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Five questions to ask when setting up a real estate fund

October 24, 2017

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Today’s investors are increasingly interested in real estate as an asset class because it is understandable and tangible.  At the same time, developers increasingly need access to more types of capital for their projects. While this sounds like a win-win situation, the old rules of project financing have been re-written since the Great Recession, so both parties need to proceed with caution. This leaves investors and developers asking: “How do we make this marriage work?”

Developers need to approach this with a well-thought-out plan. Consider:

  • How do you want to use the funds you raise?
  • How you will compensate your investors?
  • How you will compensate yourself?
  • How you will communicate with your investors?
  • How you will be accountable for managing their capital?

Once a developer identifies a need for external capital – typically equity – the threshold question is whether to bring investors in at the project level, or to bring investors into a fund that will provide equity to multiple projects. There are many factors that go into this decision, and for the sake of this article, it will be assumed that the developer has determined that a fund is the preferred investment vehicle. With this in mind, here are ways to approach the above questions.

How you will use the investor’s funds:

The Confidential Informational Memorandum (“CIM”) or Offering Memorandum is the key document that will guide this interaction.  It sets out your investment thesis and strategy, and describes the opportunity, risk factors, target returns, and role and relationship of the manager. It should describe the manager’s track record and experience with the types of properties to be included in the fund. It defines the mechanics of the calling and deployment, and return of investor capital.  Also, any required qualification of investors is described.

Selling investment interests in the fund is a securities offering, so the applicable state and federal rules must be followed. Know what the “market” is for structure, fund life and returns, and get legal advice in drafting the memorandum.

How you will compensate your investors:

The CIM should describe targeted project-level returns, and how those translate into fund-level returns and ultimately cash returns to investors. It will outline allocation of cash flows among the classes of investors, and carried interest or “promote” paid to the manager or developer if the fund’s performance exceeds a baseline threshold. The CIM will set out a timeline for the lifecycle of the fund, and include extension period options.

How you will compensate yourself:

Describe all fees that the fund or its projects will pay to the manager and its affiliates, which could include some or all of the following: investment management, asset management, acquisition, finance, disposition, property management, construction, guarantee/credit enhancement, as well as leasing commissions and carried interests.

How you will communicate with your investors:

The Operating Agreement is the contract, and in it you describe how you will report to your investors, including providing financial statements and the basis of accounting. Note that tax basis is easier and less costly than GAAP, but may limit the types of investors who will be eligible. For example, self-directed IRA/401(K) investors may be excluded. The frequency and timing of reports, as well as level of detail – financial statements only or operating stats on key properties/property categories and market conditions – should be defined.

Regarding tax matters such as K-1s and tax reporting, be clear on expected timing, what the fund is responsible for, and what the investor is responsible for, such as basis calculations, tracking suspended losses, etc. Many real estate projects generate tax losses in the early years. Investors may or may not be able to utilize these losses in their personal returns. The Operating Agreement will describe the allocation of profits and losses, and gains and deductions among investors. If the fund holds property in multiple states, investors may have new state filing requirements. And investors may need to extend their personal returns depending on when K-1s are prepared and delivered.

How you will be accountable for managing their money:

Here again, the Operating Agreement will be the controlling document. It should discuss governance issues such as decision-making authority, transferability of investor interests, distributions, calculations of returns and capital calls. The Agreement should also address dispute resolution.  Ideally, you want your investor group to be eager to recycle their capital with you in your next fund.

Living happily ever after

As in any relationship, establishing a common understanding at the start will go a long way to ensuring happy anniversaries for years to come. To learn more about setting up and managing a real estate fund, contact your CSH advisor, or a member of our Construction and Real Estate team.

All content provided in this article is for informational purposes only. Matters discussed in this article are subject to change. For up-to-date information on this subject please contact a Clark Schaefer Hackett professional. Clark Schaefer Hackett will not be held responsible for any claim, loss, damage or inconvenience caused as a result of any information within these pages or any information accessed through this site.

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