Forming a Real Estate Fund

STRATEGY, STRUCTURE AND

INVESTMENT TERMS

Capital Fund Law Group

John S. Lore, Esq. | Managing Partner

Real estate securities offerings span a broad continuum of size and complexity. The most
basic structure is a single-asset acquisition vehicle. This is a company formed to hold a
single real estate investment property. Next is the private real estate fund (sometimes
known as a real estate private equity fund, which is the subject of this white paper). A
private real estate fund is a pooled investment fund structure intended for the acquisition
of multiple real estate properties. At the largest and most complex end of the
spectrum are non-traded and traded Real Estate Investment Trusts (REITs), which
are pooled investment vehicles requiring a large number of investors to satisfy
regulatory and tax requirements and generally requiring a substantial asset base to
justify the costs of formation and operation.

The private real estate fund strikes a balance between the two ends of the spectrum,
enabling a sponsor to raise capital in a pooled fund without being constrained to do
successive securities offerings on a deal-by-deal basis, and without the complexity, scale
and substantial regulation of forming a REIT. This white paper discusses some of the
key considerations in forming a private real estate fund, including strategy, structure, and
investment terms.
HEDGE FUND STRUCTURAL CONSIDERATIONS PRINCIPAL DOCUMENTS AND FILINGS NEEDED TO LAUNCH A FUND

REAL ESTATE FUND STRATEIGIES Joint Venture Real Estate Funds

Real estate funds are trending toward Joint venture real estate funds use a strategy
greater levels of specialization. of co-investment with other funds in a
Specialization may be by asset class, syndicated investment. Joint venture funds
strategy or both. Examples of asset class- can sometimes subject the investment
specific funds include: office, advisor to investment advisor registration
retail, medical, industrial, agricultural, requirements, as the co-investment
storage, hospitality, etc. relationship can be considered a security.

Real estate fund strategies can be loosely Real Estate Development Funds
categorized into one or more of the
following groups: Development funds are funds that acquire
unimproved land or demolish existing
Distressed Asset Funds property for re-development. These funds
require substantial management
Distressed asset funds seek to identify
involvement in working through the various
undervalued assets that are over leveraged,
municipalities permitting complexities as
suffer from cash flow issues, or are
well as coordinating the various stages of
otherwise unable to access needed debt
real estate construction. Accordingly,
financing. Distressed asset funds tend to
be cyclical, following general real estate development funds require substantial and
market patterns. complex offering document disclosures.

Structured Finance Real Estate Funds Opportunistic/ Special Opportunity Funds

Structured finance funds, often referred to Opportunistic funds, closely related to

as leveraged buyout funds, seek to use distressed asset funds, focus on special
substantial leverage to purchase real estate circumstances where assets are selling at a
that has fairly stable value projections. discount, such as through buying foreclosed
Structured finance funds are also cyclical real estate, unfinished construction, surplus
in nature, as they rely heavily on or damaged real estate.
inexpensive access to debt financing.

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 FORMING A REAL ESTATE FUND STRATEGY, STRUCTURE, AND INVESTMENT TERMS

Multi-Strategy Funds

Multi-strategy funds are the exception to the Once funded, an investor’s capital will be
specialization trend. Multi-strategy funds are returned only upon the sale or refinancing of
not confined to a single investment strategy a fund asset, or upon positive cash flow from
or objective (although they tend to be more rents and other operations. Most real estate
asset-class specific). Multi-strategy real funds, private equity funds, venture capital
estate funds tend to have a low risk tolerance funds, and other funds investing in illiquid
and maintain a high priority on capital assets are structured as closed-end funds.
preservation. Even though multi-strategy
funds have the discretion to use a variety of
strategies, we have found that fund sponsors Successive Funds
tend to focus primarily on one or two core
investment strategies. With closed-end, once an investment is sold,
it cannot be reinvested in the fund. Rather,
the fund sponsor would create a subsequent
REAL ESTATE FUND STRUCTURE fund as assets are sold and investment
proceeds returned to facilitate reinvestment.
The structure of a real estate fund is
Successful private equity fund sponsors
dependent on a number of tax, regulatory, and
typically develop a portfolio of various
financial considerations. Fund structure is
funds. Fund sponsors can form subsequent,
driven in large part by tax needs of the
investors. analogous real estate funds at substantial cost
savings to the initial funds, because less legal
Closed-End Structure structuring is required.

