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How to Start a Real Estate Investing Fund From Scratch
Before tackling the fund formation steps, you must choose either an open-end or closed-end fund. Real estate open-end and closed-end funds are two distinct investment vehicles with key differences in structure, liquidity, and investment approach.
Structure and Duration
Open-end funds:
- 1. Have no predetermined expiration date.
- 2. Continuously accept new limited partner investments and allow withdrawals under a specified schedule.
- 3. Operate with a flexible capital amount.
Closed-end funds:
- Have a fixed term, typically 10-12 years
- Operate with a fixed capital amount from the limited partners (LPs).
- Are not liquid until the fund reaches maturity.
Liquidity
Open-end funds:
1. Allows investors to sell their shares at regular intervals to get money back
2. Shares of these funds trade according to their daily or monthly calculated net asset value.
Closed-end funds:
1. No secondary exists for selling the shares.
2. These funds have a set maturity date where all assets are sold, and the original capital and profits are distributed to the investors.
Investment Strategy
Open-end funds:
1. Focus on income-generating properties
2. Aim for stable, long-term returns
3. May hold cash reserves for redemptions
Closed-end funds:
1. Often target value-add or opportunistic investments
2. Employ strategies like property repositioning or development
3. Can fully invest capital without liquidity concerns
Performance and Returns
Open-end funds:
1. Generally provide more stable, income-focused returns
2. The funds generate conservative returns because they keep cash ready and focus on safe investments
Closed-end funds:
1. The strategy of adding value and using leverage creates opportunities for higher returns.
2. Investors often earn more through property value gains rather than income streams.
3. Reinvesting the profits compounds the ROI.
Investor Considerations
Open-end funds:
1. Attract investors seeking steady income and liquidity
2. Allow for flexible entry and exit via selling shares
Closed-end funds:
1. The fund targets investors who want to hold their investments for extended periods.
2. Earn better returns with this option, but capital may be harder to access.
Open-end funds let investors enter and exit freely, yet they lack the opportunity for higher returns that closed-end funds provide through specialized investment strategies.
Step One: Create Your Presentation
When speaking with a potential investor, you can't be ambiguous with something like, we will buy and flip houses. That tells the investor a whole bunch of nothing. You must clearly and concisely explain your investment model and how it makes the investor money. The investor will buy in emotionally (they click with you) and then use the investment model information to justify their decision.
In another article, I wrote about the importance of crafting a compelling story. When your fund is new, people invest as much in you and your team as in the fund. This captivating story is where most new fund managers drop the ball and why Fund Launch coaches work so hard to help each student craft the perfect pitch deck and story.
Staying with this example of a real estate fund doing residential fix and flips, there are certain core elements you need to include to refine your story.
1. Who are you, and what is your experience?
2. What is each team member's background and experience?
3. What outside contractors will be involved, and why did you choose them?
4. What is the city or Geographical area you will focus on?
5. Single-family or multi-family?
6. Property acquisition price limit?
7. Capital improvement cost limits per property?
8. Sell properties outright to exit or hold for rental cash flow?
9. Increasing profits by creating a real estate note and selling the note after a set period.
And so forth…
Suppose you and your Fund Launch coach have finished creating an interesting and compelling story. Of course, the next step is to get your entity formation and legal documents done.
Nope.
Although your entity formation and legal documents are essential to-do items, I am discussing how to start a real estate investing fund from scratch. Spending a lot of money and time on fund formation diverts your attention, robbing you of the time you should spend testing your fund marketing to see if it resonates with investors.
While speaking with potential investors, what if you find out your investment model needs work or even a new direction after spending all that money on fund formation?
Ouch!
We have worked with hundreds of aspiring fund owners at Fund Launch© and would like to work with you. We want you to be successful and build the fund of your dreams, so we do things differently than an old-school law firm. By the way, Fund Launch© saves its members a ton of money with the legal docs and accounting.
Test, test, test before you pay the bucks to launch.
Spending time with investor prospects, testing your investing concepts, and nailing down soft commitments will get you out of the gate and pump up your confidence to jump in and spend that time and money.
