A Primer on Real Estate Private Equity Fund Formation and Operations – Part II

The economic terms of a real estate fund are ultimately going to be dictated by market conditions.

The purpose of this article is to educate the real estate professional contemplating forming a real estate fund. Click here to read Part I. After reading this article, the real estate professional should have a basic understanding of the questions which need to be answered as he or she decides whether to proceed with a fund and an overview of the complexities of structuring and operating a real estate fund. Ideally, the issues discussed above will provide an excellent starting point for the real estate professional who elects to move forward with sponsoring a real estate fund.

The economic terms of a real estate fund are ultimately going to be dictated by market conditions and in certain circumstances, as noted below in Section V, the tax considerations of the fund’s investors. While the terms of the offering vary widely from fund to fund, the following is an outline of the three primary economic terms contained in real estate funds:

Contributions:  Upon the sponsor’s formal request to the investor for a specific percentage of the investor’s capital commitment, as set forth in the subscription agreement, the investor will have a finite amount of time, usually about two to three weeks, to wire or send a check to the sponsor as a capital contribution to the fund for the requested amount.  Once contributed, an investor’s capital will usually only be returned upon the occurrence of a capital event, such as a sale or refinancing of all or a portion of the fund’s assets, or upon the fund’s payment of dividends to investors resulting from positive cash flow from operations.

Traditionally, investors have demanded an annually compounded preferred return between 8% and 12% for their initial capital contribution.

Usually, investors are not obligated to contribute capital in excess of the amount they initially agreed to contribute, although investors may be diluted if a fund requires capital and such investors decline to contribute.

Distributions:  The distribution provisions of a real estate fund effectively control the economic relationship of the investors and the sponsor.  Generally, distributable cash generated by the fund (which includes both cash from operations and capital proceeds generated by capital events such as the sale or refinancing of assets) is distributed in the following priority before the sponsor receives any compensation (except for fund fees):

First, to investors who made a requested, non-mandatory, additional capital contribution until their additional capital contribution and any preferred return on their additional capital contribution has been paid;

Next, to investors until the preferred return on their initial capital contribution has been paid; and next, to investors until their capital contributions have been paid.

After the investors have received their cumulated preferred return and the return of their initial capital contribution, then the remaining allocations are based upon the agreed upon back-end percentage split between the sponsor and the investors.  The back-end percentage split for the remaining proceeds has typically been 20% to the sponsor (sometimes called the “promote” or “carried interest”) and 80% to the investors, but varies depending upon the nature of the fund and the projected performance of the fund’s assets.

Distribution provisions may also include a “waterfall” whereby the back-end percentage split payable to the sponsor would increase (and the back-end percentage split to the investors decrease) as the overall IRR realized by the investors surpasses certain milestones.  For example, back-end proceeds could be distributed 20% to the sponsor and 80% to the investors until the investors’ overall IRR reaches 15%, at which point the remaining back-end proceeds would go 30% to the sponsor and 70% to the investors until the investors’ overall IRR reaches 20%, at which point back-end proceeds would be distributed 40% to the sponsor and 60% to the investors.

There are many variations of the distribution structure that may be considered during formation of the fund.  Most of the negotiations surrounding the distribution structure depend on the expectations of the sponsor and its perceived ability to raise funds.

There are a number of fees typically payable to the sponsor or its affiliates which impact the economic structure of a real estate fund.  One fee that may be included is an asset management fee, which usually ranges from 0.5% to 2.0% per year of the fund’s committed capital, until the capital draw down period expires and the asset management fee is then based on invested funds or funds accruing a preferred return.  Other fees that might be charged by a fund include leasing fees, property management fees, financing fees, loan guarantee fees and other administrative fees.

Once again, it will be up to the sponsor to establish a fee structure that he or she believes will be acceptable to its potential investors.

Tax issues affecting real estate funds

The tax issues associated with the formation and operation of a real estate fund will depend both upon the investment strategy of the fund (e.g., development versus rental properties and whether debt is going to be used to acquire properties) as well as the type and number of investors the sponsor is seeking to invest in the fund (e.g., tax exempts, pension funds, foreign persons and/or U.S. taxable persons).

As discussed above, a real estate fund will typically be structured as a pass-through entity for U.S. income tax purposes as either a limited liability company or limited partnership in accordance with state law.   As a result, the fund will not pay an entity level tax and the income of the fund will pass through directly to the investors.

In forming the fund, and ultimately in structuring the investments of the fund, special consideration must be given to the following tax issues set forth below as they may impact the ultimate economics of both the fund itself and the underlying investments of the fund, as well as the mix of investors from whom the sponsor may ultimately solicit funds.  Note, this discussion does not address all of the issues associated with the formation or operation of a real estate fund.

Unrelated Business Taxable Income (UBTI)

A significant amount of capital is often available from tax exempt investors, including university foundations, governmental entities, pension funds and other tax exempt investors.  Tax exempt entities are generally not required to pay tax on passive types of income such as dividends, interest, royalties and rents or gains from the sale of non-dealer property.

However, tax exempt entities are required to pay tax on income that is considered unrelated business taxable income or “UBTI”.  In the context of a real estate fund, an investment by the fund will result in UBTI to a tax exempt investor if the fund is a dealer in real property (e.g., home or condo sales), or has active business income (e.g., service income from management or development fees, or percentage rents based on the net income of a tenant’s operating business).

In addition, passive income that is generally not considered UBTI (e.g., dividends, interest, rents or gains from the sale of non-dealer/inventory property) may be treated as UBTI if the fund (or its subsidiaries) uses leverage to acquire its real property investments.

In most circumstances the recognition of UBTI may not be avoidable; however there are exceptions to UBTI treatment depending upon the type of tax exempt investor and alternative structures for avoiding or minimizing the recognition of UBTI by tax exempt investors. Some tax exempt entities may accept UBTI and pay the tax if the expected return from the fund is high enough.  However, the sponsor should be clear upfront with its potential tax exempt investors as to what its obligations are with respect to the investor’s tolerance to recognizing UBTI.

If the fund is seeking investments from benefit plan investors, such as employee benefit plans and pension funds that are subject to ERISA, the fund may want to structure the ownership or operations of the fund in a manner that avoids the assets of the fund from being treated as “plan assets” under ERISA.

Attorneys Stephen D. Fox and Heather L. Preston of Arnall Golden Gregory LLP also contributed to this story.

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