A Primer for Establishing a Private Real Estate Fund: Key Legal, Structural, and Strategic Considerations

The following is a brief explanation of the terminology used in the above diagram:

• Private Real Estate Fund – The Private RE Fund can be structured either as an LP or LLC, as discussed above. As a holding company, the fund typically invests in real estate assets indirectly through its ownership of special purpose vehicles that own and operate the real estate assets (see REH below).
• Sponsor – The sponsor is the person or entity that initiates and organizes the Private RE Fund. The sponsor is usually responsible for raising capital from investors, managing the fund, and leading transactions. The sponsor typically manages the fund and its properties by holding interests in the GP or manager entity (see below) and in the Management Company (see below), if separate from the GP as illustrated above.
• Investors – Investors are individuals or entities that contribute capital to the fund with the goal of earning a return on their investment. Investors do not participate in day-to-day management of the fund, and their liability is limited to the amount of their investment. Depending on the fund structure (LP or LLC), the investors are either LPs or Members.
• General Partner (GP) / Manager (MGR) – The GP or Manager makes the Private RE Fund’s investment decisions, manages its day-to-day business and provides reporting to investors. The GP/MGR is usually an entity, often LLC, especially in LP structure. The GP/MGR receives fees for managing the fund’s assets, typically based on either the total capital raised or assets under management, and also receives carried interest (also known as “promote” or “carry”), which is a share of the fund’s profits as compensation for its success. If there is no management company and the GP/MGR also manages the assets of the fund, it will also receive property management fees. The GP/MGR is usually owned and controlled by the sponsor and often invests its own capital in the fund.
• Management Company – (optional) The management company is an entity that is responsible for managing the real property assets of the fund. It is usually owned and controlled by the sponsor. Depending on the organization’s structure and the duties performed by the management company, it and its agents may be required to hold separate licenses (e., real estate broker/agent licenses) to perform its management duties.  The management company earns a fee for managing the properties held by each REH.
• REH LLC – A special purpose vehicle owned and controlled by the fund (“REH”). Each REH is established to limit liability and owns and operates a real estate property.

Taxation

Typically, Private RE Funds are formed as pass-through entities, to avoid double taxation—at both the entity and investor levels.  LP, and multi-member LLC by default, are taxed as a partnership, which means that the tax passes through from the entity to the individual investors.  The LP/LLC must file an annual Schedule K-1 with the Internal Revenue Service (IRS) to report each investor’s share of the entity’s income and provide a copy to each investor.  Each investor must pay taxes on their share of the income reported. Generally, the fund will have discretion to make tax distributions or advances to investors to pay taxes on their allocable pass-through income. The operating agreement should have provisions reflecting the fund’s tax structure.

Blocker Corporations

Blocker corporations are special purpose vehicles sometimes formed to facilitate indirect investment in a Private RE Fund, particularly by non-U.S. investors. This structure allows the blocker corporation to receive income from the fund directly, rather than passing it through to individual investors.  For non-U.S. investors, using a blocker corporation ensures they are not required to file individual U.S. federal tax returns and pay U.S. income tax related to the fund’s income. However, use of blocker corporation involves additional complexity and costs, such as corporate setup, ongoing administration and filing of annual tax returns. Sponsors and non-U.S. investors should consider these costs when determining whether indirect investment through a blocker corporation is preferable to direct investment in the fund.

Strategy

Private RE Funds typically have a defined investment strategy, including property type, their geographic focus and monetization strategy. Funds with multistate operations may invest in multiple locations, e.g., several metropolitan areas and states. Depending on their expertise, funds may combine more than one property type, e.g., multifamily and retail or datacenters and warehouses. Monetizing strategies may include property development and sale or hold, turnkey income producing properties or a combination thereof.  The fund’s investment strategy should be described in a private placement memorandum (“PPM”, see below). A fund usually does not change strategy once the fund starts making investments, except for extraordinary circumstances, and even then, it should usually require investors’ approval.

Economics

The Private RE Fund’s economics—including investment term, projected returns and distribution methods—should be clearly described in the PPM. The fund’s term represents the period in which the fund will acquire and hold properties.  Funds usually liquidate within this term or shortly thereafter, often with allowable extension. Typically, a fund term is not more than 10 years.

The PPM should provide projected returns on capital investment for the investors, representing the fund’s expectations and beliefs regarding returns from the investment properties that the fund will acquire.

