private real estate investment fund

private real estate investment fund

How To Invest In Private Equity Real Estate

Private equity real estate funds allow high-net-worth individuals and institutions like endowments and pension funds to invest in equity and debt holdings in property assets. Using an active management strategy, private equity real estate takes a diversified approach to property ownership. General partners invest in a variety of property types in different locations. Ownership strategies can range from new development and raw land holdings to complete redevelopment of existing properties or cash-flow injections into struggling properties. (For more, read: What Is Private Equity?)

Here is a look at how investors can participate in private equity real estate, and an overview of the industry's opportunities, risks, and restrictions.

Finding the Ideal Private Equity Real Estate Fund

First, the average person is incapable of taking part in private-equity real estate investments. The traditional private-equity fund requires investors to inject a minimum of $250,000 into a fund, although most managers are seeking individuals or institutions that are willing to provide upwards of $20 million to $25 million into a long-term collective investment scheme with other investors. (For more, read: Exploring Real Estate Investments: What Is Real Estate?)

Since there is little regulation over private equity real estate funds, opportunities are traditionally limited to “accredited investors.” This means that the investor must have personal or joint assets of at least $1 million (not including the value of their primary residents) or the individual’s yearly income must be at least $200,000. Couples who have combined income of at least $300,000 over the previous two years – and have a “reasonable expectation” that their income levels will remain at this level in the current year – are also eligible.

Individuals or couples seeking to invest in private equity real estate should locate a firm that specializes in the discipline. Upon examining a private equity firm's options of funds, they should understand the nature of each private equity fund’s structure, which is typically a limited partnership.

When joining a fund, outside investors will become limited partners, meaning they accept liability for the money they invest in the fund and have no veto control over the properties selected by the general partners (GPs). A limited partner’s money will be pooled with other participating investors, and fund managers will build a portfolio of properties aimed at maximizing profitability and minimizing financial risk.

Understanding the Fund’s Costs and Investment Structure

Private equity real estate funds have a number of management and performance fees that must be paid by investors. It's common that private equity funds require an annual fee of 2% of capital invested to pay for firm salaries, deal sourcing and legal services, data and research costs, marketing and additional fixed and variable costs. However, there are no limits to these investor fees.

Individuals should have a good grasp of these costs before investing because that will limit the total return on investment. For example, if a private equity real estate fund raised $500 million, it would collect $10 million each year to pay associated expenses. Over the duration of its 10-year cycle, a fund would collect $100 million in fees, meaning that only $400 million would actually be invested during that decade.

Private equity managers also receive a “carry," which is a performance fee that's traditionally 20% of excess gross profits for the fund. Investors are traditionally willing to pay these fees due to the ability of the fund to help mitigate corporate governance and management issues that might negatively affect a public company.

Most private equity real estate funds are considered “need-based” investments, meaning that partners commit capital to general partners in installments on an as-needed basis. As GPs locate potential investment properties, the fund will send a formal request for capital that limited partners pledged to the real estate fund at the beginning of the cycle. Known as a “capital call," it's a legal obligation that the limited partners must fulfill. (For more, read: Learn The Lingo Of Private Equity Investing.)

Should a limited partner fail to meet a capital call, a fund may force that person or institution into default and forfeit their entire ownership share. Other limited partners typically receive the opportunity to purchase any forfeited shares in the event of such a default.

Types of Private Equity Real Estate Strategies

When investing in private equity real estate, there are traditionally four types of investment strategies:

  • Core is the most conservative strategy, and might only include properties offering lower-risk and lower potential returns because they exist in well-populated or well-traveled locations. This strategy might also focus heavily on investment in high-quality, high-value properties that require very little redevelopment or maintenance. These properties offer predictable cash flows and are commonly comprised of fully leased, multi-tenant structures.
  • Core-plus requires a bit more risk, but can offer a higher return than the core strategy. These properties require modest levels of value-added activity or enhancement to the location.
  • Value added is a medium-to-high-return, moderate-risk strategy that centers more on property development and market timing. In this strategy, portfolio managers purchase properties, engage in some level of redevelopment, and sell when the market is performing. Value-added properties typically require changes to management, physical improvement, or the addressing of capital constraints. These steps include building renovations and seeking ways to increase rental rates in improving markets. Value-added strategies also include the turnaround of failing operating companies or assuming debt for control of underlying properties.
  • Opportunistic provides the highest level of return but assumes the most risk. With this strategy, managers purchase properties that include undeveloped land or in markets that are underperforming or lightly trafficked.

