Real estate investment funds are similar to mutual funds in that investors pool their money to buy a property or properties. While real estate investment funds are usually created to buy commercial property, they can also purchase apartment buildings, land development or even agricultural land. These funds can help investors diversify their portfolios and take advantage of booming real estate markets without the hassle of becoming landlords themselves.
While participating in a real estate investment fund can be a sound financial choice, the regulations and financial risk surrounding them should not be underestimated. If you’re unfamiliar with them, you should seek out legal advice before moving ahead with making one yourself. This is what you need to know to begin making your decision.
Decide on the Scope
The first step in setting up a real estate investment fund is identifying a potential property or properties to buy. Because the property purchased must increase in value to be profitable and attractive to investors, you should come up with a plan to make that happen beforehand. It could be constructing new buildings, cashing in on economic trends by allowing the land to appreciate in value or something else, but no matter what, you need a sound strategy.
The other thing you need to know is the scope of the real estate investment fund. The fund may be created only by you and a few trusted business partners (which is often the case for a real estate investment fund for a single property), or you may be managing the property or properties alone or with only a couple other people but with many investors supplying capital (which is more common for large commercial funds).
Real estate investment funds are set up as corporations so that investors can pool their money together. In most cases, that means creating a limited liability corporation (LLC), limited partnership (LP) or other pass-through entity that doesn’t have to pay corporate taxes that might otherwise keep the real estate investment fund from being profitable. Rather than the entity being taxed directly, the partners and owners of the fund are taxed individually.
Additionally, you should choose the state to incorporate in. While the most obvious choice is of course the state where the property or properties are, that’s not always the best option. For instance, many real estate investment funds choose to incorporate in Delaware because of its corporate government laws and efficient court system.
Management and Partners
At the same time that you’re setting up a corporation to run the real estate investment fund, you also need to decide who will be managing the property or properties. You or one of your partners might choose to do this yourself, or you might join up with a property management company or other entity. Whatever you do, keep in mind that trustworthiness and experience are essential for managing a real estate investment fund, as there’s more than a little money on the line.
Similarly, you need to have an idea of the scope of the fund. If your real estate investment fund is comparatively small, you might just need yourself, any partners and likely a bank to borrow money from. If this is a larger project, however, especially one for multiple commercial properties, you’ll probably want investors. To attract them, you’ll need to raise enough initial capital, usually through a loan. You may also have to contribute some of your own money, particularly if investors are less confident in your plans.
Investors then make up the difference between your owned and borrowed assets and the price of the property or properties. The initial investors are known as seed investors, and they often get a better deal compared to later investors.
Structuring the Fund
Real estate investment funds are temporary. You suggest an investment strategy, investors buy in, and unless something extremely unexpected happens, you follow through on your proposal. Profits are reinvested into the fund until a set amount of time has passed (agreed to during the creation of the fund) and investors receive a minimum return as well as an additional portion of profits over that amount. The manager also receives a portion of the earnings, but there is a strict order in which parties are paid in a real estate investment fund, and it must be followed.
How investors enter into the fund — and how they leave is also affected by the structure of the real estate investment fund. In an open-end fund, investors can take out their money (at the fund sponsor’s discretion) before the project is complete. That has the benefit of being a more liquid — flexible — asset for investors, but at the cost of making the fund less stable and more risky overall. A closed-end fund is much more reliable, as investors can only withdraw funds once the fund has reached the end of its agreed-upon lifespan, but it’s also closed to new investors once the initial funding period is over.
Which kind of investment fund is right for you depends on your specific situation. Keep in mind that the regulations around real estate investment funds can vary from state to state. Because of the complexity of this sort of enterprise, you should consult a legal or financial expert before committing to creating one.