With a slower deal flow and more available capital, the current environment suggests that structuring real estate deals as funds might be a strong alternative strategy. There are significant benefits to forming funds to structure your real estate investments. The fund structure lets the buyer close deals quicker with committed capital readily available; attract larger commitments from more sophisticated investors; and, overall provides more creditability in the marketplace with sellers and investors. However, with these benefits come many nuances and concepts you may not have thought about before.
All private fund managers need to consider regulatory requirements that may apply to them, this includes the Investment Advisers Act of 1940, as amended (Advisers Act), the Investment Company Act of 1940, as amended (Investment Company Act) and related state laws. Real estate fund managers, unlike their private equity fund counterparts, often invest in assets that are not securities — in many cases, this leads to a very different analysis of the regulatory regime. Similar to a typical private equity fund or hedge fund, private real estate funds are generally offered to investors pursuant to a private placement of the fund’s securities (i.e. interests in the fund) conducted pursuant to Rule 506(b) of Regulation D under the Securities Act of 1933.
Typically, a real estate private equity fund invests in real estate-based assets. Properly structured, smaller real estate funds generally fall outside of the regulatory regime imposed on private equity funds that buy, sell, and invest in businesses and the securities related thereto. However, for example, if the real estate private equity fund were to invest in real estate securities (i.e. shares of REIT stock) or debt securities the sponsor or adviser would need to consider filing to be a Registered Investment Adviser (“RIA”) under the Advisers Act. As an RIA, the adviser must implement a comprehensive compliance program, appoint a Chief Compliance Officer, provide public disclosures of the sponsor’s operations, and become subject to examinations by the Securities and Exchange Commission (SEC).
Lastly, along with registering and executing the above-mentioned items, RIAs must evaluate their practices with relation to Rule 206(4)-2 (the “Custody Rule”) of the Investment Company Act. The vast majority of private funds under RIAs use the audited financial statements alternative for compliance with the Custody Rule as opposed to an annual surprise custody examination. The auditor must be independent of the fund and its affiliates, and registered with and subject to regular inspection by, the Public Company Accounting Oversight Board (PCAOB). In addition, the auditor is prohibited from performing certain non-audit services. Therefore, management must design effective internal controls over financial reporting and take responsibility for the preparation and fair presentation of financial statements in conformity with generally accepted fair value-based accounting principles (FV GAAP). This may result in additional costs or reassignment of existing resources to prepare, produce, and distribute a full set of financial statements and the accompanying notes together with the independent auditor’s report.
Real estate companies may be used to present their real estate assets at historical cost, net of depreciation. Over the years, the private equity real estate industry has transitioned to reporting at fair value under the guidance in Financial Accounting Standards Board Accounting Standards Codification (ASC) 946 – Financial Services – Investment Companies (ASC 946). The impetus for this transition was to provide more transparent and meaningful reporting to investors. A private real estate fund will need to understand the requirements of ASC 946, as it will play a significant role in their financial statement reporting and disclosure obligations. Some significant differences from historical cost reporting to fair value reporting are presenting real estate assets at fair value, calculating and disclosing financial highlights including internal rates of return and showing the fund’s activities without the real estate operations, including the recognition of dividend income and unrealized gains and losses. Benchmarks will change from net operating income to internal rate of return (IRR) for reporting purposes and assessing the success of the fund in the marketplace.
With all this said, there are many aspects to think about when evolving into this type of reporting. First, as a roadmap for the fund, it is necessary for a fund to establish a valuation policy. Factors to focus on when designing the policy include the type of assets the fund will be investing in, the strategy of the fund (i.e. will it be a core fund, value-add fund or open-ended versus closed-ended fund) and the specific valuation techniques and methodologies to be used. Most importantly, while assessing these factors, the fund needs to make sure the policy is consistent with ASC 820, Fair Value Measurements and Uniform Standards of Professional Appraisal Practice (USPAP).
Many sophisticated investors will also require quarterly reporting, via side letters to the funds’ operating documents, which will include presenting the fair value of the investments and the IRRs, compared to peer funds in the same sector of the real estate market, on a quarterly basis. It is important to understand how to calculate these benchmarks and how to obtain the relevant industry information so the fund can appropriately report to its investors. These side letters also typically include restrictions and guidelines for the fund sponsor in connection with certain activities of the fund.
The real estate private equity fund structure provides many advantages and increases opportunities for an overall real estate business. As described above, it does require a different set of reporting and possibly regulatory requirements but if managed in the appropriate manner, with the help of professional advisers, it can lead to significant success and unlock alternative avenues in the marketplace. It could be the next stepping-stone in the growth for your real estate empire.