The Nuts and Bolts of Raising Capital: 4 Types of Real Estate Funds

This entry was posted in Commercial Real Estate, Deal Funding. Bookmark the permalink.

Sharing is caring!

If you do not understand the essential principles of what a real estate fund is or why you need to grow into your position as a fund manager, you will need a refresher course.

This is done so that when you are creating and instituting your capital raising strategies, you do not misstep and lose out on potential investors because of your limited field knowledge.

Today we’ll be talking about the first step in raising capital for a real estate fund. When you are looking to raise capital efficiently, you must first decide on your fund type.

Before we dive in, let’s answer a question I’ve heard more times than I can count…

What Exactly Is a Real Estate Fund?

Your real estate fund is whatever you have structured it to be based on a planning and creation process that involves a lot of research and time-consuming documentation.

But simply put, a real estate fund is—quite literally—a supply of capital.

When your investors pool their money together and hand it to you to increase it, they retain ownership.

You can also reframe it and say that a real estate fund is a financial entity.

Multiple investors get together and pool their money so that this lump sum can be efficiently invested in multiple assetsfor the goal of making money from money.

It takes nerves of steel to raise capital from many sources and to be responsible for an earning fund.

Funds can raise capital from an indefinite number of joint deals as well. This widespread diversification is excellent for your investors.

They will enjoy much greater access to interesting investment opportunities while benefitting from your constant attention, professional expertise, and invaluable research as a fund manager.

When a fund manager focuses on one specific type of real estate investment, they usually have years of valuable knowledge behind them and can meet their targets easily.

In return for handing over an investment amount to their chosen fund manager, an investor will pay the manager fees, often a percentage value of the fund.

As a fund manager, it is your job to raise capital, find good deals, execute those deals successfully, and manage the fund—all while making your investors’ money.

Funds invest in real assets like commercial property, residential property, shopping malls, land, small holdings —anything tangible.

A good fund manager will earn their investors stacks of cash from their expertly planned investments.

I know of many real estate experts who have started their own funds and earned huge gains for their investors and themselves. With these larger deals, all that remains is for you to consistently learn how to raise capital.

Fund Economics

This video below is one of our market updates. I’ve placed it here so you know what institutional and other sophisticated investors are looking at as far as fees and incentives, such as profit splits.

If this sounds too complicated, don’t worry about it, in subsequent blogs we’ll dig deeper into these.

However, it’s important to realize you can’t just pile fees on top of your fund without performing first; this is something almost all novices do and they immediately shoot themselves in the foot.

The Four Main Types of Funds

Any good fund manager will tell you that there are four main types of real estate funds.

Get your pen and paper out and prepare to take notes, because we’ll be diving into each of these types of real estate funds you’ll be choosing from:

Open-Ended Funds

This type of fund is a collective investment that allows for the issuing and redemption of shares at any time during the investment process.

Funds are usually bought directly from the fund itself, not from shareholders.

Closed-Ended Funds

This type of fund is a collective investment that has a fixed number of shares. New shares are not created at any stage to meet the investor demand, as they are in open-ended funds.

The Accessible Fund

As a method of identifying the type of fund, accessibility is key.

Sometimes investors will pool in exclusive groups, and sometimes they will raise capital from middle income groups; it depends on the fund.

Fund Capital Structure

As a method of identifying the type of fund, capital structure also leaves some accurate clues.

Sometimes all of the investors will invest the same amount and, in other circumstances, different investors will invest different amounts.

Despite the economic downturn, fund managers are cropping up all over the place.

Targeting the right investment structure is instrumental in attracting the right quality of investor needed to populate your fund with working capital.

The choice you make here will also have multiple tax consequences.

If a fund, for example, is formed as a limited liability company, it is taxable as a partnership for federal income tax purposes.

The fund itself will not be taxed, however, which means that any income, loss, credits, or deductions will find their way to the investors.

Settling on the correct fund structure will help you piece together your investor pitch, which is crucial in raising capital. Bringing up great tax breaks, for example, could be that little something extra that causes you to land another excellent investor.

  • Pay close attention to the entity types that you select for your fund.
  • Focus on admission and withdrawal of your investors when structuring.
  • Check on your capital contributions and capital calls.
  • Determine the allocation of your profit/losses, clawbacks, and capital returns.
  • Work out conflicts of interest, fees, and expenses.

The Open-Ended Fund

Traditionally, an open-ended fund can be defined as a type of fund that has no restrictions on the amount of shares that the fund can issue.

