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The Top Legal Issues Facing Real Estate Fund Managers

At a time in which the real estate market is booming, with the median existing-house price-setting records this June, the appetite for real estate investments has seldom been higher. Investors realize that the combination of pent-up demand and scarcity, in a climate of easy money, has pushed housing prices high and that returns from real estate investment are likely to be good, at least in the near term. Real estate fund managers are keen to exploit this market opportunity. However, once you have formed a real estate fund, you face a number of legal issues, especially if the combined assets under management of the fund or all funds (if the fund is part of a fund of funds) exceed $110 million, or if there are other regulations involved tied to the fund’s jurisdiction.  In this article, I will discuss the top legal issues facing real estate fund managers, so they can more effectively exploit this market opportunity.

Given the compensation structure of many real estate funds, managers are often keen to increase the size of assets under management. This comes with a downside, however, because as the size of the fund increases, the closer that fund gets to falling under regulations that require registration and tighter regulations. The increased regulatory oversight creates costs. Funds must invest in operational infrastructures such as an investor relations department, cybersecurity, investment operations, and compliance.

Growing Your Investor Base

Typically, your first investors are people you have a pre-existing relationship with. As you build a track record, the nature of your investor base changes. This is because as you develop a track record, grow your business network and build your capital base, investors will be attracted to your business. It is important that your actions are not solicitous and that you do not advertise for investment. This is because, if they are, you are subject to the conditions specified under Rule 506(c) of the Securities Act, you will then have to ensure that your new investors are “accredited investors” according to federal regulations. If you did not solicit those investors or there was no advertising involved, then you will be subject to Rule 506(b) of the Securities Act, which still stipulates that your investors are accredited, but, and this is crucial, you are not obliged to take any steps to verify if they are accredited, investors.

Qualified Purchasers or Qualified Clients

As a real estate fund manager, you have to verify if your investors are “qualified purchasers or “qualified clients” as per the Investment Advisers Act of 1940. If you are registered with the Securities and Exchange Commission (SEC) or you have operations in certain states, you may not be able to levy a performance-based fee on non-qualified clients. A qualified client must have, for instance, at least $1 million in assets under management with your fund, have a net worth of at least $2.1 million (excluding the primary residence).

You may also have to check if your investor is a “qualified purchaser” as defined under the Investment Company Act of 1940. These are people with at least $5 million in investments or an entity with $25 million or more in investments. The regulations say that depending on the portfolio and number of intended investors, a fund may have to get exemption from registration under the act. The exemption can be granted if all the investors are qualified purchasers. It;s clear then that there are legal implications to the investor base you choose and the number of investors you get, as well as subsequent costs, complexities, and disclosures.

Accounting and Tax Structure

Some investors have an internal pool of investors. When soliciting investors from abroad, you will have to engage tax advisors in order to secure the most tax-efficient structure possible. A tax advisor can guide you through a number of options, such as the use of feeder funds domiciled in the country or abroad.

How you structure your fund will depend on the demographics of your investor base and their preferences. For instance, a pension plan investor will be wary of investing in a vehicle that exposes it to unrelated business taxable income. Or, another example is that of a German investor who needs a special purpose vehicle created in compliance with German law. There are many examples of structures that you can use to achieve tax efficiency in a responsible and legal manner.

Larger funds sometimes create custom vehicles for their new investor by using parallel funds. Parallel funds have the same portfolio assets and structure as that of the main fund, but comply with the regulatory, tax and other requirements of these investors. Complex structures come with their own demands. You have to track all these funds’ expenses and allocate budgets for them. This implies assuming huge costs in order to make the strategy work.

Compliance and Investment Adviser Issues

Once you breach the $110 million in regulatory assets under management (RAUM) threshold, your fund has to register as an investment advisor with the SEC. RAUM is calculated by adding up the assets managed by a fund, fund of funds, under the umbrella of a portfolio manager, venture capital firm, brokerage firm, or investment advisor. As your clients’ “fiduciary”, you have a responsibility to ensure that your actions are aligned with the best interests of your advisory clients. You have to act in good faith and without conflicts of interest, in order to achieve your clients’ investment goals. Any action that goes against the best interests of your clients is contrary to your responsibilities. If there are unavoidable conflicts of interest, they have to be fully and honestly disclosed so that your clients can make intelligent decisions about those conflicts. Maximum effort must be made to ensure you never mislead your clients. Finally, anything material to the best interests of your clients or prospective clients must be fully disclosed to them.

Finally, you need to have written rules, regulations, and policies that prevent violations of the Investment Advisers Act of 1940. It is not enough to want to comply, the law demands that you create structures to ensure compliance.