Accepting Risks and Long-Term Outlook

Investors in private equity real estate should understand that by investing in a fund, they must be willing to accept that their capital may be tied up for a predetermined period that could last many years.

In addition, multiple risks exist in the real estate market and a large amount of investment could be required during capital calls at a time when an individual has low cash flow. Many GPs structure their funds as decade-long investments or longer and they provide little or no opportunities for investors to withdraw or redeem their money. The illiquid nature of private equity funds requires investors to understand the risks of keeping their money tied up for an extended period.

The nature of private equity fund structures makes it very difficult to evaluate a fund’s financial performance or the properties it holds. Since limited regulation of private equity real estate funds exists, general partners aren't required to offer any updates to investors on potential investments, valuations of the portfolio, or any other additional information related to the investments. Investing in private equity real estate requires limited partners to commit significant capital and fully trust that the fund manager will meet his or her investment goals without having any required level of transparency. Fund managers, however, do typically send updates to their investors and may choose to be transparent about performance in order to instill confidence in any current or future fund.

Prior to investing in private equity real estate, individuals must determine if they're qualified to take part in the process. Those who are qualified will want to explore their personal investment objectives, liquidity requirements and tolerance for risk in the real estate markets. After speaking with a financial adviser, investors should study a variety of different funds to obtain a better understanding of the management strategies of the general partners and the past performances of other property funds.

Difference Between a Private Real Estate Fund & a REIT

by Steve Lander

Private and public REITs frequently own large office buildings.

Private real estate funds and real estate investment trusts are both ways that you can invest in real estate without actually buying properties. Both types of investments collect money from investors and use it to buy real estate. They then pass the gains and losses from the real estate back to the people who invest in them. Both types of investments can be structured as REITs, but there is a key difference between them. Public REITs are traded on the stock market and are extremely liquid, like any other share of stock, while private REITs aren't.

You can buy shares in a public REIT like you would any stock. All that you need is a brokerage account and enough money to buy your desired amount. It's possible to buy as little as one share at a time, although transaction costs might make this an unwise strategy. Private real estate funds, on the other hand, can set their own minimum investment requirements, and they could be sizable. Because they are not registered with the Securities and Exchange Commission, you might not be able to buy them unless you're an "accredited investor," which means that you either have a lot of money in your investment accounts or a very healthy salary. As of the date of publication, you need to have either $1 million in net worth (excluding your house) or an annual salary for $200,000, or $300,000 if you file jointly, for the past two years.

Public REITs are publicly traded, so you can buy and sell them whenever and however you want. Private real estate funds are generally less liquid. Bear in mind that in a private fund, the money that gets raised is usually directly invested in properties, while public REITs are just shares that you buy. Because the private funds aren't publicly traded, and the money is tied up in properties, it's challenging to get the money out of the fund.

Because public REITs are publicly traded, they're subject to the same stock exchange and SEC requirements as any other publicly traded companies. They have to make annual and quarterly releases of audited financial data to meet SEC requirements. Stock exchanges like the New York and NASDAQ require them to also have independent audit committees to ensure that the information released is accurate. If the company's disclosures aren't enough, third-party analysts also provide information on the performance and comparative value of publicly traded REITs. None of these exist for private real estate funds.

Most REITs stick to large properties in their sector and geography of expertise. When you buy shares of "Big Office REIT," you probably won't find retail centers in its portfolio. Furthermore, REITs get their money from the public markets primarily. Private funds, on the other hand, can be more nimble and can invest in different properties. They also frequently use leverage, which can increase carrying costs but also gives them to opportunity to increase the returns they deliver to their investors.

