How are Real Estate Funds Structured?
In a previous article, we discussed the different types of real estate funds that are available for investment. That article covered mutual funds, debt funds, private equity funds, and Real Estate Investment Trusts (REITs). These funds can vary widely in scope and complexity. The most simplistic form of fund is an entity that is set up to acquire a single asset. On the opposite end of the spectrum are Real Estate Investment Trusts (REITs), which are public or private companies in which investors can purchase equity (stocks) of the company. This article will focus on a type of private equity fund structure that falls somewhere in the middle of the two mentioned above.
The private real estate fund
As mentioned above, the private real estate fund falls somewhere between a single-asset entity and a complex REIT structure. In order to better understand why a fund is such an attractive structure for so many companies, we need to first look at the structure of a single-asset acquisition and a REIT, covering the two ends of the spectrum.
While a single-asset entity is easy to set up, structure, and operate, it does have some limitations. Each time an investor wants to purchase a new property, a new entity must be formed and new funds must be raised for that entity. Many investors have sources of funds already lined up when they come across an attractive acquisition that limits the amount of time fundraising, but even if funds are easy to come by, the investor needs to go through the legal setup for each new property. In the case the investor must find new sources of capital for each investment, the amount of time spent fundraising for each new deal could be significant and take away from the investors real purpose of finding new properties to acquire.
REITs, on the other hand, are complex legal vehicles that are expensive to set up and operate and come with a significant amount of regulation the REIT must adhere to, such as minimum payouts of dividends that limit the amount of capital the REIT can re-invest to grow the portfolio of properties. However, the REIT structure allows the company multiple ways to raise capital and achieve liquidity.
What do private real estate equity funds do?
Real estate private equity funds can take many different forms and pursue many different strategies, from focusing on a specific niche of real estate in a specific geographic area to a broad approach pursuing different strategies at different times according to market cycles or unique opportunities. But all of these funds go through a similar lifecycle of activities in order to accomplish their business objectives.
The first thing a fund must do is set up the legal structure, including tax, regulatory, and financial considerations that investors consider when determining whether or not to invest in a fund. Funds can focus on specific niches within real estate such as the acquisition of medical office properties or urban multi-family properties. They can focus strictly on the development of new properties or strictly on providing debt or equity funding for the acquisition of properties. There are numerous strategies a fund can pursue. The factors considered are discussed in more detail in the next section and vary widely depending on the strategy of the fund, but to better understand why each factor matters, we need to look at how the fund does what it does.
All firms must first raise capital, regardless of the strategy they’re pursuing. The goals of the fund, legal considerations, and market conditions play a large role in what sources of funding are targeted. Likewise, a good fund will be set up with an awareness of what tax and return goals the funding sources are looking for in the current investment environment. After funds are raised or committed, the fund needs to start looking for attractive investments. Once investments are identified and vetted, the fund will start placing money in those investments, whether that means the acquisition of stable properties, developing new properties, or providing the debt or equity piece of the capital stack to another investment firm. After the acquisition or placement of capital, the fund must manage the investment over its lifecycle.
Finally, the investment is re-captured through the disposition of a property or the return of capital in some other way. Then, depending on the structure of the fund, that capital will be distributed to investors or could be reinvested in other investments the fund is now pursuing.
How are real estate funds structured?
While there are numerous nuances and legal considerations, most go beyond the scope of this article. Thus, we’ll cover some of the more common components here.
Roles – Funds have two major players: the general partner and the limited partners. The investors who contribute capital to the formation of the fund are the limited partners and the fund itself, including the executives, analysts, etc. are considered the general partner of the fund. The general partner (GP) is also sometimes referred to as the manager of the fund. The GP plays an active role in fulfilling all the activities discussed in the section above, “What Do Funds Do,” while the limited partners are passive investors in the fund.
Type of Fund – Funds can be either open-ended or closed-ended. Open-end funds are more appropriate when dealing with investments that are easily tradeable (are traded in an open market with a decent amount of liquidity) and allow investment to come and go at any point. Closed-end funds, on the other hand, are more appropriate when investing in assets with long hold periods and are not easily transferable. Due to the nature of real estate investments, most real estate funds are closed-end funds, so we’ll focus on these for the rest of the article.
Closed-end funds typically have a specific term (for example, five or ten years) with the option to extend under certain circumstances. Investors are usually not allowed to withdraw or contribute additional capital during the life of the fund and receive a redistribution of capital when assets are sold or some other kind of capital event occurs, such as a refinancing.
Term – Closed-end funds usually have a term of around ten years, give or take, and have commitment periods which determine when they can take money in and investment periods which determine how much time the fund has to invest those funds.
Distributions – Closed-end funds typically do not allow investors to reclaim their capital until the expiration of the funds’ term or upon disposition of the funds’ investments. Many funds do have language that allows investors to pursue the transfer of the funds to another party should an investor have a need to divest their share of the fund.
Fund Fees – Most funds charge management fees that are usually a certain percentage of the total funds managed and assist the GP in operating during the initial stages of the investment lifecycle. Management fees usually run between 1% and 2% and can sometimes be offset by other fees such as transaction fees on brokerage, financing, or other activities related to the functions of the fund.
Performance based compensation
The compensation structure for funds can be extremely complicated and based on multiple breakpoints for waterfalls, cumulative vs. deal specific returns, and other factors. Initial returns of capital at the end of a funds’ life is generally done as follows:
- The return of invested capital to investors
- Investors then receive an annual preferred return on their contributed capital
- The GP/manager of the fund receives their return
- Remaining profits are split between the investors and the GP
As an example, if an investor contributes $1 million at the inception of the fund, the investor will first receive that $1 million back. Then the investor will receive a preferred return on that investment. Once the investor has received their entire cumulative preferred return, the GP will receive their portion of the proceeds. If profits exceed a certain breakpoint, then those remaining profits are split between the investors and the GP based on a predetermined distribution scale.
Returns can also be distributed on either a deal basis or a cumulative basis. On a deal basis, any profits are distributed according to the four steps listed above, but are made each time a property is sold. Cumulative distributions are made based on the cumulative performance of the fund.
Advisory Committee – Most funds have valuation or advisory committees that are not part of the company and serve to assist the fund in making investment and disposition decisions. The committee can also make decisions on extending the funds term or how to reinvest proceeds during the life of the fund.
Forming or investing in a real estate fund can be a complicated process based on numerous strategy, legal, technical, tax, and regulatory factors. While this article briefly touched on some of the activities and structures associated with real estate funds, there is much, much more to know before deciding on which fund to invest in.