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.
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.
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.
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.
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.
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.
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.
Matters to consider
DOES THE TEAM HAVE A TRACK RECORD TOGETHER?
WHO WILL TAKE WHAT ROLES?
BUILDING THE TEAM Do you have someone in place to fulfil the CFO role?
WHAT IS THE FUND STRATEGY – IS THIS REPLICATED IN THE TRACK RECORD?
WHAT SORT OF STRUCTURE AND DOMICILE WILL THE FUND TAKE?
ARE YOU USING AN OFFSHORE FUND?
WHAT REGULATORY APPROVALS WILL BE REQUIRED?
WILL A PLACEMENT AGENT BE USED?
WHICH FIRM OF LAWYERS AND AUDITORS WILL BE USED?
PREPARATION OF PITCH BOOK AND PRESENTATION PRACTICE This will be taken care of by the Placement Agents if being used
BUILD ELECTRONIC DATA-ROOM
PREPARATION OF INVESTOR REPORTS – MAY BE REQUESTED DURING FUND RAISING
PREPARATION OF LEGAL DOCUMENTATION This will be done by the Lawyers –
OBTAIN REGULATORY APPROVALS
OPEN BANK ACCOUNTS It is now taking much longer for account openings with intense scrutiny being undertaken by most banks. This should be borne in mind in the launch timetable.
CARRY OUT INVESTOR DUE DILIGENCE AND KYC Investor DD must be carried out at the time the investor joins the fund and then on an ongoing basis – at least annually