Real estate investors who want to scale up their business might consider creating a real estate investment fund. A fund allows other investors to submit capital that is used to purchase real estate properties within a structured environment (i.e., the fund).
Creating a fund doesn’t require the same costly restrictions and regulations as a public REIT. The fund follows its mandate, and as it succeeds, so do its investors. But what is involved in setting up a real estate fund? Let’s find out.
Initial Formation
A private real estate fund doesn’t require SEC registration, which is very costly in fees, legal expenses, and time. Adherence to SEC regulations is a different ball game from private placements/memorandums (i.e., private funds).
Initial set-up costs can be $10,000s. This cost is mostly the legal cost of creating the fund. It includes the necessary documents and entities. Documents consist of the partnership and offering memorandum.
Fund entities consist of the following:
- Fund — Limited partnership or LLC, usually formed in the state of Delaware.
- Investment Management (IM) — Formed as LLC that manages the fund. This entity also collects a management fee.
- General Partner (GP) — Formed as GP and is a managing member of the LLC. Collects carried interest fee.
Investors in the fund are called LPs (limited partners).
A real estate fund is a pooled investment structure. Investors put money into the fund and leave it to the sponsor to choose properties based on its mandate (outlined in the offering memorandum). Investors have no say in the properties that are chosen.
Sponsor’s Role
A sponsor is the manager of the fund and is basically responsible for everything. In many cases, the sponsor may be an investment firm. The benefit of a firm is that they have a team of analysts and can potentially provide more thorough research.
It’s important that the sponsor has a good track record and experience, which investors will be looking for.
Fund Fees
Similar to hedge funds, real estate funds charge a 2% management fee and a 20% incentive fee (i.e., carried interest or promote). The management fee goes to the sponsor and is used to pay for salaries, expenses, and other operating costs. This fee is based on AUM (assets under management). So a $10MM fund with a 2% management fee will charge $200,000 annually.
The incentive fee is based on profits. If the fund returns 15% in a year, the sponsor will take 20% of those returns. If the fund breaks even for the year or has a negative return, the sponsor does not earn an incentive fee. In the case of negative returns, there may be a clawback where LPs can take back part of the incentive fee.
Sponsors may also charge fees for acquiring and selling properties.
Financing Structure
From an investor's point of view, real estate funds can be financially structured in two primary ways — debt or equity.
A debt-based fund pays regular interest payments, assuming everything is going to plan. The debt is also secured by the property. Because the debt is secured, investors should get their principal back if the fund fails. A drawback of a debt fund is that there is no upside participation. If property held in the fund appreciates, investors will not be able to participate in the appreciation.
Equity investors have the benefit of being able to participate in property appreciation. This can be in addition to any distributions (from rents). However, it is a more risky place in the capital stack since equity investors are often wiped out if the fund fails.
Fund Strategy
There are many strategies for real estate funds to choose from. The following are a few:
- Distressed Asset Funds
- Structured Finance Real Estate Funds
- Joint Venture Real Estate Funds
- Real Estate Development Funds
- Multi-Strategy Funds
Most real estate, private equity, and venture capital funds use a closed-end structure. Closed funds don't allow redemptions or additional capital contributions. These funds also have a fixed duration, generally 5-10 years. Closed-end funds are common with illiquid investments.
Investors receive their principal once the fund sells its assets, which is a terminal event (i.e., the fund liquidates). Until then, investors may receive distributions from cash flows (i.e., rents).
Creating a real estate investment fund is a big undertaking. It requires a lot of legal input, willing investors, and a solid strategy. Those with potential investors lined up may have a quicker start. Otherwise, the capital-raising journey can be very long.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Holdings will generally be illiquid until which time they are converted to OP units. Even after exchanging into the OP units, repurchase of the OP units by the REIT Sponsor is at their discretion via their share repurchase plan which may be modified, suspended or terminated by the board of directors of the REIT at any time.
