We get potential clients who reach out to us every week who want to start a fund. While we could simply take their money and set them up with fund offering documents, we actually talk a lot of people out of doing a fund. Why? Because they don’t have the necessary prerequisites to be successful with a fund and we want to set our clients (and their investors) up for success.
First, let’s talk about the three most common types of real estate offerings:
1 – Joint Ventures
This is where you raise money from a very small group of active investors to buy a specific project. The distinction between a joint venture and a securities offering to passive investors is that in a joint venture all investors must be actively involved in generating their own profits — and there is no single person or group that is taking control of the investors’ funds. This is a good way to do small projects that don’t require large amounts of money. The magic number of members in a joint venture seems to be 5 — any more than that becomes problematic and often ends in disputes (e.g., litigation) or paralysis where vital decisions are delayed or simply can’t be made in a timely fashion. The preferred entity for joint ventures is a Member-Managed LLC, wherein all of the members are considered to be “managing members” and each has the right to open and close bank accounts and bind the company contractually. Joint ventures are a good way to start your real estate investing business, but if your goal is to scale your business and buy bigger properties, you will need to graduate to a model that can effectively be operated with more than 5 members, and puts a select group of people with the right experience in charge of the finding, vetting, and overseeing operation of the property.
2 – Specified Offerings or “Real Estate Syndicates”
This is where you raise money from passive investors for a specific project that you already have under contract. In this scenario, you typically have passive investors who buy interests in your company in exchange for a share of “equity” (i.e., profits) or a fixed return. This is the easiest way to raise money for commercial real estate, where the raise amount is $400k or more. For less than a $400k raise, you might consider a joint venture, or consider our segregated offering program that allows you to streamline the legal documents and contain the costs for a series of separate offerings that follow an identical business model. The challenge with specified offerings is that you usually have to raise the money within a window of 30-90 days, which can be daunting for those who haven’t taken the time to develop substantive relationships with a list of pre-vetted and interested investors. Specified Offerings can cost anywhere from $10k-$15k to set up.
3 – Blind Pool Funds
A fund is a securities offering that, instead of describing a specific property, describes your business model. You do this by attaching an “Investment Summary,” which is basically a business plan for your fund. The advantage of a Fund is that you can raise money from investors before you have a deal under contract, which to some real estate entrepreneurs sounds like the magic answer, but there’s a catch … A fund is the hardest way to raise and manage investor’s money. We have written many fund documents for clients who have never raised a dime, or who have raised a fraction of their target raise amount. Why? Because a fund has some prerequisites (i.e., a thing that is required as a prior condition for something else to happen or exist), and if you don’t have them, you could easily waste money on setting up an expensive fund that goes nowhere. Funds can cost anywhere from $20k-$30k to set up.
So What are the Prerequisites to Starting a Fund?
Think of it this way: You wouldn’t try to scale Mount Everest if you hadn’t gotten yourself in shape and spent time gaining significant experience scaling smaller peaks. When you do attempt the climb, you would only do it with experienced guides who have vast experience climbing it and other peaks. In fact, it’s unlikely you could even get a permit to do the climb unless you could demonstrate that you have the prerequisite experience or guides with such experience. Why? Because if you don’t have the right prerequisites, you are likely to endanger yourself and others on the climb. However, if you take the time to establish the prerequisites, you will significantly increase your chances of success and decrease the odds of failure.
The same goes for real estate funds. In the context of investors, if you don’t have the right prerequisites to start and manage a real estate fund, you are putting your investors’ funds at risk, and you may end up doing irreparable harm to your own reputation. Worst case, you misappropriate investor funds and go to jail; or you are required to disgorge all of your gains plus penalties and interest and you may be prohibited from ever raising capital again. Or your investors sue you and you end up in expensive, no-win litigation that ruins your life and negatively affects your family and your reputation.
Bottom Line — You shouldn’t start a fund unless you have the following prerequisites:
- Prior experience owning the same thing with investors that you plan to buy with your fund. If you don’t have such experience, you will need someone in our fund management team with a “track record” of doing 5-10 similar deals with investors, so you can talk about the qualifications of your “team.” Don’t try to include asset classes with which your team has no experience, as doing so will cause investors to drop out; they don’t want you learning how to acquire and manage new asset classes and business models with their funds. Including too many asset classes, even if you do have experience with them, could also cause some investors to say “no thanks.” They like to know you have a specific, executable plan for investing their money and a proven track record of doing it in a proven asset class.
