.png)
Reading this article, you’ll learn all about real estate funds, including REITs, mutual funds, and private equity funds. You will also learn about the roles of the General Partner, the Fund Manager, and the Limited Partners. And of course the fees. If you’re starting a real estate fund, wouldn’t you say it’s good to know how you’ll make money?
What is a Real Estate Fund?
Real estate funds are an excellent way for investors to get into the property game without going it alone. The fund pulls together money from a bunch of investors to buy properties, which means collectively, they can take down more extensive and varied real estate opportunities that would be too pricey for someone on their own.
These funds usually focus on different types of properties, like apartments, office buildings, or even medical spaces. The person running the fund, known as the fund manager, sets the investment strategy. They outline what the fund aims to achieve and what properties they'll go after. This way, everyone involved knows what to expect and has higher confidence about the investment goals.
Investment Model
The primary function of the fund is to raise capital and acquire properties that align with its investment objectives. In obtaining these properties, there are typically several fees to consider. These fees are generally calculated as a percentage of the purchase price and can significantly impact the overall cost of the deal.
Management of Properties
Once the properties are secured, the fund manager takes on the responsibility of overseeing their management. This includes managing cash flow, budgeting for expenses, and evaluating the properties to enhance their value and returns. Day-to-day financial and strategic aspects are also part of the manager's role.
Fee Structures
Fund management encompasses a range of fee structures that are important to consider. For instance, rental property management fees typically fall between 1% and 2% of the total equity invested. Regarding portfolio management, fees generally range from 3% to 6% of the gross income.
Legal Agreements
The private placement memo outlines the investment opportunity. It describes the investment structure, how it works, and why it's worth consideration.
It's just as important to consider the fund investment risks. The memorandum should list known variables that can affect the performance of the investment so that investors know what's in store before signing.
Disposition and Distribution
The final phase of profit harvesting for a real estate fund involves the strategic disposition of the properties through either outright property sales or portfolio refinancing. When these transactions are completed, the investment capital and profits are paid out to the limited partners per the terms of the partnership agreement.
Types of Real Estate Funds
Private Equity Real Estate Funds
Private equity real estate funds invest directly in real estate properties.
Investment Approach:
Most private equity funds have an active management approach, which involves investing in assets that require redevelopment, repositioning, or other added-value measures.
Holding Time:
Private equity funds are closed-end with a set maturity of 10 years or more, giving the fund manager time to find investments, add value, and turn a profit.
Real Estate Investment Trusts – Exchange Traded Funds (REIT-ETF)
REITs hold, operate, or fund income-producing real estate assets. Such trusts may also hold shares in other real estate companies.
Real Estate Mutual Funds - REITs
Property mutual funds and REITs have significantly better liquidity than direct property investments, and many investors prefer them over the latter. The main benefit is that if these funds are on the stock exchange, investors can liquidate their holdings more quickly than if they had physical properties. This trading feature eliminates liquidity risk, which can be problematic for those directly involved in real estate since selling a property can take a lot of time.
When you own direct property investments, selling an asset takes time: making arrangements for appraisals, negotiating the sale, and overcoming legal or financial obstacles. Unlike real estate funds, investors can get to their money more effectively because they can sell their shares in the fund.
Moreover, having the flexibility to jump into and out of investments enables investors to change their tactics as the market changes. For example, if real estate is declining, fund investors can reduce their market exposure by selling shares more easily. Meanwhile, private property owners may sit on the sidelines while awaiting the right offer.
Enhanced liquidity in real estate mutual funds and REITs also encourages a more dynamic investing environment where investors can diversify their capital when new opportunities arise, potentially improving overall returns. Real estate funds democratize the property market so that many investors can get involved without being bound by direct management and sales.
Open-Ended Funds
Open-ended funds don’t have a fixed maturity and can operate for the long term. The fund can raise and invest capital continuously until the GP(s) either liquidate the assets or sell the fund.
Closed-Ended Funds
Closed-ended funds have a set time limit to raise investment capital. No more investors are allowed in the fund when that timeframe runs out (usually 12-18 months). The fund then operates for a fixed time, commonly 8-10 years. Upon the expiry of this time, fund assets are sold, and the investment proceeds and earnings are returned to investors.
Core Funds
Core funds invest in predictable, income-producing assets. For example, multi-family developments with steady historical returns. These properties are generally fully occupied and have long-term leases with creditworthy tenants. The investment model focuses on moderate returns, usually lower than other strategies but more consistent and predictable.
Value-Added Funds
Value-added funds target properties that require improvements to increase their value. These funds involve moderate risk, focusing on properties with existing cash flows but requiring active management to enhance their value, including physical renovations, repositioning, or operational improvements.
By making targeted improvements, value-added funds aim to increase the properties' net operating income (NOI), leading to higher potential returns than core funds. Fund managers employ various strategies such as reducing operating expenses, increasing occupancy rates, and enhancing the property's appeal to attract higher-quality tenants and achieve better market rents.
