The Next Phase in the Evolution of Real Estate Investment

As Seen in Crain's New York Business

With the uncertainty in the real estate markets brought on by the COVID-19 crisis, many real estate firms are reconsidering their investment strategies and the structure of their investments. This year has seen many new real estate funds form as real estate players look to gain market advantages.

Are you contemplating starting a real estate fund? Have you recently launched your first fund? Raising capital for real estate investments through a fund can certainly have its returns.

One of the biggest benefits: It provides the opportunity for a buyer to strike quickly and close deals with capital already committed and ready to be deployed instead of going through the process of raising capital and negotiating investor terms after identifying a potential acquisition. A fund can be a necessity when a buyer needs to move expeditiously to close a distressed deal.

In this unpredictable and competitive real estate market, the flexibility of having committed capital at a buyer’s disposal can be the edge that gains the confidence and trust of the seller and wins the bidding war. 

Other benefits to raising capital through a real estate fund: It allows you to attract larger commitments from larger investors, and it helps you to build relationships with institutional investors and gain their trust. This gives you added marketplace creditability and attracts others to invest alongside them.

This means larger funds, more capital to invest, better investment opportunities, more management fees and momentum for the next fund.

When launching a real estate fund, there are critical questions fund managers should ask themselves before they approach investors. For example, what is the real estate fund’s clearly defined strategy? In what types of assets will the fund invest? What class of properties? What geographies? What are the targeted returns? What is the execution plan to generate the targeted returns?

To sell to potential investors, fund managers should be prepared to show their performance records on deals compared to industry benchmarks. This will provide investors the opportunity to assess managers using the same metrics. Funds should thoroughly research the market on fees and fee structures, such as management fees and how they are charged, acquisition-disposition fees, and preferred returns. In addition, funds should be prepared, through side letters, to meet any unique requirements by specific investors.

Fund managers may need to demonstrate to investors that they have the capacity to handle the workload that will come from launching a fund, and they should be prepared to consider expanding their back office or seek outsourced solutions to fill gaps.

For example, hiring a third-party fund administrator can assist in investor relations and financial reporting tasks, and engaging third-party property managers can ease the burden on fund managers of day-to-day, on-site operations. Fund managers should be able to leverage off the efficiency of the fund structure by better utilizing their internal resources. Th is should allow more for fund-level operations, including enhanced cash flow management to achieve the targeted returns.

Many funds’ operating agreements require audited financial statements. Fund managers should ensure they are equipped with the proper internal controls and financial reporting systems to make it through a financial statement audit with an unqualified opinion. Furthermore, a fund would be required to report its investments at fair value on its financial statements if the fund meets the definition of an “investment company” under U.S. Generally Accepted Accounting Principles.

FASB Accounting Standards Codification 946-10-15-6 states that an investment company has these fundamental characteristics: “obtains funds from one or more investors and provides the investor(s) with investment management services” and “commits to its investor(s) that its business purpose and only substantive activities are investing the funds solely for returns from capital appreciation, investment income, or both.” While fair value reporting could add complication and require additional sophistication to the financial reporting process, fair value financial statements are generally seen as more useful to investors.

Fund managers should be familiar with the rules and regulations of the Securities and Exchange Commission and their states’ regulatory agencies, and consult with their professional service providers on whether they must file to become Registered Investment Advisers, which have additional oversight and reporting requirements.

Finally, fund managers should work with their tax attorneys and accountants during the formation process to ensure that the fund is tax-efficient and optimally structured for all parties. Ownership, operation and disposition of real estate through funds should provide investors with at least the same tax benefits as deal-by-deal transactions.

After assessing the benefits and considerations of launching a real estate fund, make sure to consult with your professional service providers to address your opportunity.

The time is now to prepare for the new wave of real estate investment. The structure of real estate deals is evolving. Focus on what counts and call your trusted advisors to help put evolution into action. 

For more Citrin Cooperman thought leadership on real estate funds, click here.