When they're well-managed, private real estate funds should be able to outperform REITs. Much of their fund managers' income comes from their carried interest -- which is an investment in the fund's assets, giving them good alignment with their investors. Furthermore, private funds benefit from leverage and don't have to deal with regulations or with limitations on what they can own. Because they aren't publicly traded, private REITs also tend to be less volatile and to perform more like real estate and less like stocks. On the other hand, private REITs that are not well managed can lead to significant losses for investors.

Steve Lander has been a writer since 1996, with experience in the fields of financial services, real estate and technology. His work has appeared in trade publications such as the "Minnesota Real Estate Journal" and "Minnesota Multi-Housing Association Advocate." Lander holds a Bachelor of Arts in political science from Columbia University.

Private Real Estate Funds: Structuring for a Winning Deal

Structuring Private Real Estate Funds

Forming a private real estate fund provides a means for the successful real estate developer to access a dedicated pool of capital to fund new investment deals without having to raise capital on a deal-by-deal basis. This article provides an overview of some of the key structural considerations related to the formation, launch, and operation of a private real estate fund.

Private real estate funds enable managers to pool capital without having to navigate the cumbersome securities registration process involved in launching an REIT (Real Estate Investment Trust) or other publicly-offered investment fund. Despite the relative ease of implementation, private real estate funds are structurally complex and sophisticated investors will expect to participate on terms that not only align interests between the investor and general partner/ sponsor, but that also reflect current market trends.

If you have questions about the process or costs to launch a private real estate fund, or are ready to start a fund, we invite you to contact us to schedule a complimentary consultation.

Private real estate funds are typically formed using an entity that is either a limited partnership or a limited liability company. Both of these entity types are known as pass-through entities so that they are essentially disregarded for tax purposes and all gains and losses are directly attributed to the limited partners or members of the entity. There has been a long standing tradition among private investment funds of using Delaware limited partnerships or limited liability companies as the entity of choice. However, principals should be aware that the laws of many states may deem holding real estate for income producing purposes to be an activity that requires an entity to be qualified to do business in the state where the real estate is located. In some states, qualifying an out-of-state entity, or a particular type of entity, to do business can be expensive in certain jurisdictions and might not be necessary if some advance planning is utilized. More particularly, principals should carefully discuss their investment strategy and implementation plans with experienced counsel and consider the benefits and drawbacks of using a particular entity type or jurisdiction for its formation.

Admission and Withdrawal of Investors

Since investments in real estate are illiquid, private real estate funds have many unique structural issues that must be addressed. An initial consideration is whether to use an open-end or closed-end fund structure. Many investors favor the open-end structure, which, in the simplest form, allows investors to enter and exit the fund at regular intervals determined by the fund’s sponsor. However, the illiquid nature of a private real estate fund’s investment assets often makes the open-end structure unworkable since it presents the fund with the dual problems of establishing a fair value for each contributing and withdrawing investor. Closed-end funds, on the other hand, cause all investors to join the private real estate fund at the same time, removing the issues concerning the initial value of their investments, and restrictions can be crafted to match investor withdrawal rights with the fund’s liquidity profile.

If managed properly, a private real estate fund’s investment assets should appreciate over time and, therefore, many early investors would consider the participation of subsequent investors inequitable without some sort of compensation for that appreciation. The difficulty comes in trying to determine the appropriate valuation for subsequent investors since formal real property appraisals may be the only way to properly assess the value of the fund’s investment assets. The appraisal process is expensive, can be time consuming, and, in some circumstances, may not be available at all. One potential solution is for a fund to utilize what are called “side pockets.” A side pocket refers to an internal accounting system where investors essentially participate in a private real estate fund’s investment assets on an investment-by-investment basis. Therefore, the valuation of the private real estate fund’s earlier investment assets is not at issue for subsequent investors because they will not be permitted to participate in the profits and losses resulting from the earlier investment assets.