Real estate funds are almost always closed- Domestic Real Estate Fund Structure
end funds. A closed-end fund is an
investment fund intended to last for a fixed A domestic-only investment fund structure is
term, usually between five and ten years. typically comprised of the following entities:
Investors in a closed-end fund are generally • A limited partnership, typically formed in
not permitted to make withdrawals or the state of Delaware, to act as the fund
additional capital contributions during the life entity (although LLCs are becoming
of the fund. increasingly popular);

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 FORMING A REAL ESTATE FUND STRATEGY, STRUCTURE, AND INVESTMENT TERMS

Offshore Fund Structures

• An LLC to act as the investment
manager of the fund, formed in the
When properly structured, an offshore fund
jurisdiction of the sponsor; and
structure blocks offshore and tax-exempt US
investors from direct US tax liability. The
• A general partner of the fund (managing
most common offshore fund structures are
member in the case of an LLC), also
the master- feeder structure and the side-by-
formed in the jurisdiction of the sponsor.
side structure.
The investment manager and general
Master-Feeder Fund
partner entities are typically formed in the
jurisdiction of the fund sponsor. For real
A master-feeder structure consists of a
estate funds, the general partner and the
domestic feeder fund and an offshore feeder
investment manager are formed as two
fund (in a tax-free jurisdiction) that feed into
distinct entities to allow subsequent funds
a single offshore master fund, where all the
to maintain separate general partners for
liability purposes. Management fees are trading activity of the fund takes place.
paid to the investment manager, while
carried interest is allocated to the general
partner.

US Tax-Exempt Investors—UBTI Issues

Tax-exempt entities, including IRAs,

401Ks, pensions, charities, etc., are
subject to the unrelated business income
tax (or “UBTI”), a tax on certain business
income that is imposed notwithstanding
the organization or exempt status.

Under Sect. 512(b) of the Internal Parallel Fund Structure

Revenue Code, investment income,
including income from real estate, is A side-by-side structure has a U.S. fund and
subject to UBTI if derived from debt- offshore fund that parallel each other in
financed property (acquisition trading and have the same investment
indebtedness). Such distribution may manager but maintain separate investment
subject the fund to UBTI. portfolios.

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FORMING A REAL ESTATE FUND STRATEGY, STRUCTURE, AND INVESTMENT TERMS

Cayman Islands

The Cayman Islands has historically been This is primarily because of the tax
the top choice for offshore funds because complication faced by offshore investors
of its business friendly structure, stable and considerable structuring that needs to
government and well-developed be put in place to avoid negative tax
investment laws. The Cayman Islands is consequences.
the world leader as a jurisdiction for
investment fund domicile. FIRPTA Considerations
British Virgin Islands (BVI)
The primary concern for offshore investors
in US real estate funds is the US Foreign
BVI is a popular jurisdiction for offshore
funds. BVI has recently gained the Investment in Real Property Tax Act of
reputation for being a cost-effective and 1980 (known as FIRPTA). Under FIRPTA,
convenient jurisdiction. BVI’s regulatory non-US investors are taxed on income from
structure has sought to create a flexible US real property investments, including
jurisdiction with streamlined processes and gains from real estate investment funds, at
strong legal certainty. BVI’s regulatory extremely high effective rates. Additionally,
filing fees are considerably lower than FIRPTA requires that offshore investors file
those of the Cayman Islands. US tax returns and become subject to to the
IRS’s investigatory and subpoena powers.
Offshore Investors Fund sponsors are also required to make tax
withholding on offshore fund investments.
An initial consideration when structuring a
real estate fund is whether to admit For most funds, an offshore master-feeder
offshore investors or rely solely on structure set up in a tax neutral jurisdiction
investment from US persons. There is (Cayman Islands, British Virgin Islands,
admittedly an underrepresentation of non- etc.) would be sufficient to shield offshore
US investors in US real estate funds. investors. Not so with real estate funds. The
principal method used to mitigate tax
consequences to offshore investors is a more
complex solution: the leveraged domestic
blocker.

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FORMING A REAL ESTATE FUND STRATEGY, STRUCTURE, AND INVESTMENT TERMS