- Prior experience raising capital and a substantial list of previous investors who are eager to invest in your fund. If you haven’t taken the time to develop substantive relationships with investors, you are unlikely to be successful trying to do so after you have your fund offering documents in place. This is NOT a “build it and they will come” scenario. Some people erroneously believe that institutional investors (investment banks, family offices, private equity funds) will invest in your fund. That is rarely the case. They will team with you on individual projects, but even they want to invest in specified offerings so that you don’t have the ability to mismanage their funds.
- Sufficient deal flow to support a fund. With a fund, you usually specify some limits such as a maximum dollar amount, or a certain number of properties that you expect to acquire with the fund in a finite period of time (open-ended funds rarely work and are not recommended; and some states don’t allow them). If you are only doing 1-2 deals/year, you probably don’t need a fund; you need to do one or two specified offerings. Your fund will likely languish if you don’t have sufficient deal flow or fundraising momentum to achieve your fund goals within a year or two. Even with a fund, you might take commitments, but you won’t collect money from investors until you have a place to invest it that matches your fund’s investment summary. If you collect the money too far in advance, your investors will want it to start earning a return after 90-120 days; and if you can’t offer that, they’ll want their money back. Or if you have too much money in the bank and pressure to get it earning a return, you are liable to make poor decisions that you will later regret.
- A tried-and-true fund management team that will be constant for the life of your fund. With specified offerings, you can create a new syndicate manager for each deal, so loan guarantors and members of your management team can be fluid, and you are only stuck with the same members for as long as you own that property. But once you set up a fund management team, you are stuck with them for the life of the fund, which could be a 5-10 year venture. Before you start a partnership with people you don’t know very well, you might want to try them out on a specified offering or two so you can see who performs — and who doesn’t — in a specified offering context, before committing to a long-term, challenging relationship.
- Loan guarantors in your fund management team who can guarantee loans for all of the projects your fund intends to acquire. Your lenders will require that you put forth loan guarantors for each deal who have collective net worth equal to the loan amount (yes, even for non-recourse loans), and they’ll want to see them on your fund management team. For the reasons stated above, once they are part of your fund management team, they’re entitled to their share of all of your fund’s deals.
- An established bookkeeping system and accountants who can assist you with fund management. Face it, funds are harder to manage than specified offerings. You have to be able to consolidate earnings from multiple projects at the fund level and reconcile your financials for all projects quarterly, to be able to make distributions from your fund to yourself and your investors. If you haven’t already learned how to do this with a series of specified offerings, it’s going to be a challenge to maintain accurate books, records and tax reporting for your fund and each of its properties. You can hire a fund manager, but their fees will typically be $5k-$15k/month, which you will pay out of pocket until your fund generates sufficient revenue (if ever) to cover it — taking money out of your pockets and the pockets of your investors. An investor management platform will help, but you still need property and fund level bookkeeping systems as well as accountants who will file your annual tax returns.
- You have an actual “launch plan” for your fund. If you write a book, the way to get it on the best seller list is to generate some pre-launch hype, informing prospective buyers that it’s coming and offering them a benefit (special price, etc.) if they all buy the book on a certain day. You can launch your fund in much the same way. Build some excitement; let investors know it’s coming. Let them know you have a limited number of spots available that offer a higher return than what later investors will receive, etc. The most successful funds raise money (or get fund commitments) in a short period of time versus trying to raise money from individual investors over a long period of time.
What’s the alternative if you don’t have the prerequisites?
- Do a series of 5-10 Specified Offerings to build a track record with the same management team, buying the same type of properties you want to include in a future fund. If you’ve worked together well on several projects, and you have the right team members and have generated the necessary prerequisites, it’s time to consider a fund.
- Talk to your investors and see if they are even interested in investing in a fund. You could lose some of your best investors if you change business models from specified offerings to a fund.
- Instead of doing a fund to buy more small deals, think of scaling your syndication business by building a management team that is capable of buying bigger deals — still doing specified offerings. You may find that you achieve the same financial goals for yourself and your investors with bigger deals (and bigger dollars) without the headaches of managing a fund.
Just because you meet the prerequisites doesn’t mean you should set up a real estate fund. We’ve had several clients with the right prerequisites try to create funds, with mixed levels of success. Some ended up giving money back to investors because they didn’t have sufficient deal flow, and others polled their investors, who said they preferred the specified offerings, so they elected not to go forward with their fund. Some raised small amounts of money and some were successful, but found that fund management was a full-time job.
That being said, we do draft fund offering documents for clients who have the sufficient prerequisites, and not only can we do this for you, but we will also take the time to help you decide if a fund is good fit for you and your investors. Please see the article “Which Offering Type is Right for You” on our website. And if you would like to schedule a consultation with one of our team who can help you explore a real estate fund option, please click here.