How To Start a Real Estate Fund

If you follow the world of real estate investments and investing, you know that institutional real estate funds are invested heavily in various deals across the country. It’s not uncommon for a large shopping center or apartment complex to be owned by a state pension fund or other similar entity.  

But did you know that you, or you and a group of investors, can pool your resources and start your own real estate fund? With a little bit of planning and fundraising, you can start a real estate fund and invest just like the big boys. Would you like to learn how? Keep reading!

What Is a Real Estate Fund

A real estate fund is a type of corporate entity that, through a combination of its own funds and investor contributions, invests in real estate. The most common types of real estate funds are mutual funds and institutional funds such as private employee pension funds or public employee pension funds. 

Real estate funds exist to invest in real estate, but they should not be confused with real estate investment trusts (REITs). Real estate funds and REITs both use combined investor contributions to make real estate investments, but the way the entities make those investments, and the manner in which investors make money, differs significantly. 

REITs use a combination of investor funds to buy, manage and sometimes sell rental property, all with the end goal of generating passive income for investors. Real estate funds, on the other hand, invest in a variety of real estate-oriented offerings, such as REITs, structured notes and other mortgage-backed securities. As opposed to just passive income from rents, the payoff for investors in real estate funds also comes from asset appreciation.

While a REIT will have an active role in operating the properties in a given portfolio, a real estate fund’s portfolio is more likely to own an equity share of multiple REITs all over the country. The distinction is important because while both REITs and real estate funds have hold periods, real estate funds are less likely to pay annual or quarterly dividends to their investors. 

That’s because real estate funds grow in value as the assets in the fund’s portfolio appreciate. When assets in the fund’s portfolio, or the entire fund itself, are sold, the fund’s investors take a share of the profit based on how much equity they have in the fund. 

Types of Real Estate Funds

There are two basic structures for the corporate entity that underpins a real estate fund.

Limited Liability Company (LLC)

The first is a limited liability corporation (LLC). An LLC is a type of corporate entity or partnership where each member has a defined ownership share of the entity that’s usually based on an investment contribution, although equity is sometimes given to people in exchange for specialized knowledge or expertise. Once formed, the LLC — not the individual partners — assumes liability for the assets controlled by the LLC and the business done by the LLC. 

One of the main reasons people form LLCs can be found in the name. The words “limited liability” in LLC mean exactly that. They limit the liability for any losses or damages incurred by the LLC to the LLC itself. That means the members of an LLC cannot be sued individually, or have other assets not pledged to the LLC, subjected to legal judgements or other liabilities. 

Imagine your net worth was $10 million. You and your two brothers put in $100,000 each to buy a four-unit apartment building, which tragically ends up burning to the ground because of a faulty wire. If you and your brothers own the building as sole proprietors, the surviving tenants of the building or their families can sue you and your brothers personally for damages and losses caused by the fire. 

If you lose in court, and the amount of the judgment against you exceeds the value of the building, the tenants are legally entitled to pursue payment of the judgment by placing liens on your personal property such as your home and seizing any other assets you possess until the judgment is satisfied. 

If, on the other hand, you and your brothers formed an LLC first, which then purchased the building, your liability in the court case would be limited to the amount of your original contribution to the LLC, or the total value of the property itself. 

This is because the tenants are suing the LLC and not you or your brothers personally. So, if the amount of the judgment exceeds the value of the property, the LLC will go bankrupt and the building might be seized to pay off as much of the judgment as possible. But the tenants would have no legal standing to pursue any personal property or assets you have that are unrelated to the LLC. 

This is why so many savvy landlords and property owners form LLCs to shield themselves from the liability that can come with owning investment property. It’s also why many REITs and real estate mutual funds operate as an LLC or some other legal entity that limits their liability. 

Limited Partnership (LTD)

The other most common corporate entity for a real estate fund is a real estate limited partnership (RELP). The basic principles behind LLCs and RELPs are the same, but there are several key differences. LLCs can be managed jointly by the members or an outside third party on behalf of all the members. Limited partnershpis are typically managed by the general partners themselves, with one of them being designated as the managing partner.  

The other difference between LLCs and RELPs is in the legal privileges and protections they offer. Under the LLC, outside management with no equity can be appointed to run the entity, and no member of the LLC can be held personally liable for the actions of the management. 

A limited partnership, however, must have a managing partner who assumes personal liability for the partnership and its decisions. Each partner of a RELP is legally shielded from bad acts or negligence committed by other members, with the exception of the managing partner who can be sued or held personally responsible for acts of negligence, but the maximum liability is limited to the initial financial contribution of each partner. 

So, if the three brothers formed a limited partnership instead of an LLC, and the wiring was faulty because the managing partner ignored an inspection report or didn’t repair it in a timely manner, the tenants can sue the LLP. If they win, the building’s status as a RELP would shield the brothers from any additional liability, but the brothers can sue the managing partner for negligence and recover damages up to the amount of their original investment — $100,000 in this case. 