If people want to invest in an open-ended fund, they will be able to—regardless of the number of investors that currently invest.

Another way of looking at it is that open-ended funds refer to the method of capital raising used. As the fund manager, you will continuously raise capital in your open-ended fund—and this capital will be deployed throughout all other fund processes.

When you come across a new investor, the fund assets will simply increase.

That means that the capital amount and the share amount will both increase to make room for the new investor. When an investor decides to call it quits and cashes out —whether it is all of their money or part of it—the shares will be sold back to the fund, and they are cancelled.

While this reduces the number of shares and the overall fund assets, it does not affect anyone else’s investment. Open-ended funds raise money by selling shares of the fund to the public.

The fund manager will earn income by collecting fees from the purchase of shares or as a percentage of the overall lump sum.

You could also collect commission based on your performance with your investments.

Open-ended funds are consistently and continuously managed—which means that you source, purchase, and manage the real estate investments and are responsible for the financial outcome of the fund.

Sometimes when an open-ended fund has grown too large, a fund manager will decide to close the fund to new investors. On occasion, they may even close new investments to existing investors.

This only happens if the fund performs extremely well and there is a rush for shares and profit.

The type of fund that you choose depends on your eventual purpose. A fix-and-help fund, for example, invests money into single-family homes, fixes them up, and then sells them again for profit.

These are a great fit for open-ended funds.

If your fund expects to have a large, broad number of investors with many buying and selling opportunities in short time periods, then it neatly matches with this type.

Open-ended funds are the opposite of closed-ended funds, which I will explore next. In the meantime, here are some key takeaways to help you decide on your capital raising structure.

  • Investors can enter and exit as they see fit.
  • Management continues on an ongoing basis for the fund manager.
  • Buying and selling real estate models suit this well.
  • Growing, larger real estate funds do better when they are open-ended.
  • Your investors maintain control of their shares and investments.
  • You have the responsibility to invest widely and make your pool money.

The Close-Ended Fund

A closed-ended fund is typically an investment vehicle that is public and raises a fixed amount of capital.

The fund is then structured, and shares are sold like stocks on a stock exchange. In your closed-ended fund, the fund manager will raise capital during an initial phase of capital raising.

This could take six months or two years depending on the manager. Once this initial phase is closed, no more shares will be created.

Only existing investors can buy and sell their existing shares. That also means that share prices will fluctuate and change—because the market value of invested assets will change over time.

In the wide world of real estate, closed-ended funds are a lot more common than other types.

This is particularly true when you plan on buying high-cost property to hold for extended periods of time. Because of this, you will find the bulk of institutional real estate funds are, in fact, closed-ended funds.

Investors tend to enter the fund during the capital-raising period—before any investing has taken place. Then everyone purchases shares at the same price.

The typical buy-in for these funds can be 5, 10, or even 20 million dollars each. Immediately after the allotted fund-raising period, the investment phase kicks in.

During this phase, which is also predetermined for, say, five years or so, the fund will be liquidated. On that day, every investor will get their pro-rata share of the proceeds. Sometimes fund managers choose to leave the investment period open-ended.

In these types of funds, investors may want to liquidate their investment in the fund, either partially or fully. When this happens, they will need a willing buyer. You will need to think very carefully about these models before selecting one.

A closed-ended fund gets its name because of the different phases of investment.

Once the initial allotted shares are sold, the fund is basically closed to new investors. Buying and selling, however, can still take place between individual investors of the fund.

Here are some key points about closed-ended funds. Consider them when selecting your ideal real estate fund structure.

  • Investors can only enter during the capital raising phase.
  • Management continues until the allotted time or until the fund is liquidated.
  • Long-term buying and selling models suit this common fund type.
  • Closed-ended funds are great for single investors looking for diversity.
  • Investors are able to buy and sell after the capital raising phase.
  • The fund manager still seeks out and manages investments.
  • You have the responsibility to turn your investments into profit for your shareholders.

(NOTE: Want access to The Commercial Investor business vault? Right now we’re offering access to systems, strategies, templates, trainings, and recordings. It’s all included in The Investors Syndicate, and is available to you here.)

dnd-tis-1200x628

The Accessible Fund

The third type of fund refers to the method that the investors have for accessing the fund.

Many funds are closed, in which case the manager will look for capital close to home via their own network contacts and connections.

These private equity funds often require large-scale investmentsreaching millions of dollars.

