Key Considerations for Starting a Real Estate Fund – Part 2

This is Part 2 of Key Considerations for Starting a Real Estate Fund that was published on June 9, 2021. 

Sponsoring a real estate fund can be highly rewarding, both financially and personally, but it can also be a costly and complex undertaking. As you start planning, keep in mind the following steps managers should follow to successfully launch a real estate fund.

Raising Capital

You’ll need to raise enough capital to ensure that the fund can cover start-up expenses and ongoing administrative/professional costs while generating acceptable returns for you and your investors. Although there is no minimum amount of capital required to start a fund, as a rule of thumb, a minimum of $15-25 million in capital is needed. Potential investors will also want to see a “meaningful” contribution from the fund manager (or fund management group) to better align their interests. Based on our experience and industry standards, fund managers have generally provided at least 1% to 3% of the fund’s total capital commitments, or have contributed an existing asset to the fund, generally at a discount to the fair market value to entice investors.

Additionally, you will need sufficient funds of your own to carry the start-up expenses, which can be significant, during the fund’s formation period. Start-up costs include marketing costs to capture and present your investment strategy, historical returns and your experience; attorney fees to draft legal documents, and accounting fees to assist you with tax structuring. In marketing your fund, it’s important to articulate the fund’s vision clearly and ensure that investors’ interests are aligned with that vision.

It is important to contact your current investors and ask for a soft commitment, making sure they understand how investing in a fund is different than investing in a direct, single-asset syndicated investment. For example, they will not have a say on the specific properties the fund invests in and they will participate in all of the fund’s investments.

If you need new investors, options include institutional investors, such as pension funds or other large funds that have allocated capital to other emerging managers, but be aware that, depending on the extent of your experience, your “anchor” institutional investor may demand additional economic interests in the fund or the general partner. Another option is to market your offering or “generally solicit” funds from the public. Understand, however, that this approach raises securities law issues that will likely limit participation to “accredited” investors who meet certain net worth and income thresholds, a potential obstacle to investments by friends and family. In 2020, the Securities and Exchange Commission did amend the long-standing definition of an accredited investor, broadening the categories of individuals and entities that meet this definition.

At some point, while raising capital for your fund, you will most likely be asked by one or more potential investors to enter into a side letter. A side letter is an agreement between the fund and an investor to vary the terms of the limited partnership agreement for that particular investor. Some of the most common side letter requests from investors are to take profits-interest ownership in the general partnership to participate in future fees, for a partial or complete waiver of the fund’s fees (management fee, carried interest, or both), to reduce the lock-up requirements (which would give these investors the right to withdraw capital at an earlier date than other investors) and “most favored nation” clauses (which would, in essence, give that investor the right to obtain any benefit granted to other investors via a side letter). Tread lightly and carefully when assessing each side letter request from potential investors and seek legal assistance in drafting and negotiating such agreements.

If any of the investors are foreign, various compliance issues will need to be considered.

Fund Expenses, Fees and Distribution Waterfall

One of the most important questions to address when forming your real estate fund is to understand the fees that will be borne by the management company and the fund, and to set the fees that will be charged to your investors by the fund. Well thought out and sound real estate fund offering documents contain terms that look to protect the fund manager and that are amenable to potential investors. Accordingly, the following will focus on real estate fund industry best practices regarding fund expenses, fee terms, and distribution waterfalls.

• Fund Expenses – Expenses such as legal, fund administration, tax preparation, and audit fees are generally the costs to set up and run a real estate fund. The fund generally bears expenses directly related to forming and operating the fund. Overhead expenses are typically the responsibility of the fund manager. Your fund documents should clearly state which expenses will be borne by the fund and its investors and which by the fund manager. Quite often an expense cap is placed on the number of expenses that can be charged to the fund, with the excess to be paid by the fund manager.
• Management Fees – Real estate fund managers generally charge their investors an annual management fee as well as an incentive fee (also known as performance fee or carried interest). Management fees typically range from 1.5% to 2.00% and are charged either on committed or contributed capital. Incentive fees (also known as carried interest or promote) range widely and represent an allocation of appreciation of assets or net profits by the fund. However, in order for the fund manager to begin receiving carried interest, the fund must first achieve a stated hurdle rate (also known as the preferred return).
• Incentive Fees – Once the fund’s administrative expenses have been covered, there are many ways to allocate the fund’s profits, including a carried interest allocated to you. A carried interest is a disproportionate share of the fund’s profits above a predetermined return threshold allocated to the fund manager. The most common ways to allocate the carried interest are:

1. The European waterfall is where the carried interest is calculated at the fund level across all portfolio company deals. In this scenario, the fund manager does not begin to take any carried interest until the fund has returned all limited partner contributions across all portfolio company deals, and has delivered the preferred return.

2. The American waterfall is calculated on a deal-by-deal basis whereby the fund manager is compensated for each successful deal. This allows the fund manager to begin taking carried interest earlier in the life of the fund, but can also result in the fund manager receiving carried interest on a fund that is underperforming its preferred return (or hurdle rate), as long as there are individual portfolio company deals that have outperformed the preferred return. For funds that use the American waterfall, a clawback provision is needed and should be included in the fund offering documents. Such a provision allows investors to recoup the carried interest at the end of the fund’s life if the fund underperformed in total and the fund manager collected more than its share of the overall fund’s net profits.

• Distribution Waterfall – This defines the economic allocation of the incentive fee. There are four primary components to a distribution waterfall, although the catch-up provision is not always present, and the return of capital and the preferred interest provisions are sometimes reversed:

1. Return of Capital – All distributions go to the fund investors until they have received back their fully-committed capital contributed to the fund.

2. Preferred Return – Fund investors will continue to receive all distributions until the fund has achieved its preferred return (or hurdle rate). These percentages can range from 6% to 12% of the investor’s contributed capital, are compounded annually, and are generally defined in the fund’s offering documents.

3. Catch-up Provision – Once the fund has returned all capital to its investors as well as the preferred return, the fund manager (general partner) is then able to start collecting carried interest. This is generally calculated by going back to the first dollar of net profits of the fund and allows the fund manager to retain most of the fund’s future profits until it has received its stated share of cumulative distributions, with a 20% catch-up hurdle being a common percentage.

4. Remaining Distributions – After the fund manager has received its carried interest for fund returns beyond the preferred return, and the catch-up provisions have been satisfied, all remaining distributions are then allocated between the limited partners and the fund manager at the rate specified in the fund offering documents. For example, if the first hurdle is 12%, any profits above this hurdle rate would be allocated 80% to the limited partners and 20% to the fund manager.

Audits and Taxes

You will need to engage an accounting firm to perform an annual audit of your fund and to prepare the fund’s tax returns (including Schedule K-1s that you will need to provide to your fund’s investors). It is prudent to meet with a firm like Anchin that is experienced with start-up real estate funds before you finalize your legal documents so that you can discuss and better understand the tax issues involved with your particular fund strategy, fund investors and investments. These include reviewing fund and related entity structures, identifying requisite Federal and state tax filings, potential issues related to foreign investors, foreign investments, retirement plans, beneficial tax elections, your plan for manager and employee compensation, and the overall tax impact of running your fund. Preferably, you should look to hire a firm to partner with that not only covers the basics for your accounting needs, but is also capable of helping as you grow your fund. The firm should be actively working with you to minimize tax exposure and to consult and advise on your operations. We suggest looking for a firm with a strong reputation of working with emerging managers, as larger accounting firms may not be initially focused on your start-up needs. A coordinated and experienced audit and tax team focused on your business and personal needs are what you will need as you launch your new fund.

These are the financial implications and issues to consider when  starting a real estate fund. Perhaps the most important words of wisdom are that you need to be realistic about the significant investment of time and energy — not to mention seed capital — necessary to get a fund off the ground and oversee its operations. A fund of this sort requires partnering with experienced professionals and a tremendous effort to refine your business strategy, develop your business plan and build your team.

For more information about what is involved in launching and operating a real estate fund, please contact a member of Anchin’s Emerging Manager Platform or your Anchin Relationship Partner.