Leveraged Domestic Blocker INVESTMENT TERMS

A leveraged domestic blocker is a US One of the most important aspects of

corporation (usually set up in Delaware) forming a real estate fund is setting the
that is capitalized with a mix of loans and terms of the investment. When properly
equity. The aim of the leveraged domestic structured, real estate fund offering
blocker is to shield offshore Investors from documents contain terms that adequately
the US-tax filing obligations that FIRPTA protect the fund sponsor and are attractive
imposes, while reducing non-US investors’
to investors. Real estate fund terms are
effective rate on the real estate fund
driven by the fund’s strategy, the market
investment. The mechanics of the
trends within the fund’s specific asset
leveraged blocker are beyond the scope of
this white paper, but the primary benefit is class and the particular needs and
the interest deduction available with a objectives of the fund. It is crucial that
leveraged investment that is used by the the investment fund legal counsel have an
leveraged blocker to reduce the leveraged in-depth understanding of current
blocker’s income subject to US tax. The investment market trends and how those
protection afforded by the blocker will trends affect the strategy the fund will
vary depending on the particular investor employ.
and investment. While there is no failsafe
method to shield offshore real estate fund Fund Expenses
investors from FIRPTA, the leveraged
domestic blocker provides significant During the formation process the fund
protection from FIRPTA consequences for sponsor designates which of the expenses
many investors. of the fund will be borne by the manager
and which will be borne by the fund.
Typically, the fund bears expenses
directly related to forming and operating
the fund, including: legal formation costs,
accounting and administrative services,
regulatory filings, brokerage costs,
clearing costs, etc.

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FORMING A REAL ESTATE FUND STRATEGY, STRUCTURE, AND INVESTMENT TERMS

Sponsor Fees

A real estate fund sponsor’s compensation Once contributed, an investor’s capital

includes the carried interest (generally will be returned only upon the occurrence
approximately 20% of the fund’s capital of a capital event, such as a sale or
appreciation) and certain fees. There are a refinancing of all or a portion of the fund’s
number of fees that real estate sponsors assets, recognizing income, or other events
can charge, depending on the fund’s resulting in positive cash flow from
negotiating position with investors and the operations.
extent of involvement required by the
particular strategy. We recommend that Preferred Return
the shorter the track record of the sponsors
the more streamlined the fee structure Many real estate funds include a preferred
should be. The most basic fee is an return. Preferred returns can range from
investment management fee. The
6% to 12% of the initial capital
investment management fee is assessed
contribution. The preferred returns are
annually, typically ranging from 0.5% to
accrued and compounded annually. The
2%, (based on committed capital during
the commitment period and based on preferred return is distributed in
capital contributions thereafter). Other accordance with the distribution
potential fees include property provisions upon capital events.
management fees, leasing fees, financing
fees and other administrative fees. Distribution Waterfall

Capital Commitments The distribution provisions control the

priority of distributions from capital
When real estate fund investors subscribe events. The priority of distributions
to an investment in the fund, they usually between limited partners and the general
do so by entering into an agreement partner is referred to as the “distribution
committing them to invest a certain sum (a waterfall.” The distribution waterfall can
capital commitment) when called for by be pictured as a set of allocation pools.
the fund sponsor (a capital call). Upon the When a higher priority allocation pool is
capital call by the sponsor for a specific filled, the capital flows into the next pool.
percentage of the investor’s capital Distribution waterfalls vary significantly
commitment, the investor has a fixed from fund to fund, depending on a number
period of time in which to satisfy the of factors, but generally follow the
capital call. following conceptual framework.

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FORMING A REAL ESTATE FUND STRATEGY, STRUCTURE, AND INVESTMENT TERMS

Distribution waterfalls typically follow the Carried interest Phase

following three phases:
Following the catch-up phase, capital
(i) preferred return and recovery phase; allocations will be distributed based on the
carried interest (typically 20%). The general
(ii) catch-up phase; and partner will then receive 20% of the
distributed amount, while the limited
(iii) carried interest phase. partners will receive 80%.

Preferred Return/Recovery Phase General Partner Clawback

The first phase in the distribution waterfall Upon liquidation of the fund, limited
is the preferred return and recovery phase. partners are sometimes distributed less than
Generally, investors receive distribution the agreed-upon allocation (due to early
first, until their preferred return and capital positive performance and lagging
contributions have been repaid in full. performance toward the end of the fund).
When this occurs, the limited partners “claw
Catch-up Phase
back” the unpaid amount from the carried
interest distributed to the general partner.
After the preferred return and capital
contributions are recovered by investors, Since the clawback provision is only
the remaining funds are split between the activated at end of the fund, fund sponsors
investors (typically 80%) and the sponsor, must be cautious to maintain reserves to
in the form of carried interest (typically satisfy any such contingencies. Reserved
20%). However, since the limited partners funds are sometimes held in escrow for
have already received substantial investor protection.
distributions, the distribution waterfall now
accelerates allocations to the general
partner according to the catch-up rate
(often 50-60%). In the catch-up phase, the
general partner receives allocations at the
catch-up rate until the carried interest
allocations are caught up.

John S. Lore, Esq. is the managing partner of Capital Fund Law Group, a boutique law
firm providing expertise focused on the alternative investment industry. Call
801.456.3620 or email us to schedule a consultation to discuss your fund.

Call 801.456.3620 for a free consultation