For other types of funds, you as the fund manager will raise capital through traditional markets, which means that you will be attracting middle-class investments.

These funds are open, and they can be created as Intrastate Offerings or 506 Reg D funds. Speaking of 506 Reg D funds, they may have a complex name, but this is because they are based on a specific rule—(506) of Regulation D.

All of these types of funds were subject to 506 rules, which enforced limitations on advertising and sourcing investments.

The fund manager can only approach investors that they have an existing business relationship with when they choose this fund structure.

Investors have to be accredited, and no more than 35 non-accredited investors are allowed per individual fund.

Your accredited investors can self-certify, and the ones that are not certified must, at least, be able to adequately assess the suitability of your fund for investment.

In about 8% of cases, Reg D funds benefitted from the non-accredited investor exemption.

I have personally only ever taken on accredited investors, and I would highly recommend that you think along the same lines when you have to set up your real estate fund.

When you select a 506, you will have to file a form D no later than 15 days after the first sale of shares to keep everything in order.

Luckily, these were the rules prior to September 2013, which have now passed.

A new provision, Rule 506c, allows you to use general solicitation in your investor strategies—which means that you can now raise capital from investors you have no relationship with at all as long as they are accredited.

It is your responsibility to verify that each of your investors is accredited, and this verification process will most likely increase your capital raising costs.

In the new 506c version, you have to file a Form D at least 15 days before starting general solicitation, which means that you cannot switch at the last second from B to C.

Your Intrastate Offerings are just securities that are registered in the state that your fund operates in.

These types of funds have far less restrictions on advertising and sourcing investors, and you can accept non-accredited investors as you see fit. It does allow you to advertise in newspapers and cold call people—as long as they are in the same state as you.

While these funds offer more flexibility in terms of capital raising, they can place more restrictions on your investment assets. For example, the fund requires that at least 80% of all capital raised needs to be invested in your chosen state. 

The Capital Structure Fund

The final type of fund structure that you need to be concerned with is defined by its capital structure.

All of the funds that I have mentioned until now have been equity funds.

An equity fund is when an investor becomes the owner or member of an LLC—or another entity—which is the fund itself.

These are considered “Pari Passu,” which means equal footing in Latin.

When all shares have equal seniority and rights of payment, this term is used. But now I am going to talk about another type of structure—a debt fund.

In this instance, instead of selling equity in the fund to your investors, you as the fund manager will borrow the money from your investors—who then become lenders or note-holders.

Do you see the difference?

Instead of becoming equity partners and shareholders, they become lenders and note-holders. Debt funds are not something you should consider at the beginning of your adventure with real estate funds, so I will only touch on this so that you remain informed about it.

If you do choose to walk down the debt fund path, there are many implications involved that you need to investigate.

For the purpose of this post, I will be focusing mainly on 506 Reg D funds—which is the safest and best form of equity fund, in my humble opinion. .

In this particular model, your investors own their shares but have no real say in the way that you manage the fund, and they have no claim on your management company.

The fund setup works like this: First you set up your entity (LLC), which becomes the fund. Then you create a separate management company that manages the fund.

Your investors will own the shares in the fund, but they will not own a thing in your management company.

Because of this, how you decide to invest is the best path forward—and no investors can interrupt that, which they often try to do. These two separate vehicles work in unison to create a real estate fund that is straightforward to manage.

The best part is that capital raising still remains open and flexible so you can carefully screen, select, and “trial and error” your strategies as you gain experience with your fund.

(NOTE: Want access to The Commercial Investor business vault? Right now we’re offering access to systems, strategies, templates, trainings, and recordings. It’s all included in The Investors Syndicate, and is available to you here.)

dnd-tis-1200x628

Sharing is caring!

Salvatore M. Buscemi
A former investment banker for Goldman Sachs in NYC, Sal is one of the nation’s leading authorities when it comes to investing in residential and commercial real estate. He’s raised over $50 Million in capital for his real estate hedge funds.

Comments

Salvatore M. Buscemi

About Salvatore M. Buscemi

A former investment banker for Goldman Sachs in NYC, Sal is one of the nation’s leading authorities when it comes to investing in residential and commercial real estate. He’s raised over $50 Million in capital for his real estate hedge funds.
Top

DO NOT DELETE

×

Get "Never Use a Bank Ever Again to Buy Income Real Estate” Today for FREE


×

The Definitive Guide to Commercial Real Estate Capital Raising

×