Meanwhile, giving investors flexible withdrawal rights can cause significant problems for a private real estate fund. It is very difficult to provide timely liquidity from investments in real estate assets because there are really only two ways to accomplish this objective. One option is to arrange for the sale of the real property investment. However, several problems arise with this option, including:

    • forced sales generally result in substantially reduced sale proceeds
    • sales transaction can take a considerable amount of time to consummate
    • there may not be a ready buyer for the asset or the asset may not even be in salable condition (e.g., if the asset is a partially completed development project)

The second option is for a private real estate fund to leverage its real estate investments. This option may not be particularly attractive or even available based upon the fund’s existing indebtedness and creditworthiness and whether the fund’s real estate investments are already encumbered. Current market conditions have also made the availability of debt financing rather scarce in comparison to pre-financial crisis market conditions. Additionally, each of the two options mentioned previously can adversely impact the performance and risk profile of the fund for each investor that does not withdraw. Real estate fund sponsors should carefully match the liquidity of a private real estate fund’s investment assets with the withdrawal rights offered to the fund’s investors.

If you’re ready to begin the process of structuring private real estate funds, or you’d like to receive additional information regarding the timeline or costs involved in structuring funds, schedule a complimentary consultation today.

Initial Capital Contributions and Capital Calls

Private real estate funds possess certain unique capital needs based on the nature of the fund’s investment assets. Most funds utilize a “capital call” structure where investors are required to make an initial capital contribution at the time the fund accepts investment subscriptions. The remaining amount of each investor’s capital commitment is periodically “called down” by the fund. The capital call structure recognizes that most private real estate funds will be unable to precisely time the closing of the fund and the full deployment of all of the fund’s capital. The fund may also be making real estate investments where:

  • a substantial amount of time is required between the fund’s commitment to purchase the investment and the consummation of the underlying transaction, or
  • development activities are being undertaken and the fund is only required to make periodic progress payments on its investment asset

Not only is the timing of investor’s capital contributions critical to a private real estate fund’s ability to fund its investments, the contribution of capital also generally starts the clock running on the “preferred return” that the fund will pay to the investors.

Allocation of Profits and Losses; Clawbacks; Return of Capital

Most private real estate funds offer their investors a preferred return, together with a split of the fund’s overall net profits. The structure that specifies the order in which a fund’s profits and losses are allocated among investors and the fund’s manager/ sponsor is often referred to as the “waterfall.” Waterfalls vary widely in their structure and operation, depending upon a private real estate fund’s investment assets and overall investor profile.

Generally, profits are allocated in the following order:

  1. investors will receive a return of their capital contributions
  2. investors will receive a preferred return, calculated on the total amount of their capital contributions while such sums are held by the private real estate fund
  3. the fund’s manager/ sponsor will receive an allocation equal to a portion of the total preferred return allocated to the investors (usually in the same percentage as the profit split and referred to as the preferred return “catch-up” or sponsor/ GP “catch-up”)
  4. finally, the remaining profits are split between the investors and the fund’s sponsor

While no fund can ever guarantee the payment of a preferred return, investors are assured that they will receive the initial profits from the fund’s investment activities before the fund’s manager/ sponsor is entitled to any allocation of profits. However, there are a variety of ways to specify the calculation of a preferred return based on the timing of capital contributions or fund investments. The purpose of including a preferred return “catch-up” in a waterfall is to allow a private real estate fund’s general partner/ sponsor to have some participation in the fund’s profits, so long as the preferred return has been allocated to the investors. The catch-up feature ensures that the profits resulting from a successful private real estate fund are allocated exactly in accordance with the agreed upon profit split and, conversely, the profits from a marginally successful fund will be primarily allocated to investors rather than the fund’s manager/ sponsor.

