Real Estate Hedge Fund Structure

Real estate hedge funds have always been popular and considering the current stock market turmoil and volatility many real estate hedge fund sponsors believe that the time is ripe to offer a real estate product to market weary investors.

Potential Investments

Real estate hedge funds are not limited in their investment strategy and many such funds have different strategies. Many funds purchase real property and hold onto the real property for appreciation. Other funds will purchase raw land and then develop the land or hire other companies (including companies related to the sponsor of the fund) to develop the land. Still other funds will buy properties to manage for current income. Our law firm has handled all of these types of funds, as well as funds which seek to profit from turning around distressed real estate. The real estate may or may not be located in the United States. Other popular strategies include investing in commercial, multi family, general investment quality properties, and properties which have not yet been developed.

Structure and offering documents

Investors

The real estate hedge fund structure is similar to a hedge fund focused on trading securities; however there are some important differences. Most importantly, as long as the real estate fund is not investing in any securities (or money market accounts which may, in certain circumstances, be deemed to be securities), the fund will not be subject to the Investment Company Act of 1940 and therefore will not need to fall within either the 3(c)(1) or the 3(c)(7) exemption. This allows the real estate hedge fund a little more flexibility than securities hedge funds. Notably, the fund will need to adhere to the Regulation D requirements of the Securities Act of 1933 only and not the Investment Company Act. This means that the fund will be able to have an unlimited amount of accredited investors and up to 35 non-accredited investors. There is no requirement that investors in a real estate fund be either a qualified client or a qualified purchaser.

Structure

Because real estate hedge funds invest in assets which are not easily valued the real estate hedge fund will oftentimes take on a private equity like fund structure. The major characteristics of the private equity fund structure is the (i) closing/drawdown process for capital contributions and (ii) the limit on withdrawals until there is a disposition event. In this way the private equity fund does not have to deal with valuation issues until a value is determined. This helps to prevent the problem of the general partner taking a performance fee on an unknown rise in the asset value. In addition many general partners will also agree to a clawback provision.

An alternative to the strictly private equity structure is for the fund to implement side pocket investments. In their most simplest form a side pocket investment is an investment which is carried on the books to the side. Generally only those investors who were in the fund at the time of the investment (or in some programs, those who opt into the investment) are “owners” of that investment. Generally there will be no performance allocation on any investments in a side pocket account until there has been a disposition of the investment. Then, profits can be distributed to the investors in the side pocket account. Like the private equity structure this allows the fund to invest in hard to value assets without having to actually value the assets until distribution.

The side pocket account also allows a real estate hedge fund to offer a “hybrid” hedge fund product. Managers are finding that hybrid hedge funds are becoming more popular with investors and allow them to sell a product which may potentially resonate with a larger group of potential investors.

There are numerous iterations of a side pocket account and what is allocated to the account and when so we will not go into these in detail here. Once the manager has decided on a general structure the lawyer will work with the manager to identify any questions or issues with the structure. The general rule is that any structural design of the fund can be accommodated within the hedge fund structure – the question is how long it will take the manager and the lawyer to talk through and identify all of the issues of any particular structure.

The real estate hedge fund offering documents will follow the same standard format for hedge fund offering documents which includes a private placement memorandum, a limited partnership (or limited liability company) agreement, and subscription documents.

Real estate hedge fund fees and expenses

Because no two real estate hedge funds are going to have the same investment program and structure of the investment program, there are not any standard fees for these funds. Generally there will be some sort of asset management fee which might range from 1% to 3%. Often a fund will feature a preferred return and then some sort of carry over the preferred return. In this way the performance fees of a real estate hedge fund resemble the structure of the private equity funds. Because of the great variety of fee structures, though, for real estate hedge funds, there is no expected fee structure like for a securities hedge fund.

In addition the asset management fee and performance fees, real estate funds are unique in the fact that they have other expenses which are different from a securities only hedge fund. Specifically there are property acquisition fees as well as fees related to: property managers, leasing and sales agents, construction managers or other services as necessary. It is very common for the general partner to control entities which will provide such services to the fund. Generally the offering documents will note this conflict of interest and/or include a statement that such affiliated entities will be compensated at current market rates.

