Real Estate Funds: What’s Your Ideal Structure, and How Will You Get Paid?

Launching your own real estate fund can be an exciting endeavor, especially with the right team at your side. But figuring out how to structure your fund to entice other investors and protect your own interests can be challenging. There are many things to think about before you dive in and get started. Let’s go over a few of these considerations.

Entity Selection

Most real estate funds are organized as LLCs (limited liability companies). As an LLC, owners can choose how they are taxed: as a partnership, a corporation or an S corporation. Because partnerships allow for the most flexible ownership and creative allocations among its owners, most real estate funds choose to be taxed as partnerships.

If the real estate fund chooses to be a partnership, the syndicator or sponsor is often the general partner (GP) while the passive investors are the limited partners (LPs). This makes the investment more appealing, as passive investors’ risk is limited to their capital investment. Sponsors/syndicators may be personally liable for the real estate fund, but they might be able to limit their exposure by placing a single member LLC as the fund’s GP. Real estate funds can also commonly be organized as an LLC in which the sponsor member has a separate class of ownership and control.

Paying the Sponsor/Syndicator

If you spend time strategizing, researching new investment properties, building relationships with banks, securing financing, conducting due diligence, following regulatory guidance, hiring contractors and managing the business, you should structure your real estate fund so that you are rewarded for your efforts. Here are a few ways syndicators or sponsors of real estate funds can get paid.

Fees

Syndicators can collect fees on a monthly, quarterly or annual basis to be paid for their work. Here are a few types of fees to consider building into your owner’s agreement:

• Acquisition fee: A certain percentage of the building’s purchase price to reward the sponsor for their search efforts and due diligence. Acquisition fees are typically between 1% and 5%.
• Disposition fee: A fee to reward the syndicator’s efforts for marketing and selling the property.
• Asset management fees: A certain percentage of company revenue paid to sponsors. For example, if the real estate fund owned an apartment building and collected $100,000 in tenant payments each month, a 1% asset management fee could return $1,000 each month to the syndicator.
• Asset management fees can also take the form of a flat fee for each asset. For example, the real estate fund’s apartment building has 20 units and the flat fee for managing each unit is $200 per year. The syndicator could pull $4,000 each year under this arrangement.

Waterfall Distributions

While passive investors can enjoy the benefits of long-term real estate appreciation, they often place a higher value on annual returns (known as a cash-on-cash, IRR, etc.). When the real estate fund earns income, that income is typically distributed to its owners on a monthly, quarterly or annual basis. How should these distributions be divvied up?

There are many ways to distribute business earnings. But most real estate funds use a method known as a distribution waterfall. You can think of this concept as a waterfall feeding a series of pools. As one pool is filled, the excess drains into the pool below, and so on.

Waterfall provisions must be stipulated in the owner’s agreement and it’s important that you understand how they impact the accounting of your real estate fund. A common waterfall provision might look like this:

1. Preferred Returns to Passive Investors
   Once investors have been returned their capital investment, passive investors are often guaranteed a return on their investment. These returns typically range from 6% to 12%, and they are distributed in proportion to investors’ initial investment. Syndicators don’t usually receive preferred returns.
2. Return of Capital
   The very first distributions work to make investors whole. These distributions pay investors in proportion to their capital investment.
3. Promote Fee to Syndicator
   Once passive investors receive their preferred returns, a [typically much larger] fee is distributed to the syndicator. This is also called the carried interest. Another option is to have a catch-up provision. This is when the syndicator receives all the fund’s future profits until it has surpassed a certain hurdle. For example, let’s say the distribution hurdle was 25%. The syndicator would receive catch-up provision distributions at this point in the waterfall structure until they have received an amount equal to 25% of cumulative lifetime distributions.
4. Remaining Distributions
   The remaining distributions can be divvied up in whatever manner is outlined in the organization documents. In some cases, all remaining distributions are allocated to the syndicator. In others, it’s split among all active and passive investors based on ownership percentage or some other arbitrary percentage. Most often, remaining distributions favor the syndicator.

Ownership Percentages

If you don’t want to do a waterfall provision, you could simply give yourself a portion of the ownership in the entity (known as a carried interest). In a 30/70 split, for example, you would have a 30% ownership in the entity as the syndicator while all other passive investors would split the remaining 70% (based on their investment in the entity). These ownership percentages matter, especially when you refinance or sell the property.

The Right Structure Will Attract Quality Investors

Bringing on the right investors can be one of the most difficult parts of establishing a real estate fund. Creating a well-structured fund (that balances returns for the investors with profits for the sponsor) with a sound investment philosophy goes a long way in this effort. Your investors will not only see the benefits of working with you, they’ll also be excited to participate in your venture (over and over again).

Reach out to our real estate team to discuss how you should structure your next real estate fund. And if you’re considering getting involved in real estate funds for the first time, we can help you get started.

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