Real estate funds are considered illiquid investments, meaning investors’ capital is typically invested for the duration of the fund until capital distribution occurs following the sale of its investment properties. Depending on the type of monetization strategy, the fund may generate regular income and distribute profits periodically during its term. For instance, a fund holding stabilized income producing multifamily properties may distribute income regularly, while a fund focused on property development (e.g., construction or rehabilitation) and sale, may distribute income only after properties are sold. The fund’s monetization strategy should be reflected in the PPM.

Methods for distributing income and capital can range from simple to complex, but should be stated in the fund’s operating agreement and described in the PPM as the agreed economic arrangement between the sponsor and investors. Usually, distributions are made according to a “waterfall” structure, which sets the triggering events and the priority sequence for distribution among various tiers. For example, a basic waterfall provision may distribute funds first to preferred returns, second to the return of investor capital, and third, divide the remaining funds between investors and the sponsor, accounting for the sponsor’s carried interest. In practice, waterfall provisions tend to be more complex and may include certain prioritization of the sponsor’s carried interest and even certain clawbacks, depending on the negotiating leverage of the sponsor and investors.

Compliance Considerations

Securities Act

Private RE Funds rely on private placements of securities to raise investment capital, meaning securities representing interest in the fund are sold privately to investors. Selling securities in private placement requires compliance with federal and state securities laws, known as blue sky laws.

It is recommended that sponsors consult with a securities attorney when planning private offering of fund interests to determine the availability of exemptions under the Securities Act of 1933 (“Securities Act”) and safe harbors provided under its Regulation D, which allow exemptions from the registration requirements with the Securities and Exchange Commission (“SEC”). Securities counsel can also advise on required filings and disclosures under federal law and states blue sky laws.

Securities Exchange Act

Private RE Funds with total assets exceeding $10 million may be required to register with the SEC under the Securities Exchange Act of 1934 (“Securities Exchange Act”), unless an exemption applies.

Additionally, Rule 10b-5 of the Securities Exchange Act makes it unlawful to make any material misrepresentation or omission in the fund’s offering materials, e.g., PPM or presentation materials, or in oral presentations (e.g., statements made by the sponsor in a road show).  Investors and the SEC have a right of action against the fund, its sponsor and any person who makes such misrepresentation or omission.  To mitigate risks of Rule 10b-5 claims, the fund’s PPM should fully and adequately disclose potential risk factors in making the investment and appraise investors of key conflicts of interest involving the fund and how those conflicts will be managed.

Investment Company Act

Managers of Private RE Funds should consider whether the fund and its management must be registered with and report to the SEC. In general, a fund may be required to register as an investment company, under the Investment Company Act of 1940 (“ICA”) and be subject to the ICA reporting obligations, unless an exemption applies.

Failure to register and report under the ICA, if required, could result in severe legal and operational consequences, including prohibition from interstate offering, selling and purchasing of securities and controlling companies engaged in such activities, unenforceability of contracts, enforcement actions by the SEC and civil penalties.  The consequences for foreign entities that fail to comply with the ICA’s requirements are even more severe and could result in effectively barring them from operation. ICA violations, even if inadvertent, may not be curable, so Private RE Funds should carefully analyze their activities and transactions to avoid becoming subject to the ICA registration requirements.

Investment Advisers Act

Fund management (i.e. GP or manager) should also consider whether it is required to be registered with and report to the SEC as an investment adviser under the Investment Advisers Act of 1940 (“IAA”), or whether an exemption applies.

Failure to register under the IAA could result in significant legal consequences, including enforcement actions by the SEC, civil penalties and civil liabilities for the fund and management. Additionally, failing to register, if required, may prevent an adviser from legally providing investment advice, potentially resulting in contractual disputes or invalidation of advisory agreements. Accordingly, fund management should carefully evaluate whether they fall within the definition of an investment adviser under the IAA and whether they qualify for any exemptions.

Compliance with Real Estate Laws

Fund’s property management could require adherence to federal and state laws relevant to the type of property held by the fund. For example, a fund that specializes in investment in multifamily real estate must ensure compliance with federal and state housing laws, e.g., fair housing requirements, and state and local codes protecting tenants and with building codes.  So, sponsors must ensure from the outset that they are aware of the legal requirements governing the operation of the properties they invest in, that they identify material risks that should be identified for investors and include such risks in investment offering materials.