Opportunistic Funds
Opportunistic funds are risk-reward driven. These funds target bankrupt assets, development projects, or properties that need extensive renovation. These funds chase maximum returns, often with an Internal Rate of Return (IRR) of 15-25% and equity multiples of 1.5-3x. Those earnings depend on the team and the proper execution of the business plan.
Real Estate Fund Structure - Key Positions
Four main elements comprise a real estate fund that, working together, accomplishes the investment objectives.
General Partner(s). The founding person(s) or entity that oversees the fund and the investment model.
The Fund Manager is responsible for the day-to-day business operations and may or may not be the GP.
Limited Partners (Investors) provide the bulk of the investing capital. As an LP, these investors do not have a management role in the fund and are not liable for the management decisions. Second, the monetary risk these investors face is limited to their investment amount. Their potential returns are specified in the partnership agreement.
Portfolio Management may be handled by an in-house team or contracted to an outside company.
The Capital Structure of a Fund
The capital structure of a real estate fund determines how the fund is financed and managed.
Equity Financing
Equity financing means raising funds by selling ownership of the properties or the fund to investors. Limited partners (LPs) in a typical private equity fund provide most of the equity investment and are passive investors. The GP (fund manager), on the other hand, puts in a smaller share of the equity and runs the fund.
Debt Financing
The GP usually seeks loans from a bank to buy properties. The banks or other institutional lenders are secured by a first lien on the property. It is the least risky and, therefore, a lower interest rate. The equity contributions from LPs are considered subordinated debt in a second position to the senior debt of the lending institution(s).
Fund Managers and Team
The right fund manager and team will be key to the real estate fund's success.
Acquisition Manager: Responsible for sourcing properties, due diligence, negotiations of purchase price, and financing. They are central to the long-term growth and diversification of the real estate portfolio.
Asset Manager: Manages the day-to-day aspects of the properties, such as tenant interaction, leasing, repairs, and financials. They are supposed to make the property run efficiently and more profitable.
Legal and Regulatory Considerations
Securities Law Compliance
Real estate fund managers are subject to the Securities Act of 1933 unless they qualify under exemption. The most common exemptions are private placements per Rule 506(b) or 506(c) of Regulation D, allowing securities to be sold to investors.
There is the Investment Company Act of 1940, too. However, a lot of real estate funds can avoid registering under exclusions like Sections 3(c)(1) and 3(c)(7) or by making sure that the fund invests in real property and not in securities.
Investment Advisers Act of 1940
When fund managers manage assets in excess of $100 million (150 million for private funds), they must register with the SEC as investment advisers and advise on securities for compensation. However, even though you might not need to register, fund managers should at least adopt the same policies and procedures that RIAs do to comply with the regulations.
Compliance with SEC Rules
Capital calls need approval by the SEC if the fund is regulated by the agency. There are a few exceptions, but in general, the SEC treats real estate funds as issuers of securities, and capital calls and redemptions must be subject to SEC regulations.
Custody and Audit Requirements
Registered investment advisers are subject to the Custody Rule that requires an annual audit of the fund’s financial statements and releasing those audited statements to investors for transparency and investor protection.
Tax Considerations
Foreign Investment in Real Property Tax Act (FIRPTA) requires withholding taxes for specific transactions and filing US tax returns for real estate assets held with foreign investors.
ERISA Compliance
Suppose at least 25% of any type of equity in the real estate fund is owned by "Benefit Plan Investors," such as pension plans or other ERISA-covered plans. In that case, the fund manager is acting as a fiduciary to these investors that brings with it additional duties and restrictions.
Anti-Money Laundering (AML) and OFAC Compliance
Managers of real estate funds will also need to use AML and Office of Foreign Assets Control (OFAC) compliance to screen and track the movement of ill-gotten money and obstruct transactions with certain persons and countries.
State Laws and Regulations
Real estate fund managers are also subject to state securities laws besides federal laws. Despite the federal exemption, fund managers may need to register for or follow certain exemptions in some states.
Contractual and Governance Aspects
Real estate fund managers must prepare and review various contracts and investment agreements that spell out the entire investment, including capital investment, distribution of profits, and management duties. The LPA or operating agreement deals with governance – roles and responsibilities of the GP and LPs, conflict of interest clauses, and dispute resolution.
So, there's much to consider when setting up and running a real estate fund. You have to deal with many regulations, which can get complicated, like following securities laws, registering as an investment adviser, and keeping tax rules in mind. You will need to observe specific laws, like ERISA, AML, and OFAC, along with various state laws and the contracts that govern everything. It's crucial to stay on top of all these requirements because doing so is key to making the fund successful and ensuring that investors are well-protected.
If you think all of this sounds like a lot, that's because it is. This is precisely why over 900 fund managers have turned to Fund Launch© to save money and headaches and drastically shorten their go-to-market timeline.
Get a free Real Estate Fund training here!
