How To Start a Real Estate Fund

If you follow real estate investing, you know that institutional real estate funds are heavily invested 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. You might have considered fractional ownership in a real estate fund or a real estate investment trust (REIT).  

But have you considered starting your own real estate fund? You, or you and a group of investors, can pool your resources and start your own real estate fund. With some planning and fundraising, you can start a real estate fund and invest like the big funds. Would you like to learn how to start a real estate fund? Keep reading.

What is a Real Estate Fund?

A real estate fund is a type of corporate entity that invests in real estate through a combination of its own funds and investor contributions. 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 are created to invest in real estate, but they differ from real estate investment trusts (REITs). While both use combined investor contributions to make real estate investments, the way the entities make those investments and the manner in which investors make money differ significantly. 

REITs are corporations that use a combination of investor funds to buy, manage and sell rental property, generating passive income for investors. They also invest in mortgage notes, mortgages and mortgage-backed securities. REITs must distribute at least 90% of their taxable income to shareholders as dividends. As corporations, shares of REITs are bought and sold like stock. 

In contrast, a real estate fund is a type of mutual fund. Real estate funds invest in securities offered by public real estate companies, such as REITs, rather than directly in real estate. Both REITs and real estate funds raise initial capital from investors, but then the source of fund growth varies. 

Real estate funds' portfolios are more likely to own equity shares of multiple REITs across the country or globally. Real estate funds are not required to pay annual or quarterly dividends to investors. Investors in REITs gain passive rental income and interest paid as dividends while investors in real estate funds primarily gain asset appreciation.

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. 

Setting up a Real Estate Fund

You can set up a private real estate fund with varying legal structures, although a limited liability company or a limited partnership are the most common. Here are the steps to form a real estate fund. 

Initial Formation

The initial formation of a real estate fund includes forming a legal entity. It's important to consult with a reliable business lawyer to ensure the correct formation steps. Assuming you plan to start a private fund, you will need to establish the fund and then determine your investment strategy, including the types of real estate funds or assets you plan to invest in and any geographic focus.

You'll also need to consider the minimum fund size. While historically, the minimum fund size for a strong portfolio was $20 million, crowdfunding platforms have reduced this in some cases. 

Fund Fees

Various fees are associated with real estate funds, including fund, asset, and property management fees. Each fee is typically calculated as a percentage. Common fee ranges are:

Fund fees: Fund fees include administrative, legal and operational expenses and typically range from 0.5% to 1% of the fund's net asset value (NAV) per year.

Management fees: Management fees cover the cost of the fund manager and are around 1% to 2% of the fund's net asset value (NAV) per year. 

Property management fees: Property management fees cover the day-to-day management of properties within a fund's portfolio. However, you won't typically pay these directly since most private real estate funds invest in other real estate funds. If your fund invests in properties directly, property management fees are 4% to 10% of the property's rental income.

Even with fund fees, there may be clauses or reasons for a clawback. A clawback provision that allows investors to recoup previously paid performance fees in case of underperformance, early withdrawal of capital or cases of accidental overpayment of fees.

Sponsor's Role

A real estate fund sponsor is an individual with expertise in real estate investment and management or a real estate investment firm. The sponsor's key responsibilities include fund formation, fundraising, deal sourcing and underwriting. 

The sponsor is also responsible for acquiring and disposing of real estate assets or investments in other real estate funds and managing the fund's real estate portfolio.

The sponsor must communicate with investors and ensure legal compliance with all regulatory requirements.  

Financing Structure

Real estate funds may employ different financing structures. The most common is equity financing, in which the fund raises capital from investors and offers a stake of ownership in the fund. This is the preferred funding structure for most investors, whether they choose to open their own real estate fund alone or with other investors. Investors can participate in property appreciation. 

However, debt financing is another viable option if you plan to purchase real estate assets. With debt financing, you borrow money in the form of a mortgage from lenders to finance real estate purchases. This funding option involves using debt to purchase real estate and build equity in acquisitions over time.  

The mortgages are repaid using the income generated from the properties. Debt financing allows funds to leverage their investments, potentially increasing their returns and risk.

Fund Strategy

One of the main advantages of a private real estate fund is the personalized fund strategy. Real estate funds may focus on certain assets, such as distressed assets, or choose multiple investment strategies.

