FORMING A REAL ESTATE FUND - Capital Fund Law Group
FORMING AREAL ESTATEFUNDstrategy, structure andinvestment Terms
The private real estate fund strikes a balance between the two ends of thespectrum, enabling a sponsor to raise capital in a pooled fund without beingconstrained to do successive securities offerings on a deal-by-deal basis, andwithout the complexity, scale and substantial regulation of forming a REIT.This white paper discusses some of the key considerations in forming aprivate real estate fund, including strategy, structure, and investment terms.Real estate securities offerings span a broad continuum of size and complexity. The mostbasic structure is a single-asset acquisition vehicle. This is a company formed to hold a singlereal estate investment property. Next is the private real estate fund (sometimes known as areal estate private equity fund, which is the subject of this white paper). A private real estatefund is a pooled investment fund structure intended for the acquisition of multiple propertiesin a blind pool. At the largest and most complex end of the spectrum are non-traded and tradedReal Estate Investment Trusts (REITs), pooled investment vehicles requiring a large numberof investors to satisfy regulatory and tax requirements and generally requiring a substantialasset base to justify the costs of formation and operation.
REAL ESTATEFUND STRATEGIESStructured Finance Real Estate FundsAs is the case with investment funds ingeneral, real estate funds are trending towardgreater levels of specialization. Specializationmay be by asset class, strategy, or both.Examples of asset class-specific firms include:office, retail, medical, industrial, agricultural,storage, hospitality, etc.Structured finance funds, often referred to asleveraged buyout funds, seek to use substantialleverage to purchase real estate that has fairlystable value projections. Structured financefunds are also cyclical in nature, as theyrely heavily on inexpensive access to debtfinancing.Real estate fund strategies can be looselycategorized into one or more of the following Joint Venture Real Estate Fundsgroups:Joint venture real estate funds use aDistressed Asset Fundsstrategy of co-investment with other fundsin a syndicated investment. Joint ventureDistressed asset funds seek to identify funds can sometimes subject the investmentundervalued assets that are over leveraged, advisor to investment advisor registrationsuffer from cash flow issues, or are otherwise requirements,astheco-investmentunable to access needed debt financing. relationship can be considered a security.Distressed asset funds tend to be cyclical,following general real estate market patterns.
Real Estate Development FundsMulti-Strategy FundsDevelopment funds are funds that acquireunimproved land or demolish existingproperty for re-development. These fundsrequire substantial management involvementin working through the various municipalitiespermitting complexities as well as coordinatingthe various stages of real estate construction.Accordingly, development funds requiresubstantial and complex offering documentdisclosures.Multi-strategy funds are the exceptionto the specialization trend. Multi-strategyfunds are not confined to a single investmentstrategy or objective (although they tend to bemore asset-class specific). Multi-strategy realestate funds tend to have a low risk toleranceand maintain a high priority on capitalpreservation. Even though multi-strategyfunds have the discretion to use a variety ofstrategies, we have found that fund sponsorstend to focus primarily on one or two coreinvestment strategies.Opportunistic/ Special OpportunityFundsOpportunistic funds, closely related todistressed asset funds, focus on specialcircumstances where assets are selling at adiscount, such as through buying foreclosedreal estate, unfinished construction, surplusor damaged real estate.
REAL ESTATEFUND STRUCTUREThe structure of a real estate fund isDomestic Real Estate Fund Structuredependent on a number of tax, regulatory,and financial considerations. Fund structureA domestic-only investment fund structureis driven in large part by tax needs of theis typically comprised of the following entities:investors. a limited partnership, typically formedin the state of Delaware, to act as the fund entity(although LLCs are becoming increasinglyReal estate funds are almost always closedpopular);end funds. A closed-end fund is an investmentfund intended to last for a fixed term, usually an LLC to act as the investment managerbetween five and ten years. Investors in aof the fund, formed in the jurisdiction of theclosed-end fund are generally not permittedsponsor; andto make withdrawals or additional capitalcontributions during the life of the fund. Once a general partner of the fund (managingfunded, an investor’s capital will be returnedmember in the case of an LLC), also formed inonly upon the sale or refinancing of a fundthe jurisdiction of the sponsor.asset, or upon positive cash flow from rentsand other operations. Most real estate