Real Estate Investment Funds

People often seek to form a real estate investment fund to pool their resources and invest in real estate. The transaction might involve something relatively simple as a few business partners identifying a specific property they want to buy, hold, and sell. Or the transaction might involve something more complicated such as a professionally-managed real estate investment fund that will invest in certain types of real estate and reinvest the proceeds from any sales for a set period to time.

Real estate investment funds are often formed as limited partnerships or limited liability companies. The relationship between the investors and the managers of the real estate investment fund should be clearly defined in a written agreement. The following are some of the keys terms investors and managers should consider when creating a real estate investment fund:

Separate Entities for Each Property

Sometimes the arrangement will be structured so that each property is held by a separate entity. This reduces the likelihood that a liability affecting one property, such as environment contamination, will affect another property. This also allows different ownership arrangements for each property. If the fund intends to reinvest the proceeds from any sales or refinancings, it may make more sense to have a single entity own the properties.

Capital Commitments

The fund agreement should specify when capital contributions from investors must be made. The capital contributions can be made at the time a person makes their investment in the fund or the fund can make a capital call as it gets close to purchasing a particular property. Investors prefer to keep their capital until it is needed. The fund agreement should also address how subsequent capital calls are handled in the event the fund has unexpected expenses and is running short on cash. Investors may be required to contribute equally, or the investors may be required to contribute equally up to a certain amount. Investors may want to have their subsequent contributions subject to a cap so they know that their liability to the fund will never exceed a certain amount.

Subsequent Investors

The fund agreement should specify whether or not and under what circumstances subsequent investors are allowed in. This can be helpful if additional capital is needed. However existing investors will want to avoid having their ownership interests diluted. These concerns can be addressed by providing the existing investors antidilution rights in the event subsequent interests are sold at a discount or by providing the existing investors with a preemptive right to purchase the subsequent interests.

Term

The fund agreement should specify how long the fund will operate. If the fund will hold a single property, then the fund agreement should specify when and under what circumstances the property will be sold and the proceeds distributed. If the fund will reinvest the proceeds, the fund agreement will usually set a time frame during which proceeds from sales can be reinvested and after which the proceeds are returned to the investors. Often the term can be extended upon the approval of a specified percentage of the investors.

Compensation

The biggest negotiated point is the compensation that is given to the manager of the fund. The manager may a single individual or it may be a company that specializes in real estate investments. The goal is to properly incentivize the manager to invest the fund assets appropriately and generate high profits for investors. Compensation to the manager may include some or all of the following: (1) a percentage of the value of the assets under management; (2) a percentage of the profits generated on the sale of assets; or (3) a percentage of the profits generated on the sale of assets after the investors receive a preferred return.

Expenses

The fund agreement will usually specify that out-of-pocket expenses of the real estate investment entity and the manager will be reimbursed from fund assets. It may make sense to specify that certain preorganization expenses should also be reimbursed from fund assets.

Removal of Manager

The fund agreement should specify when and under what circumstances that manager may be removed. Usually removing the manager requires a majority or a super-majority of investors. Sometimes a fund agreement will lower this threshold if a certain key person is no longer involved in the management of the fund.

Tax consequences

It is important that an experienced tax professional be involved in the creation of a real estate investment fund. There may be certain ways of structuring the fund or the management compensation structure that may be more advantageous from a tax perspective than other structures.

Securities laws

The interests in a real estate investment fund are considered securities under state and federal law. The manager and others involved in creating the real estate investment fund should ensure they have complied with federal and state laws regarding the marketing and sale of securities.