Funds may invest in equity REITs and other funds that generate revenue through properties. Or, you can choose to invest in debt-based investment funds that purchase mortgage notes and other debt, generating income through interest payments.  

There are pros and cons to each. Equity-based funds allow investors to participate in property appreciation but carry more risk. On the other hand, debt-based funds offer regular interest payments but no participation in property appreciation.

Documents Needed to Start a Real Estate Fund

When you form a real estate fund with either an LLC or LP legal status, additional documentation is essential for fund operations, including the articles of organization, operating agreement and possibly additional documentation. 

Articles of Organization

Articles of organization, which are also called a certificate of formation, are filed with the state during company formation. They include information like the entity's name, address, purpose, registered agent details and member information. 

Articles of organization are state-specific and must meet requirements set by the state. Depending on where you plan to form the real estate fund, you must file the signed articles of organization with your state's secretary of state or department of corporations.

Operating Agreement

An operating agreement outlines the duties and responsibilities of each stakeholder or owner within a business, including the percentage of ownership, key responsibilities and voting rights. 

The operating agreement outlines the company's structure, management, decision-making process and operating procedures, including capital investments, ownership stakes, income distribution, member expectations and responsibilities, voting rights, decision-making processes and dissolution procedures. You may also include a partnership agreement. 

A partnership agreement is one of the most important steps in creating a real estate fund, 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 representing your interests in drafting and revising this partnership agreement. 

This agreement puts details of your fund in writing. Once it’s signed, it is legally binding, so take the time to craft a solid partnership agreement that works in all of your best interests. If there are provisions in your partnership agreement where investors only invest in specific holdings, that must be spelled out with no ambiguity about what they are and who has access to them. 

Before raising funds, you must 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 buy-in
• 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. 

Other Documents

Depending on investors' requirements and state-specific regulations, you may need other documents to form and operate a personal real estate fund. These include a letter of intent, purchase and sale agreement, development agreement, management agreement and loan guarantee fee agreement. Speak with a business or real estate attorney to understand any required documentation. You will also need to prepare all necessary state and federal tax filings. 

How Does a Real Estate Fund Differ From Direct Investment?

With direct investment, a significant portion of capital is tied up in a single investment or a few investments. You'll have less diversification and need to pay management fees but have operational control.   

A real estate fund typically invests in other funds, such as REITs, mutual funds or real estate stocks. Instead of purchasing properties directly, real estate funds eschew direct management and operational control of real estate investment in favor of diversification, decision-making flexibility and flexible levels of initial investment. This requires less direct involvement for investors, with greater opportunities to maximize diversified real estate investment across market sectors and real estate types. 

Open-End vs. Closed-End Real Estate Fund

You can also choose to have an open-end or closed-end fund. Open-end funds have an indefinite term and can raise capital in perpetuity. In contrast, close-end funds operate with a fundraising period of 12-18 months and a fixed investment period of four to six years.

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

In an open-end real estate fund, investors can buy or liquidate shares during pre-determined periods throughout the fund's life. The fund manager determines how many of these periods there are and how long they last. Open-end funds offer more flexibility, but they also pose some unique challenges. 

The ability for investors to get into and out of open-end 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 when the real estate market is down, the value of an otherwise solid fund could take a huge hit if too many shareholders make for the exit doors simultaneously. 

In a closed-end real estate fund, the investment offering is no longer available, and shareholders cannot liquidate their shares or withdraw money from the fund until the end of the hold period.  

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

Should You Start a Real Estate Fund?

Starting a real estate fund allows you and your friends to pool resources and create a fund that invests in other real estate funds, stocks or REITs. Whether it makes sense for you is unique to each investor's situation.

Investing in anything, even historically solid assets such as real estate, carries risk. To start a fund, you must raise capital and handle significant paperwork. You'll need to work with professionals on forecasting, technical analysis and fund allocation. Since private real estate funds focus on appreciation, you will need the resources to buy and hold for the long term. But with the right resources and a solid team, building a private real estate fund can be both challenging and rewarding. 

Want to consider other options? Consider the best private REITs, the best crowdfunding platforms for non-accredited investors or best real estate investment companies or the best real estate investments. 

Frequently Asked Questions