funds,The investment manager and generalprivate equity funds, venture capital funds,partner entities are typically formed in theand other funds investing in illiquid assets arejurisdiction of the fund sponsor. For real estatestructured as closed-end funds.funds, the general partner and the investmentmanager are formed as two distinct entities toSuccessive Fundsallow subsequent funds to maintain separategeneral partners for liability purposes.With closed-end, once an investment is sold,Management fees are paid to the investmentit cannot be reinvested in the fund. Rather, themanager, while carried interest is allocated tofund sponsor would create a subsequent fundthe general partner.as assets are sold and investment proceedsreturned to facilitate reinvestment. Successfulprivate equity fund sponsors typically developa portfolio of various funds. Fund sponsors canform subsequent, analogous real estate fundsat substantial cost savings to the initial funds,because less legal structuring is required.Closed-End Structure
the leveraged blocker structure and the sideby- side structure.For most funds, an offshore master-feederstructure set up in a tax neutral jurisdiction(Cayman Islands, British Virgin Islands, etc.)would be sufficient to shield offshore investors.Not so with real estate funds. The principalmethod used to mitigate tax consequences tooffshore investors is a more complex solution:the leveraged domestic blocker.Leveraged Blocker StructureUS Tax-Exempt Investors—UBTI IssuesTax-exempt entities, including IRAs, 401Ks,pensions, charities, etc., are subject to theunrelated business income tax (or “UBTI”),a tax on certain business income that isimposed notwithstanding the organization orexempt status.Under Sect. 512(b) of the Internal RevenueCode, investment income, including incomefrom real estate, is subject to UBTI if derivedfrom debt-financed property (acquisitionindebtedness). Such distribution may subjectthe fund to UBTI.Offshore Fund StructuresWhen properly structured, an offshore fundstructure blocks offshore and tax-exempt USinvestors from direct US tax liability. Themost common offshore fund structures areA leveraged domestic blocker is a UScorporation (usually set up in Delaware) thatis capitalized with a mix of loans and equity.The aim of the leveraged domestic blockeris to shield offshore Investors from the US-
tax filing obligations that FIRPTA (as definedunder FIRPTA Considerations) imposes,while reducing non-US investors’ effectiverate on the real estate fund investment. Themechanics of the leveraged blocker are beyondthe scope of this white paper, but the primarybenefit is the interest deduction availablewith a leveraged investment that is used bythe leveraged blocker to reduce the leveragedblocker’s income subject to US tax.as a jurisdiction for investment fund domicile.British Virgin Islands (BVI)BVI has gained the reputation for beinga cost-effective and convenient offshorejurisdiction. BVI’s regulatory structure hassought to create a flexible jurisdiction withstreamlined processes and strong legalcertainty. BVI regulatory filing fees areconsiderably lower than those of the CaymanThe protection afforded by the blocker will Islands.vary depending on the particular investor andinvestment. With the proper structuring, there Offshore Investorsis a potential to eliminate offshore investorsAn initial consideration when structuring afrom being subject to FIRPTA consequences.real estate fund is whether to admit offshoreParallel Fund Structureinvestors or rely solely on investmentfrom US persons. There is admittedly anA side-by-side structure has an offshore. underrepresentation of non-US investors infund and domestic fund that parallel each US real estate funds. This is primarily becauseother in trading and have the same investment of the tax complication faced by offshoremanager but maintain separate investment investors and considerable structuring thatportfolios.needs to be put in place to avoid negative taxconsequences.Offshore JurisdictionsThere are number of locations in whichan offshore fund can be formed, includingLuxembourg, Malta, Cypress, Singapore, andothers. However, the vast majority of funds areformed in the Cayman Islands or the BritishVirgin Islands for the reasons set forth below.Cayman IslandsThe Cayman Islands has historically beenthe top choice for offshore funds becauseof its business friendly structure, stablegovernment and well-developed investmentlaws. The Cayman Islands is the world leaderFIRPTA ConsiderationsThe primary concern for offshore investorsin US real estate funds is the US ForeignInvestment in Real Property Tax Act of 1980(known as FIRPTA). Under FIRPTA, non-USinvestors are taxed on income from US realproperty investments, including gains fromreal estate investment funds, at extremely higheffective rates. Additionally, FIRPTA requiresthat offshore investors file US tax returns andbecome subject to to the IRS’s investigatoryand subpoena powers. Fund sponsors are alsorequired to make ta withholding on offshorefund investments.
