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.
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
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.
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.
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.
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.
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.