Raising a real estate fund in a down economy

With real estate values plummeting and the flow of deals slowing to a trickle, these may not seem auspicious times for raising a real estate fund. But there are always opportunities even in a down market, even for developers seeking to raise their first fund.

Despite the current economic climate, fund formation remains robust, with more than 1,400 funds with $50 billion in assets out in the market. While investors have become much more discerning, allocations to real estate funds remain high, and investors continue to fund strong performers.

At a time when traditional bank and mezzanine financing have become hard to find, and loan to value ratios are much lower, raising a fund can provide developers with a ready source of liquidity for capitalizing on emerging opportunities – whether investing in distressed assets or banking land for future development.

Still a down market poses challenges. Most money is going into established funds, and 50 percent to 70 percent of that capital is flowing to foreign markets. In this environment, what can developers do to better position themselves to successfully raise and manage a real estate fund?

An important first question for developers to ask is why do I want to create a fund, and are there alternatives? Funds can be powerful tools, but they also can take considerable time to raise and often provide greater returns to investors than the developer.

Sometimes other arrangements, such as joint ventures, can be advantageous, in particular for developers that have not previously managed a fund but have a strong record of completing projects on time and within budget and generating a favorable ROI. Joint ventures generally provide better returns to the developer and can be a steppingstone for later raising a first fund.

Specificity helps

For those developers looking to capitalize on the advantages offered by a fund, past performance of the management team will be the key factor in the fund’s capacity to attract investors. Developers considering a first fund should have a solid track record in the same or similar geographic area and property type in which the proposed fund will concentrate.

Further, if possible, identifying a couple of specific projects that the fund intends to acquire may provide investors with a greater degree of confidence in the types of investments the fund intends to make.

Funds are taking longer to complete, with six to 18 months quickly becoming the norm. It’s not enough these days to just tell your story. As commonly happens in down markets, investors are looking for sponsors with strong histories of providing solid returns, and are doing considerably more due diligence on the management teams and verification of their past performance.

Developers should be prepared to respond to such diligence inquiries by producing accounting records and performance reports for their past projects that will stand up to a tougher level of scrutiny.

Developers considering forming a fund also need to do their own due diligence on existing real estate fund terms, and determine the size, focus and investment terms for their proposed fund. Most real estate funds have a two- to three-year investment period, after which capital that has not been invested cannot be called from the limited partners. Many funds also offer their limited partners a preferred return of between 6 and 10 percent in addition to the return of their invested capital, and an 80/20 split of the fund’s net proceeds following payment of the preferred return.

In the current economic climate, it is certainly more difficult for funds to find properties to acquire that may generate the returns to which investors have become accustomed. In setting the terms of their fund, developers need to be realistic about the number of deals that can actually be completed within the investment period and the level of return that can be realized.

Developers considering a fund should generate a preliminary list of target investors with whom they have a strong relationship. They also may want to speak with some of these investors on a more general level, in order to determine their appetite for investments in funds similar to the fund the developer intends to raise.

Especially in the case of first-time funds, it is important to attract a strong lead investor who can help address concerns of other investors and often change their perception of the risks of investing in such a fund. Here an initial joint venture can be beneficial, as joint venture partners can become lead investors in your fund down the road.

There are real estate fund opportunities in the current market, but if the conditions are not right, developers may be better off getting their own houses in order and exploring alternatives that can position them to raise a fund a few years down the road.

Stephen Gould of Bow is a partner in the Boston law firm of Nutter McClennen & Fish, focusing on mergers & acquisitions, private equity and venture capital investments, real estate funds and joint ventures. Paul Eklund is a partner at Nutter, where he specializes in finance, joint ventures and partnerships, and mergers and acquisitions.