WARNING
No matter how much you would like to close the sale and accept an investor's money - DO NOT ACCEPT A DIME until all legal work and regulatory filings are completed and your legal counsel has signed off. Testing your compelling story is one thing, but taking an investor's funds will complicate your life in ways you don't want.
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Step Two: Raising Capital
After helping our students launch hundreds of funds, we advise soon-to-be fund owners first to find an incredible deal. It's all about the deal once a potential investor is comfortable with you and your team!
Seriously, that's the secret sauce!
It doesn't matter whether you have a real estate fund, debt hedge fund, or venture capital fund;
When you have a juicy deal to showcase, this ramps up your ability to line up soft investor commitments.
Here is a presentation example:
Mrs. Johnson, we just placed a property into escrow. It's in Miami, Florida, and was just appraised for $8.2 million. But as long as we can close on it before the end of this month, we get it for $4.2 million, almost half off!
The owner is very motivated because he is going into bankruptcy and needs to sell it quickly. But we must close on the purchase by the end of the month.
Oh, we've had our CPA firm check and re-check all the numbers, which are verified.
Would you like to know more?
Don't believe me that the deal is the motivating force?
Put yourself into this story.
I want you to imagine it's Monday morning, and you get a call from a lady who attends your church. Her husband recently died, and she is anxious to sell off everything and move closer to her daughter. The last thing she needs to sell is her husband's 1998 Lamborghini Diablo (mint condition), and then she can move. You about fall out of your chair when she says it's yours for $50,000, but she wants the money before next Friday. She emails you pics and docs, and it's legit!
You quickly jump online and find a serious Lambo collector in California who, after looking at the photos, confirms he will buy that year/model/color for $200,000, and he emails you proof of funds.
Could you find the $50,000 to make $150,000?
Are you thinking to yourself, heck yeah, I could. I'm sure I can find the money.
What if she was asking for $100,000?
Hey, a quick $100,000 profit - would you say thanks but no thanks?
Of course not; I have no doubts that you would move heaven and earth to secure the $100,000, right?
You see, it's not the lack of experience or an Ivy League degree holding you back. If you are confident in your ability to source deals and have that same confidence in your investment model, you should always be able to raise the money.
Your belief and passion about the OPPORTUNITY, supported by market data, are the keys to attracting investors!
Step Three: Structuring The Opportunity
What real estate strategy will your core investment model be based on?
Residential:
1. Single-family fix & flip.
2. Multi-family rentals - improve the property and increase rental rates.
3. Purchase starter houses, offer seller financing, and sell the note after a specified hold period.
Commercial:
1. Self-storage complexes.
2. Strip mall repurposing.
3. Property conversions to AirBnB.
Passive Investments:
1. Residential Tax Liens.
2. Real Estate Investment Trusts (REIT).
3. Real Estate Investment Groups (REIG).
You will undoubtedly use your existing experience as the foundation for the model. When you start out, the investors you approach must be convinced you can captain your ship. Once they are comfortable that you have the experience and they understand your investment model, this will dramatically increase your odds of tipping them in your direction.
Now that you have read this far, I will list some of the high points to bring everything into focus.
Structure the Deal
So, what makes a real estate deal "great."
1. The property is located within your prime target area.
2. It is a strong candidate based on market comps.
3. A substantial ROI is supported if it is acquired within the budget limit.
At this prelaunch stage, you don't need to have pages and pages of super-detailed reports and graphs.
1. Instead, frame out the smoking hot deal.
2. Create a doc to explain the investment model
3. Address how you will deal with any market corrections.
4. Lay out how you will find an ongoing supply of properties.
5. Show them how everyone's going to make money!
*bada bing - bada boom.
Sourcing properties can be challenging, so cultivating relationships with successful Realtors is necessary. Farming an area with postcards is a proven method for finding motivated owners. Reviewing city or county delinquent tax liens can identify property owners who may be struggling and open to an offer. If demographic information is available targeting homeowners age 70 and older who may be receptive to an offer because they want to move to be closer to their family.
In many cases, they haven't put their house on the market as there are too many repairs, and the listing and selling process overwhelms them. You can penetrate this market by overcoming these obstacles. How about a concierge-like service that removes these hurdles when selling the house? Examples include assisting them with closing and arranging for a mover. Perhaps it's a long trip, and they don't want to drive, helping them to secure airfare or a nostalgic Amtrak train trip.