Some funds will employ a “clawback” mechanism as a check against any over-allocation to a private real estate fund’s sponsor group. Clawback provisions take many different forms, but they generally serve as a contractual obligation of the fund’s manager/ sponsor to return any and all profit allocations it receives, in the event that:

  1. any investor does not receive both (A) a return of the investor’s entire capital contribution, and (B) the entire preferred return on invested capital; or
  2. the total amount allocated to the general partner/ sponsor over the life of the fund is greater than the agreed upon profit split

Private real estate funds can also differ from other types of funds in how and when capital contributions are returned to investors. A private real estate fund sponsor must closely consider the fund’s investment strategy when structuring for the return of capital. For example, a fund that is focused on fixing and “flipping” real estate would likely prefer to retain the proceeds resulting from sale of early investment assets for future investment activity. On the other hand, there would be no reason for a private real estate fund focused on the development of a single project to retain investor capital. Some funds also choose to treat current income generated from the fund’s investment assets differently than the proceeds from the sale of the fund’s investment assets, such that the waterfall for current income does not include a return of capital. However, it is important to keep in mind that the preferred return generally continues to accrue on all unreturned capital contributions and it may make more sense for the private real estate fund to return capital to investors at its earliest opportunity.

If you’re ready to begin the process of structuring private real estate funds, or you’d like to receive additional information regarding the timeline or costs involved in structuring funds, schedule a complimentary consultation today.

Fees and Expenses and Related Conflicts of Interest

As an investment type, real estate is often susceptible to the imposition of many fees and costs, some of which can appear to be duplicative or improperly allocated to investors in a private real estate fund. Real estate funds generally charge investors a fixed management fee, based on a percentage of the fund’s assets under management, to cover the manager’s costs of operating the fund. General fund expenses are also typically factored into the overall net profit or net loss available to investors. For example, if a private real estate fund contracts with a third-party to serve as a property developer, general contractor, or property manager for the fund’s investment assets, rather than utilizing the fund’s general partner/ sponsor in such roles, investors may question the purpose or amount of the management fee.

Certainly, conflicts of interest may arise when a fund’s manager/ sponsor does provide development or property management services to the fund and care should be exercised to fully disclose any and all amounts that the fund may pay to the fund manager and its affiliates. It is often helpful for a private real estate fund to consider a more customized compensation system for its general partner or manager in order to better align the interests of all parties. More complex compensation structures include fully-disclosed acquisition, development, and disposition fees, fixed limitations on total fees and expenses payable to the manager, and limitations that provide that ancillary fees will only be paid from the fund’s cash flow when it is ultimately distributed to the investors. In any case, investors must be given detailed disclosure regarding any compensation to a private real estate fund’s manager/ sponsor or the sponsor group risks significant potential liability as a result of non-disclosure.

By their nature, private real estate funds often reflect many of the characteristics of traditional operating businesses. The sponsor’s principal managers and employees must consider numerous operational issues that generally don’t arise in the course of operating other, open-end private investment funds. For example, a private real estate fund must be able to provide for the development, improvement, property management, and/or maintenance of its investment assets. Real estate investments also encounter unique requirements for insurance, compliance with state and local codes and ordinances, and will usually be subject to property taxes and other ongoing taxes and assessments. Successful real estate fund sponsor groups plan for operational challenges in advance to allow the fund to achieve its objectives and return capital to investors.

The process to launch a private real estate fund involves navigating a variety of structural complexities and business challenges. Presenting investors with an offering that is not consistent with current market imperatives will make the process to raise investor capital substantially more difficult. In what has become an increasingly competitive environment for investor funds, only those sponsors that take a thoughtful approach and present a coherent value proposition will succeed to build long-term value in a private real estate fund complex.

Ready to Start a Real Estate Fund?

If you’re ready to begin the process to start a real estate fund, please contact us to schedule a complimentary consultation to answer any questions that you may have and to learn more about the timeline and costs to launch your fund.

Additional articles you may be interested in reading:

Difference Between a Private Real Estate Fund & an REIT

Most REITs specialize in a single type of real estate, such as apartment communities.

Investors can use both private real estate funds and REITs as tools for diversifying a long-term investment portfolio. You can invest in real estate as a hedge against inflation and as a source of stable income. The factors dictating whether to invest in real estate via REITs or private real estate funds should be based on factors including liquidity needs, tax considerations, risk tolerance and investment time horizon.