Valuation

As with any asset for which there is not a liquid exchange market, valuation of real estate is subjective. Accordingly valuation becomes a major issue for many real estate hedge funds if there is going to be withdrawals from the fund or if the general partner will receive a performance fee for any “paper” gains attributable to increase in the value of the real estate. Valuation becomes less of an issue if there the real estate will be placed in a side pocket account or if there are no withdrawals or performance fees until a disposition event. In the event that a fund needs to implement a valuation policy, the real estate hedge fund manager will basically choose from between three methods of valation (or some combination thereof).

The basic methods of valuation include: (1) book value; (2) outside valuation agent; or (3) by formula. There are advantages and disadvantages to each one of these methods and if you need to have a valuation methodology your lawyer will be able to help you to decide on one of theses methods.

Risks

There are always a number of risks involved in any type of hedge fund structure.  One potential risk when dealing with real property is eminent domain.  Depending on the real estate holdings and other investments a fund will make, there are considerations about the ability of the government to reposes the hedge fund holding through the eminent domain process (for more information, please see Washington state eminent domain). This is a risk which should be disclosed in the offering document if it is applicable to the fund’s investments.

Conclusion

Real estate hedge funds are a great structure for the current market and allow non-traditional hedge fund managers an entry point into the alternative investments industry. If you are a real estate professional who is thinking of establishing a real estate hedge fund, please feel free to contact us.

5 thoughts on “Real Estate Hedge Fund Structure

  1. Pingback: Overview of Hedge Fund Investment Strategies | Hedge Fund Law Blog

  2. Jason Fernandez

    My name is Jason Fernandez and I am an MBA student at Duke’s Fuqua School of Business. I’m currently involved in a research project focusing on the various structures of Real Estate Funds and was hoping you may be of assistance.

    I’m having a tough time finding examples of business plans and prospectus for currently operating RE Hedge Funds such as those who buy and manage properties for current income, those who purchase raw land for development or those who purchase property for appreciation.

    Would you have any examples of these business plans/prospectus? Or know where I may be able to find examples? Any assistance would be greatly appreciated.

    Best Regards,

    Jason

    1. Marie

      Dear Jason,

      If you have had any success in answer to your question, I would appreciate any feedback. I am also interested in the same topic but, like yourself, are not finding much luck on the topic. Thank you.
      Marie

    2. David

      Jason it would appear that most large real estate holding companies have either gone the route of Reit or privatization. While my experience in real estate investing has been 20 years in the private sector this subject has always puzzled me as well why are there not more hedge fund firms that do strictly real estate. I don’t have a definite answer but this will probably shed a little light. The structures on Wall street have different rules for dealing as you already know being an MBA student.

      Hedge funds and Reits if you speak with a securities lawyer are 2 different animals with different rules. Now my not being a sec lawyer I cannot tell you exactly why Reits have ruled the trading floor as an entity for warehousing real estate investments that are publically traded. But let me venture to tell. Real Estate when publically traded has so many places where fraud and loss of expenses can occur. Management in real estate makes or breaks it and often the entity with the most controls in place have better time keeping management accountable for there activities.

      I think Reits have already been set up to handle such rules and regulations that would need to be in place to publically trade on Wall street. Hedge funds may have too many gaps to leave the insiders too much control over the assets that investors may not want to invest in the products offered in a hedge fund. I again cant give exact examples your question should be posed to a securities lawyer on the matter! This is a great subject matter that deserves some attention especially if your a rising star and plan to do a start up. If you do decide to do a start up and want a tag aloung that has about 20 years experience in real estate investing let me know. I have always thought about starting up a publically traded company with a group of sharp individuals that want to rise fast and control some good quality cash flowing properties to set up for retirement and or just a great way to invest in this incredible down market for real estate.

      I am a value investor and would only do business with someone that wanted the core of his real estate holdings to be apts with a small part of the business focused on risky deals. This way the larger business can be stable profitable and support profitable ventures like developing raw beach front or rehabbing mid size sky scrapers and such. Today there is so much in the aspect of deals if you can raise capital that is the real problem today is getting your hands on capital.

      If you first line up 10 to 50 million in capital next you would have no problem in doing a start up in my opinion.

  3. Roger Hale

    HI,

    My name is Roger Hale, I am a real estate agent in the state of Florida. I have about 120 acres of raw, indstrial/commercial land that is buildable along I-95 in Titusville Florida.

    How do I find a hedge fund that would be interestd in my property? The land is 100% paid for and would appraise for somewhere between 40 and 50 million.

    Roger Hale, 407-433-1351

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