Because of specific laws that make it easier for LLCs and RELPs to operate there, many real estate funds are formulated as Delaware limited partnerships. Delaware, a small state without much industrial or economic base, passed LLC- and RELP-friendly legislation to encourage more such entities to organize themselves there, which increases the tax base for the state as a whole.

Regardless of what entity you chose to form your real estate fund under, or where you choose to form it, this is one of the most important decisions you’ll make. It will have long-term ramifications for your tax exposure at both the federal and state levels. Consult with an attorney and a financial adviser who specialize in real estate funds and have an understanding of commercial real estate and private equity before forming your real estate investment company or real estate investment fund. 

How Do You Admit Investors to Your Real Estate Fund?

Once you have formed your real estate fund and determined your investment objective, you need to decide how you want to raise capital or accept investment. The two structures for this are known as open-ended and closed-ended funds.

In an open-ended real estate fund, investors are able to buy or liquidate shares during pre-determined periods of time throughout the life of the fund. How many of these periods there are and how long they last is determined by the fund manager. Open-ended funds offer more flexibility, but they also pose some unique challenges. 

The ability for investors to get into and out of open-ended funds makes it difficult to value the private equity fund because share prices can fluctuate at times during what would normally be the hold period of an investment offering. So, if there is an out during a period where the real estate market is down, the value of an otherwise very solid fund could take a huge hit if too many shareholders make for the exit doors at the same time. 

In a closed-ended real estate fund, there is a pre-set amount of time — usually one to two years —  known as a commitment period during which the fund is raising capital and potential investors may buy shares in the fund. Once the commitment period ends, the investment offering is no longer available, and shareholders will not be able to liquidate their shares or pull money out of the fund until the end of the hold period.  

In theory, closed-ended funds reward investors in the long term with higher payouts when all the assets in the fund reach maturity. An open-ended fund, on the other hand, might make it easier for you to attract investors because the off ramps along the way allow greater investor liquidity. 

Regardless of whether your fund is open or closed ended, the next thing you must do is figure out your investment strategy. Which real estate asset class will your fund focus on? Will you be looking at a mixture of REITs and mortgage-backed securities for residential real estate, or will you focus on commercial property? 

After you and your partners figure this out, you will need to draw up a partnership agreement. This is one of the most important steps in the process, and a mistake here can lead to endless headaches down the road. It is a good idea for each of you to have your own legal counsel to represent your interests in drafting and revising this partnership agreement. 

This agreement is setting your fund, how it works and who gets paid what and when in stone. There will be no do-overs once it’s signed, so take the time to craft a solid partnership agreement that works in all of your best interests. If there are any provisions in your partnership agreement where investors only invest in specific holdings, that must be clearly spelled out with no ambiguity about what they are and who has access to them. 

Before you can raise funds, you must also create documentation such as a prospectus, white paper or case studies to explain your offering to potential investors. At a minimum, you’ll want a concise investment summary that includes the following information:

• Type of assets in the fund
• Minimum buyin
• Hold period
• Projected return

You must also decide whether your offering will only be available to accredited investors. Offerings for non-accredited investors can attract lots of capital from investors in smaller chunks, while offerings for accredited investors can attract capital from fewer investors in larger chunks. 

Once all of that is done, you still have one more hurdle to clear on your way to starting a real estate fund: tax paperwork. Your fund will need to prepare annual tax documents not just for you and your partners but for all of your investors and shareholders as well. The paperwork must be filed in advance of any applicable state and federal deadlines. This is a mission-critical aspect of managing your fund that must be handled by a seasoned tax professional or accounting firm. 

You Can Start Your Own Real Estate Fund, but Should You?

That’s a question only you can answer. Investing in anything, even something as historically solid as real estate, involves risk. If you do decide to start a fund, you need to be able to raise a significant amount of capital and handle an avalanche of paperwork. Then, there is the analysis.

Forecasting five to 10 years into the future on the value of even one commercial real estate asset is something that requires an incredible level of skill and experience. If you want to start a fund, you need to be able to do that effectively for multiple assets while also being good enough at pitching to raise funds from investors. 

Regardless of whether your fund is open or closed ended, it’s more than likely only going to be available privately and not traded on any stock exchanges. Remember that the point of your fund is not cash flow but appreciation, which means you need to be wealthy enough to run the fund without earning dividends for the entire hold period. 

It’s a lot of work, and you’ll be competing against fund managers who have been at it for 20-plus years. But if you have the capital, resources and moxy, there is no reason you can’t start your own successful real estate fund. The best part is that while you’re getting your ducks in a row, Benzinga will be here with useful information to guide you.

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