Building a reputation as a problem solver can make your fund the go-to resource for seniors wanting to sell.
Structure Your Fund
Let's assume you have built your investment model and have the market due diligence to support your assumptions. You have your first hot deal on the table and have met with some individuals who have given you a soft commitment.
Now, you're ready to make your real estate fund a reality.
The first step is the fund's legal structure and filing.
Real estate funds typically choose between two main legal structures: Limited Liability Companies (LLCs) and Limited Partnerships (LPs).
Limited Liability Company (LLC)
Flexibility:
LLCs present more management structure flexibility by letting members choose between direct management and electing managers.
Liability Protection:
LLC members receive protection from personal liability for the business debts and obligations.
Tax Treatment:
LLCs avoid double taxation by providing flow-through tax treatment.
Formation Costs:
Establishing and managing LLCs costs less than Limited Partnerships (LPs).
Ownership:
The ownership structure of LLCs allows for either one owner or several members.
Limited Partnership (LP)
Structure:
An LP must include one general partner and one limited partner in its formation.
Liability:
Limited partners benefit from liability protection, while general partners face personal liability unless their partnership operates as an LLC or corporation.
Investor Attraction:
Specific investors might find this structure appealing because of its established traditional framework.
Tax Treatment:
It also offers flow-through taxation.
Formation Costs:
Establishing and maintaining LPs is usually more costly than LLC structures.
Both structures offer advantages for real estate funds, with the choice often depending on specific needs.
To Summarize
Whether formed as an LP, an LLC, or a combination of both, real estate funds have certain similarities in operating and marketing. By working closely with a fund expert, they will assist you in identifying the best legal structure for flexibility, liability protection, and operational simplicity.
Raise Capital
Real estate funds have several methods available for raising capital.
Friends and Family:
The Friends and Family method collects small investments from personal contacts and is an informal yet practical starting point for new fund managers.
NOTE: Being friends and family is not an exception to the law. DO NOT ACCEPT ANY FUNDS until your legal and filing requirements are fulfilled.
Institutional Investors:
Institutional investors comprise major organizations such as pension funds, insurance companies, and endowments, which allocate large sums to real estate while targeting assets with strong fundamentals and reliable cash flows.
Private Equity:
Real estate private equity funds gather capital from high-end investors and other funds to create property portfolios that enable more significant investments and spread investment risk.
Crowdfunding:
Fund managers leverage online platforms to gather capital from numerous small investors and use this method for well-branded projects that are visually impressive.
Joint Ventures:
Joint ventures represent partnerships in which multiple parties bring together capital, resources, and expertise to invest in specific real estate projects.
Bank Financing:
Traditional bank loans from financial institutions are better suited for individual property acquisitions than for funding real estate investment funds.
Real Estate Fund Legal Documentation
Establishing and administering a real estate fund requires managing complex legal and regulatory requirements. The following will illustrate the necessity for you to work with fund experts.
Don't skim past this part because it sounds boring.
Implementing and adhering to these laws and regulations will determine if you are a sad story on the evening news or famous for a super successful real estate fund.
Securities Law Compliance
Registration and Exemptions:
Real estate fund managers must adhere to the Securities Act of 1933, which mandates securities registration except when a specific exemption is applicable. Private placements under Regulation D Rules 506(b) and 506(c) are common exemptions that enable sellers to offer securities to accredited investors without registering.
Many real estate funds can operate without registration under the Investment Company Act of 1940 by using exclusions from Sections 3(c)(1) and 3(c)(7) or by focusing their investments mainly on real property instead of securities.
Investment Advisers Act of 1940
Registration as an Investment Adviser:
The SEC requires fund managers to register as investment advisers when they manage more than $100 million in assets (or $150 million for private funds) and receive compensation for providing securities advice. Funds that solely invest in real estate assets might avoid registration requirements because they do not invest in securities.
Fund managers should adopt similar regulatory practices as registered investment advisers even when registration is not required to achieve compliance and transparency.
