As the process of real estate development, from due diligence to permitting to financing, becomes ever more capital- and time-intensive, developers are increasingly turning to the establishment of real estate funds as an important tool for pooling capital, spreading risk and responding more nimbly to changing market conditions. While funds may provide developers with important advantages, their success is not guaranteed. How well a fund performs can be affected significantly by early decisions regarding business and investor strategy and structure.

With equity behind them, developers can seize opportunities before market conditions change or competitors sweep in, have funds available to place deposits and conduct due diligence and, with a pool of investors, can consider investing in and developing larger projects. And with real estate securities continuing to yield strong returns, there remains strong interest in investing in these funds.

While there are important advantages to establishing real estate funds, before launching a fund there are several issues that developers need to consider that will have a significant impact on their ability to attract investors, raise capital and realize higher returns. First and foremost, developers should realize that real estate funds are investments, not unlike other private equity instruments, which impose certain legal and regulatory and business constraints.

Past as Prologue

As with other investments, past performance will be a key factor in the fund’s capacity to attract investors. Investors want strong evidence that their money will yield a better return than alternative investment opportunities. If “location, location, location” is the rule in real estate development, then “management, management, management” is the sine qua non of investment in real estate funds.

If you are considering forming your first fund, the best substitute for a fund management track record is your history as a developer: Can you demonstrate success in bringing projects to fruition – on time, within budget, in managing these properties and implementing a successful exit strategy? In this regard, it is advisable to target the fund in the particular market segment (whether it is office, industrial, retail or other) where your portfolio is strongest. Investors typically diversify by investing capital in different funds, so creating a diverse fund is not an advantage. Also, identifying specific projects that the fund will finance – rather than creating a blind pool – provides the promoter with a more tangible example of projects the fund intends to invest in and can be an additional selling point for potential investors.

Beyond issues of raising the fund, developers need to consider that most real estate funds are structured as limited partnerships, where the general partner is a limited liability company owned by the developer (promoter). Under the terms of such partnerships, there is typically a two- to three-year investment period, after which capital that the fund has not invested must be returned to the limited partners. There is a longer hold/disposition period – generally five to seven years during which the partnership manages and then sells the property – but developers need to be aware that the investment period may provide a very limited exit window depending on the market.

Many funds offer their limited partners a preferred return of 6 percent to 10 percent in addition to the return of their invested capital. Over the past five years, real estate funds have substantially exceeded this benchmark, but future performance can be hard to gauge – another reason why developers should create funds in market segments where they have the greatest experience.

After making payment to investors of their investment and preferred return, many funds provide the general partner with a “catch-up” distribution by disproportionately allocating cash to the general partner until the general partner has achieved a return in the range of 20 percent of all distributions. After the catch-up distribution, funds typically allocate 80 percent of the remaining distributions to the limited partners and 20 percent to the general partner. Most investors in funds like to see that the general partner has invested his own money to purchase approximately 5 percent of the equity in the fund, in order to make sure that the general partner has skin in the game.

Choosing Carefully

Short of establishing a real estate investment trust, it is generally advisable to offer limited partnership interests in real estate funds through a private placement, which exempts the fund from most of the Securities and Exchange Commission’s reporting requirements. In order to fly below the SEC’s radar, funds should target accredited investors – experienced investors with a minimum net worth of $1 million or who have earned at least $200,000 in each of the past two years and reasonably expect the same in the current year (or $300,000 with a spouse). Otherwise, the fund needs to create a detailed private placement memorandum for unaccredited investors to satisfy the SEC’s disclosure mandates. Finally, real estate funds must have no more than 100 investors in order to avoid being characterized as an investment company under federal securities laws.

In addition to determining whether the investors are accredited or not, funds must also comply with requirements regarding the sale of limited partnership interests, which are considered the sale of a security under federal and state securities laws. A limited partnership interest may not be sold through any general solicitation or general advertising, which would include advertisements or notices published in any newspaper or magazine or broadcast over television or radio, and cannot include any seminar or meeting whose attendees have been invited by any general solicitation or advertising. In the Internet age, fund promoters also need to be careful about what information they provide on their Web sites, which could be construed as general solicitation or advertising.

A fund also needs to be cognizant of who may sell the limited partnership interests under so-called state “Blue Sky” laws. While restrictions vary from state to state, the fund, as an issuer, generally can sell its own securities. However, if a fund promoter engages in repeated offerings, the offerings should be made through a broker-dealer. In practice, most established funds sell through a registered NASD broker-dealer. Some real estate developers have an affiliated in-house NASD broker-dealer, while others hire independent broker/dealers to market the fund. Funds must be careful about using so-called finders, who are unregistered broker-dealers, as this may give an investor a claim for rescission if the investor is dissatisfied with the investment. A true finder is not involved in the terms or negotiations of the investment and generally cannot receive a fee based on a percentage of the funds raised by him.

Planning ahead is important for any developer wishing to establish a fund. Developers should generally plan on a nine-month to 18-month marketing period to raise the fund, with initial funds generally on the longer side and subsequent funds on the shorter end of the scale.

As with any investment, a real estate fund is selling a promise of things to come. The formation of the fund – business and investor strategy and structure – will have a critical impact on its ability to deliver on that promise and thus to raise funds now and in the future.