INVESTMENT TERMSOne of the most important aspects of forminga real estate fund is setting the terms of theinvestment. When properly structured, realestate fund offering documents contain termsthat adequately protect the fund sponsor andare attractive to investors. Real estate fundterms are driven by the fund’s strategy, themarket trends within the fund’s specific assetclass and the particular needs and objectives ofthe fund. It is crucial that the investment fundlegal counsel have an in-depth understandingof current investment market trends and howthose trends affect the strategy the fund willemploy.Fund ExpensesDuring the formation process the fundsponsor designates which of the expensesof the fund will be borne by the manager andwhich will be borne by the fund. Typically,the fund bears expenses directly related toforming and operating the fund, including:legal formation costs, accounting andadministrative services, regulatory filings,brokerage costs, clearing costs, etc.Sponsor FeesA real estate fund sponsor’s compensationincludes the carried interest (generallyapproximately 20% of the fund’s capitalappreciation) and certain fees. There are anumber of fees that real estate sponsors cancharge, depending on the fund’s negotiatingposition with investors and the extent ofinvolvement required by the particularstrategy. We recommend that the shorterthe track record of the sponsors the morestreamlined the fee structure should be. Themost basic fee is an investment managementfee. The investment management fee isassessed annually, typically ranging from0.5% to 2%, (based on committed capital duringthe commitment period and based on capitalcontributions thereafter). Other potential feesinclude property management fees, leasingfees, financing fees and other administrativefees.Capital CommitmentsWhen real estate fund investors subscribe toan investment in the fund, they usually do so byentering into an agreement committing themto invest a certain sum (a capital commitment)when called for by the fund sponsor (a capitalcall). Upon the capital call by the sponsor fora specific percentage of the investor’s capitalcommitment, the investor has a fixed periodof time in which to satisfy the capital call.Once contributed, an investor’s capital will bereturned only upon the occurrence of a capitalevent, such as a sale or refinancing of all ora portion of the fund’s assets, recognizingincome, or other events resulting in positivecash flow from operations.
Preferred ReturnMany real estate funds include a preferredreturn. Preferred returns can range from 6%to 12% of the initial capital contribution. Thepreferred returns are accrued and compoundedannually. The preferred return is distributedin accordance with the distribution provisionsupon capital events.Distribution WaterfallThe distribution provisions control thepriority of distributions from capital events.The priority of distributions between limitedpartners and the general partner is referred toas the “distribution waterfall.” The distributionwaterfall can be pictured as a set of allocationpools. When a higher priority allocation poolis filled, the capital flows into the next pool.Distribution waterfalls vary significantly fromfund to fund, depending on a number of factors,but generally follow the following conceptualframework.Distribution waterfalls typically follow thefollowing three phases:(i) preferred return and recovery phase;(ii) catch-up phase; and(iii) carried interest phase.Preferred Return/Recovery PhaseThe first phase in the distribution waterfallis the preferred return and recovery phase.Generally, investors receive distributionfirst, until their preferred return and capitalcontributions have been repaid in full.Catch-up PhaseAfter the preferred return and capitalcontributions are recovered by investors,the remaining funds are split between theinvestors (typically 80%) and the sponsor, inthe form of carried interest (typically 20%).However, since the limited partners havealready received substantial distributions,the distribution waterfall now acceleratesallocations to the general partner accordingto the catch-up rate (often 50-60%). In thecatch-up phase, the general partner receivesallocations at the catch-up rate until thecarried interest allocations are caught up.Carried interest PhaseFollowing the catch-up phase, capitalallocations will be distributed based on thecarried interest (typically 20%). The generalpartner will then receive 20% of the distributedamount, while the limited partners will receive80%.
General Partner ClawbackUpon liquidation of the fund, limitedpartners are sometimes distributed lessthan the agreed-upon allocation (due to earlypositive performance and lagging performancetoward the end of the fund). When this occurs,the limited partners “claw back” the unpaidamount from the carried interest distributedto the general partner. Since the clawbackprovision is only activated at end of the fund,fund sponsors must be cautious to maintainreserves to satisfy any such contingencies.Reserved funds are sometimes held in escrowfor investor protection.Side LettersMost offering documents allow themanagement team to negotiate specialterms (known as side letters) that are notapplicable to other investors. Often the specialarrangement involves better economic terms,such as reduced management fees. Care mustbe taken, however, not to allow side letters toprejudice other investors. For example, sideletters that provide additional informationrights or preferential allocation should beavoided.
About the Author:Mr. Lore advises emerging fund managers throughout the United States, Europe, and the MiddleEast in forming and operating real estate funds, hedge funds, private equity funds, and otheralternative funds using varied strategies; including equity, fixed income, distressed debt, and sectorfunds. Mr. Lore also advises real estate funds during the soft-commitment pre-capital raising stage.Mr. Lore has advised hundreds of investment fund managers and real estate fund sponsors onall aspects of their business, from capital raising and fund formation to implementation of theirbusiness models. His representation of a broad range of managers allows him to keep abreast ofemerging trends, regulations, and key business issues in the capital raising process.Mr. Lore is a frequent speaker at investment management events in the US and Europe, and atsome of the world’s leading universities. Mr. Lore is regularly called on to provide insights onemerging hedge fund and private equity legal topics to institutional investors and has been quotedin more than 100 media articles in over a dozen countries.Call 212.203.4300 or visit our website to schedule a consultation with one of our attorneys.1700 Broadway 41st Floor New York, NY 212.203.4300
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