Key Legal Documents

The following is a brief explanation of key investor-facing legal documents that are typically part of Private RE Fund formation:

Fund’s LP or LLC Operating Agreement

The principal agreement governing the arrangements between the sponsor (as GP/ Manager) and the investors (as LPs/ Members) is the fund’s operating agreement. The operating agreement should include provisions that cover, among other things:

• The fund’s purpose, authorized investment activities and investment restrictions.
• GP’s or Manager’s authority and obligations.
• Investors’ (as LPs/ Members) rights, obligations and limitations on liabilities.
• Transfers of investors’ interests in the fund, including limitations on transfers and withdrawals.
• Investors’ capital commitments, capital contributions, capital calls and consequences for defaulting on capital commitments.
• Allocation and distribution, including priority of allocation and distribution of profits and losses and carried interest.
• Tax matters concerning capital accounts, allocations and distributions, including tax advances.
• Management fees.
• Fund expenses.
• Mechanisms for managing conflicts of interest involving the GP/Manager or affiliates.
• Financial reporting to investors.
• Dissolution and liquidation of the fund.

Private Placement Memorandum (PPM)

The PPM is the primary document that sponsors use to market the fund’s securities in a private placement to potential investors.  While there is no legal requirement to provide a PPM, most investors expect to receive detailed disclosure regarding the securities offered, and the PPM facilitates these disclosures. If the private placement is marketed to non-accredited investors for which certain disclosures are required, the PPM is also used to satisfy these disclosure requirements.

A PPM for accredited investors will typically include, among other things:

• Business information, including:
  • The fund’s securities offering.
  • The fund’s strategy, term and economics.
  • The fund’s sponsor and management, including the management the team’s experience.
• Summary of key terms of the fund’s operating agreement.
• Description of primary conflicts of interest involving the sponsor, its affiliates, or fund management team members.
• Risk factors involved in investing in the fund.
• Certain tax considerations.
• Key legal considerations.
• Document exhibits, for example:
  • The fund’s operating agreement.
  • Subscription documents.

Subscription Documents

Under certain private placement exemptions for accredited investors, investors are typically required to complete a qualification statement or investor questionnaire to confirm their accredited investors status before subscribing to securities in the private placement. Investors may also be required to provide additional information and documents to substantiate their qualifications to invest as required by the fund.

To subscribe to the fund’s securities (i.e., limited partnership interest or membership interest), each investor typically signs a subscription agreement with the fund specifying the investor’s agreement to:

• Subscribe to the fund’s securities and the extent of their capital commitment to the fund.
• Be an investor under the terms of the fund’s operating agreement.
• Make certain representations and warranties concerning the investment.
• Agree to certain covenants and relevant legal provisions.

Additionally, investors are typically required to provide tax information by completing an IRS Form W-9, or relevant Form W-8 for non-U.S. investors.

Side Letters

Some investors may have leverage to negotiate special conditions for their investment in the fund, for example, due to large investment commitment. To facilitate investments, the fund’s operating agreement often gives the sponsor discretion to enter into side letters or other agreements with one or more investors that add or modify those investors’ rights, benefits and obligations (e.g., economic or informational rights) under the fund’s operating agreement. When allowed, the fund’s operating agreement will also specify the extent to which side letters or other agreements may affect the terms of the fund’s operating agreement and the rights of other investors in the fund.

Conclusion

In conclusion, the Private RE Fund structure is an important investment vehicle for aggregating capital to invest in multiple income-producing and opportunistic real estate assets. Establishing a Private RE Fund involves careful consideration of legal structures, economic arrangements, tax implications, and regulatory compliance. Sponsors must weigh the advantages of LP and LLC forms, understand the roles and liabilities of all parties, and ensure that fund strategies and economics are clearly communicated to investors.  The complexity of federal and state securities laws, as well as state licensing requirements, further underscores the necessity for thorough planning and precise documentation.

Given the intricate nature of fund formation and ongoing management, sponsors are strongly advised to assemble a team of experienced real estate investment and management professionals, and to consult with experienced legal counsel and tax advisors. These professionals can help them navigate tax and regulatory requirements, draft essential documents, and safeguard both sponsor and investors throughout the fund’s lifecycle, ensuring a compliant and successful real estate investment vehicle.

Maman has extensive experience and can assist sponsors in forming a private real estate fund, in the purchase and sale of commercial real estate properties and can assist investors in evaluating investment in private real estate funds. Reach out to attorney Solomon Maman for more information.

***This article is for educational, marketing and general discussion purposes only. It does not constitute legal or tax advice and does not establish attorney-client relationship. You should consult with experienced legal counsel and tax advisor before forming private real estate funds or engaging in private placement of securities.