Publicly traded REITs must meet requirements set forth by the exchange they trade on and must also make regular disclosures to the Securities and Exchange Commission. To qualify as an REIT, a long list of requirements must be met. REITs must distribute at least 90 percent of taxable income to shareholders, derive no less than 75 percent of gross income from real estate related sources and derive at least 95 percent of gross income from real estate sources along with dividends or interests from any source. Private real estate funds are not subject to these restrictions, but larger private real estate funds are subject to the Consumer Protection Act, stemming from the Dodd-Frank reforms of the late 2000s.

Investors prize liquidity for a wide variety of reasons, and publicly traded REITs are far more liquid than interests in most private real estate firms. Liquidity in private real estate firms is dictated by the operating agreement created to form the firm and often include onerous restrictions on transfers. REIT holdings can be bought and sold anytime on exchanges via broker-dealers, or they can be redeemed directly by the REIT. REITs must also have at least 100 shareholders, and no more than 50 percent of its shares can be held by five or fewer individuals, which increases liquidity by expanding the shareholder base. REITs pay a high level of distributions -- one of the most important factors offsetting the liquidity risk for investors. All this is contrary to the way private real estate firms operate.

Most of the larger private real estate funds have high standards for admission of new partners, typically including minimum net worth requirements and the ability to commit to making future capital contributions. These funds are generally the domain of institutional investors such as pension funds, endowments and other qualified investors. REITs have outperformed private real estate funds by nearly 5 percent during the past three decades through early 2013, but institutional investors still allocate approximately 80 percent of their real estate investments to private real estate funds. This is reportedly due to concerns over pricing and volatility. The minimum requirement for investing in an REIT is the price of one share.

Both REITs and private real estate funds may hold a wide variety of investments, including mortgages, mortgage-backed securities and real estate equity. Publicly traded REITs and nontraded REITs must both make regular disclosures to the SEC, including quarterly and annual financial statements. Private real estate funds generally disclose annual results to partners and are not required to fully disclose all operating results. REITs are formed as “regular” C corporations, while private funds are set up as partnerships and limited liability companies. Share value transparency is higher with REITs, because the market prices them daily, which is not the case with private funds. Private funds are also more likely to invest in more illiquid real estate investments because they're not required to distribute such a high percentage of their income.

Henley Private Equity Real Estate Investments

Henley is a Private Equity Real Estate firm operating across a broad platform, deploying both institutional and private investor capital. Henley’s investment strategy covers its traditional opportunistic strategy with a new secure income, core fund.

As the market cycle ages our primary interest today is in business deals, niches and sectors that can demonstrate at least one attribute in the form of Arbitrage, Distress or Dislocation. This way we rely less on the economic winds for performance but instead on the specific deal situation and we can therefore juice returns if the economy remains positive whilst reduce downside risk if the economy hits the buffers.

Our new closed end Secure Income fund is for large pension fund investors looking for long term dividends that grow at least in line with inflation. The fund will benefit from our market wide perspective and access to suitable deal flow and has a 25 year life.

Our first investment principle as a Private Equity Real Estate firm is to always try and ensure we preserve the capital invested. The second principle is to fully explore the multitude of options available to maximise returns. As a result our approach has generated exceptional returns for our investors since we founded in 2006 with an average IRR of over 30% as at summer 2017. Whilst activity has concentrated in the UK, we have recently expanded to other geographies, starting with Holland and Germany. During 2016 Henley launched in the USA and now have offices in Boston, Southern California and Florida.

The majority of our investments are executed on a deal-by-deal basis providing our investors with concise and relevant information once an opportunity has been secured. This highlights the deal attributes, a clear business plan and the target for investor returns. Investors then contact us if they require further information and are interested in participation. Henley creates a Fund SPV for the investment and carries out all of the financing and asset management providing a full service approach for investors. Henley will invest its own capital along with third party limited partners into each of its deals.

Another unique aspect of Henley is that we have built a platform from which entrepreneurs can grow their businesses into much larger successful enterprises. Henley provides a fertile environment for smart entrepreneurs to prosper from capital, access to networks and synergies with other Henley businesses. If you are a smart real estate entrepreneur looking to grow into a large business please contact us to learn how Henley can make that happen.

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