- Raise Now, Spend in a Downturn
- November 24, 2016 | Author: Chad J. Richman
- Law Firm: McDonald Hopkins LLC - Chicago Office
- One thing many experts agree on is that real estate is cyclical. Therefore, the optimal business strategy is to obtain capital commitments when cash is abundant and spend it when asset prices have bottomed out. In a real estate downturn, cash is king.
Real estate prices have steadily ballooned across all sectors in the last six years. According to a USA Today article published last week, “The S&P 500 REIT [Real Estate Investment Trust] Industry Index has soared 153% since 2009, blowing away the 130% gain by the S&P 500. The outperformance is actually greater than that because REITs are yielding 3.7% which is nearly twice the yield of the S&P 500.”
It seems counter-intuitive to raise money for distressed real estate investment in the face of such extraordinary gains and with little distressed product on the market. But historically new real estate millionaires and billionaires are minted by being self-controlled enough to wait while everyone else jumps in, and then fearless enough to gobble up real estate immediately after the pendulum swings by representing the only bid in an otherwise “no bid” market.
So how can you do it? Raise the money now and be ready to fire when the rest of the world is in fear.
A private real estate fund is the ideal legal vehicle (traditionally a limited partnership but limited liability companies are gaining popularity) since it pools investor capital for future deployment in the discretion of the sponsors. It is desirable for sponsors that want to avoid the logistical difficulties of raising capital on a “one-off” basis for each deal, and the costs and complications associated with forming and maintaining a public or private REIT (which require a large number of investors and heightened regulatory and tax compliance).
If the play is to lock in capital commitments now, a closed-end fund with limited or inflexible withdrawal rights is ideal. A closed-end real estate fund is one where all investors join at the same time for a fixed term. The overall life of a fund is typically 10 to 12 years but the “investment period” varies between three and seven years. Given that the strategy is to wait for the broader real estate market cycle to rotate, the sponsors should seek the maximum fund term and investment period.
Sponsors will not “call in” the capital until such time as it is actually needed, to avoid starting the meter on investor preferred return accrual (which usually ranges from 6 percent to 9 percent compounded annually), but will wait for market bottom when assets go into mortgage default/foreclosure, are unable to tap needed mortgage financing, become over-levered, or lack operating cash as the result of tenant loss. While the sponsors wait to “call in” the capital, the fund (as opposed to the sponsors) will typically bear certain expenses related to formation and operation such as legal, accounting, and some overhead and administrative costs.
A first time fund has a higher burden to bear with prospective investors because the sponsors of the fund have no track record. This burden can be overcome with an enticing investment strategy and structure that will encourage investors to make an investment. Investors will, however, seek to minimize the annual management fee paid to inexperienced sponsors, which typically ranges from 0.5 percent to 2.5 percent of committed capital (and often gets paid prior to the fund’s first capital call). A capital contribution by the sponsors of 1 percent of the total contributions of all investors is traditional but not required. It is also common (and favorable for marketing) for the sponsors to invest additional amounts.
Beyond the management fees and a return on their investment, sponsors typically receive 20 percent of the “excess profits” (e.g., the “carried interest” or “promote”) after return of investors’ capital and preferred return. More than enough of a split to allow an innovative sponsor to walk away very wealthy.