Real estate funds can create development opportunities
As the process of real estate development — from due diligence to permitting to financing — becomes ever more capital- and time-intensive, developers are increasingly turning to the establishment of real estate funds as an important tool for pooling capital, spreading risk and for responding more nimbly to changing market conditions. With equity behind them, developers can seize opportunities before market conditions change or competitors sweep in, have funds available to place deposits and conduct due diligence and, with a pool of investors, can consider investing in and developing larger projects. With real estate securities continuing to yield higher returns than the average domestic stock portfolio, there remains strong interest in investing in these funds. (Over the past five years, real estate funds returned an average annualized return of 12.5 percent.) But, while there are important advantages to establishing real estate funds, before launching a fund developers need to consider several issues that can have a significant impact on their ability to attract investors, raise capital and realize higher returns. First and foremost, developers should realize that real estate funds are investments, not unlike other private equity instruments, which impose certain legal, regulatory and business constraints. As with other investments, past performance will be a key factor in a fund’s capacity to attract investors. Investors want strong evidence that their money will yield a better return than alternative investment opportunities. If “location, location, location” is the rule in real estate development, then “management, management, management” is the sine qua non of real estate investment. If you are considering forming your first fund, the best substitute for a fund management track record is your history as a developer: Can you demonstrate success in bringing projects to fruition - on time, within budget, in managing these properties and implementing a successful exit strategy? In this regard, it is advisable to target the fund in the particular market segment (whether it is office, industrial, retail or other) where your portfolio is strongest. Investors typically diversify by investing capital in different funds, so creating a diverse fund is not an advantage. Also, identifying specific projects that the fund will finance — rather than creating a blind pool — provides the promoter with a more tangible example of projects the fund intends to invest in and can be an additional selling point for potential investors. Beyond issues of raising the fund, developers need to consider that most real estate funds are structured as limited partnerships, in which the general partner is a limited liability company owned by the developer. Under the terms of such partnerships, there is typically a two- to three-year investment period, after which capital that the fund has not invested must be returned to the limited partners. There is a longer hold/disposition period - generally five to seven years, during which the partnership manages and then sells the property - but developers need to be aware that the investment period may provide a very limited window depending on the market. Many funds also offer limited partners a preferred return of between 6 and 10 percent in addition to the return of their invested capital. Over the past five years, real estate funds have substantially exceeded this benchmark, but future performance can be hard to gauge - another reason developers should create funds in market segments where they have the greatest experience. Short of establishing a real estate investment trust, or REIT, it is generally advisable to offer limited partnership interests in real estate funds through a private placement, which exempts the fund from most Securities and Exchange Commission reporting requirements. In order to insure that the fund will qualify as a private placement, promoters should target “accredited” investors who are experienced investors with a minimum net worth of $1 million or who have earned at least $200,000 in each of the past two years and reasonably expect the same in the current year (or $300,000 with a spouse). In addition, the fund should create a detailed private-placement memorandum for investors to satisfy SEC disclosure mandates. And real estate funds must have no more than 100 investors in order to avoid being characterized as an “investment company” under federal securities laws. As with any investment, a real estate fund is selling a promise of things to come. Formation of a fund will have a critical impact on its ability to deliver on that promise, and thus to raise additional funds in the future. nhbr Stephen Gould of Bow, a junior partner in the Boston law firm of Nutter McClennen & Fish, focuses on business and commercial real estate law. He is a member of both the New Hampshire and Massachusetts bars and can be reached at firstname.lastname@example.org. Paul Eklund is a partner at Nutter, specializing in finance, joint ventures and partnerships, and mergers and acquisitions. He can be reached at email@example.com.