing rather scarce in comparison to pre-financial crisis market conditions. Additionally, each of the two options mentioned previously can adversely impact the performance and risk profile of the fund for each investor that does not withdraw. Real estate fund sponsors should carefully match the liquidity of a private real estate fund’s investment assets with the withdrawal rights offered to the fund’s investors.

 


If you’re ready to begin the process of structuring private real estate funds, or you’d like to receive additional information regarding the timeline or costs involved in structuring funds, schedule a complimentary consultation today.


 

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 investment subscriptions. The remaining amount of each investor’s capital commitment is periodically “called down” by the fund. The capital call structure recognizes that most private real estate funds will be unable to precisely time the closing of the fund and the full deployment of all of the fund’s capital. The fund may also be making real estate investments where:

  • a substantial amount of time is required between the fund’s commitment to purchase the investment and the consummation of the underlying transaction, or
  • 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 critical to a private real estate fund’s ability to fund its investments, the contribution of capital also generally starts the clock running on the “preferred return” that the fund will pay to the 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 the fund’s manager/ sponsor is often referred to as the “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:

 

  1. investors will receive a return of their capital contributions
  2. investors will receive a preferred return, calculated on the total amount of their capital contributions while such sums are held by the private real estate fund
  3. the fund’s manager/ sponsor will receive an allocation equal to a portion of the total preferred return allocated to the investors (usually in the same percentage as the profit split and referred to as the preferred return “catch-up” or sponsor/ GP “catch-up”)
  4. finally, the remaining profits are split between the investors and the fund’s sponsor

 

While no fund can ever guarantee 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 manager/ sponsor is 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 or fund investments. The purpose of including a preferred return “catch-up” in a waterfall is to allow a private real estate fund’s general partner/ sponsor to have some participation in the fund’s profits, so long as the preferred return has been allocated to the investors. The catch-up feature ensures that the profits resulting from a 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 manager/ sponsor.

Some funds will employ a “clawback” mechanism as a check against any over-allocation to a private real estate fund’s sponsor group. Clawback provisions take many different forms, but they generally serve as a contractual obligation of the fund’s manager/ sponsor to return any and all profit allocations it receives, in the event that:

 

  1. any investor does not receive both (A) a return of the investor’s entire capital contribution, and (B) the entire preferred return on invested capital; or
  2. the total amount allocated to the general partner/ sponsor 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. A private real estate fund sponsor must closely consider the fund’s 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 early investment assets 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 the fund’s investment assets differently than the proceeds from the sale of the fund’s investment assets, such that the waterfall for current income does not include a return of capital. 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.


If you’re ready to begin the process of structuring private real estate funds, or you’d like to receive additional information regarding the timeline or costs involved in structuring funds, schedule a complimentary consultation today.


 

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. Real estate funds generally charge investors a fixed management fee, based on a percentage of the fund’s assets under management, to cover the manager’s costs of operating the fund. General fund expenses are also typically factored into the overall net profit or net loss available to investors. For example, if a private real estate fund contracts with a third-party to serve as a property developer, general contractor, or property manager for the fund’s investment assets, rather than utilizing the fund’s general partner/ sponsor in such roles, investors may question the purpose or amount of the management fee.

Certainly, conflicts of interest may arise when a fund’s manager/ sponsor does provide development or property management services to the fund and care should be exercised to fully disclose any and all amounts that the fund may pay to the fund manager and its affiliates. It is often helpful for a private real estate fund to consider a more customized compensation system for its general partner or manager in order to better align the interests of all parties. More complex compensation structures include fully-disclosed acquisition, development, and disposition fees, fixed limitations on total fees and expenses payable to the manager, and limitations that provide that ancillary fees will only be paid from the fund’s cash flow when it is ultimately distributed to the investors. In any case, investors must be given detailed disclosure regarding any compensation to a private real estate fund’s manager/ sponsor or the sponsor group risks significant potential liability as a result of non-disclosure.

Operational Considerations

By their nature, private real estate funds often reflect many of the characteristics of traditional operating businesses. The sponsor’s principal managers and employees must consider numerous operational issues that generally don’t arise in the course of operating other, open-end private 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 be subject to property taxes and other ongoing taxes and assessments. Successful real estate fund sponsor groups plan for operational challenges in advance to allow the fund to achieve its objectives and return capital to investors.

Conclusion

The process to launch a private real estate fund involves navigating a variety of structural complexities and business challenges. Presenting investors with an offering that is not consistent with current market imperatives will make the process to raise investor capital substantially more difficult. In what has become an increasingly competitive environment for investor funds, only those sponsors that take a thoughtful approach and present a coherent value proposition will succeed to build long-term value in a private real estate fund complex.

Ready to Start a Real Estate Fund?

If you’re ready to begin the process to start a real estate fund, please contact us to schedule a complimentary consultation to answer any questions that you may have and to learn more about the timeline and costs to launch your fund.

 


Additional articles you may be interested in reading:

Structural Distinctions Between Private Equity Funds & Hedge Funds

Launching An Incubator Hedge Fund



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