Compliance with SEC Rules
Capital Calls and Redemptions:
The SEC demands approval for capital calls from funds under its regulatory framework. Typically, the SEC considers real estate funds as securities issuers, which requires them to follow SEC guidelines for capital calls and redemptions, although exemptions exist.
Custody and Audit Requirements:
The Custody Rule obligates registered investment advisers to conduct annual audits of financial statements and deliver these audited reports to investors, thus ensuring transparency and protecting investor interests.
Tax Considerations
FIRPTA and Withholding:
Under the Foreign Investment in Real Property Tax Act (FIRPTA), real estate funds with offshore investors must withhold taxes on specified transactions and submit US tax returns. Fund sponsors are obligated to follow these requirements to prevent penalties.
General Tax Implications:
Real estate funds need to examine multiple tax factors, including taxes on property transfers, capital gains taxes from property sales, and rental income taxes. Investors and fund managers need to seek guidance from tax experts to create efficient tax plans.
ERISA Compliance
Benefit Plan Investors
ERISA rules apply to fund managers when Benefit Plan Investors control at least 25% of equity in any real estate fund class. The fund manager must be a fiduciary to these investors, which brings extra responsibilities and limitations.
Anti-Money Laundering (AML) and OFAC Compliance
Risk Management:
Real estate fund managers must establish AML and Office of Foreign Assets Control (OFAC) compliance programs to detect and prevent illegal money movements while blocking transactions involving specified individuals and nations.
State Laws and Regulations
Registration and Exemptions:
Real estate fund managers need to follow state securities laws alongside federal regulations. State laws could still mandate registration or specific exemptions even when a federal exemption is applicable.
Property-Specific Laws:
State and local laws that govern property ownership transfer and land use zoning also apply to real estate investments. Investors need to adhere to these laws to prevent legal complications.
Contractual and Governance Aspects
Investment Agreements and Contracts:
Real estate fund managers must provide complete contracts and agreements that specify the investment conditions, including how capital contributions will work, when profits are distributed, and who holds management duties.
Governance and Conflicts of Interest:
The operating agreement should define governance matters that cover the specific roles of the General Partner(s)(GPs) and Limited Partners(LPs), together with conflict of interest guidelines and dispute resolution processes. The system guarantees unified interests among all stakeholders while securing their rights.
The management and establishment of real estate funds require careful navigation through an elaborate regulatory framework encompassing securities law compliance, investment adviser registration requirements, tax regulations, ERISA standards, AML and OFAC rules, state legal obligations, and contractual governance. Adhering to these regulations is essential to maintain the fund's operations and safeguard investor interests.
Yes, it's a lot to wrap your head around.
Launch and Manage Your Fund
Once you've completed your legal documentation and regulator filings, the official launch of your fund can begin. You are on firm ground to raise investor capital and acquire properties. It is time to ramp up your investment model and turn those anticipated returns into real-world ROI.
Never ignore the core responsibilities that are paramount to a successful fund.
1. Regularly update investors
2. Ensure compliance with regulations
3. Manage properties to maximize returns.
Don't let this article dissuade you from staying focused on your goal of launching your real estate fund. Any skill worth acquiring must be learned and practiced to become a seasoned manager.
Please consider choosing Fund Launch© as your expert partner. Our templated steps, legal documents, and marketing strategies will shave months off the process so you can get to the fun part - making money!
Over 900 successful fund managers with over $2.8 billion (AUM) have made Fund Launch© their number-one resource for time and money-saving services, training, and ongoing support.
Here are some resources from Fund Launch© that can help you build that solid foundation and launch you to market much quicker.
We help people Launch Funds
Over 100,000 people have expanded their skills by taking the positive step to become a member of Alt St. Our courses are designed to provide you with the knowledge and tools necessary to launch or manage a fund.
You can sample some of our training resources by visiting:https://www.fundlaunch.com/training
If you are ready to fast track your fund launch then Black Card membership may be right for you. This is an exclusive fund incubator program that provides high-level mentorship and resources for aspiring fund managers aiming to scale their funds. Our members have launched over 300 funds with 15 exceeding $100 million in assets under management (AUM).
If you are on a tight timeline and need to cut to the chase, you can schedule a one-on-one call here:https://www.fundlaunch.com/call
