Structuring a U.S. Real Estate Fund: A How-To Guide for Emerging Managers – Part One

By Michael A. Bloom and Sung H. Hwang – Venable LLP (New York)

1 Introduction.

There is always a line at Starbucks.  That line means steady rents for landlords leasing to Starbucks tenants.  A common real estate fund model is to “roll up” multiple freestanding, single-tenant commercial properties, like Starbucks, into a single asset that accomplishes an economy of scale, diversifies risks, and achieves a portfolio size that is palatable to investors with real money.  These funds can offer investors steady cash flows, capital appreciation, tax-sheltered returns from depreciation deductions, and portfolio diversification away from stocks and bonds.

For emerging fund managers in this space, the structuring legalese can be confusing; but it is important.  Legal structures directly impact investor returns and risk management profile.  In general, tax considerations are foundational to any real estate fund legal structure.  The goal of these tax considerations is simple: minimize taxes on investor earnings and management compensation without undue complexity.  This article walks the reader through a basic structuring analysis.[1]

2 The Economics of Real Estate Funds.

Before we wade into the tax pond, let’s review a typical real estate fund’s economics in broad strokes.

A typical U.S. real estate fund will have a limited life span of not more than 10 years.  Its life cycle will comprise an initial investment-reinvestment period during which the fund will seek out and purchase real property that meets the investment criteria set out by its sponsor (a/k/a “general partner” and/or “managing member”), followed by a longer holding period, during which the fund will seek to increase the value of the real property (whether by mere passage of time or through improvements made to the real property) and, last, a liquidation period when the properties are disposed of and the cash is distributed to investors.  Often, the fund will have one or more optional extension periods to deal with unexpected changes in investment values or disposition strategies.

The limited life of a U.S. real estate fund often is ascribed to the fact that real estate is very illiquid, not homogeneous, typically cyclical, and sensitive to economic conditions and investor sentiments.  A sponsor generally will identify what he perceives to be a niche in the real estate valuation for a particular type of property during a particular period, and devise an investment strategy to exploit the niche.

Given the characteristics of real estate noted above, however, a real estate fund will be able to identify only so many investment opportunities that fit the fund’s investment strategy during any given period.  For example, some funds will attempt to exploit perceived valuation distortions, while some will seek to increase the property value through turn-around strategies, and others will seek stable, income-producing properties.  In addition, investing in real estate takes a significantly greater amount of time and money compared with other assets, especially liquid securities.

Because of this “lead-in” and “lead-out” nature of a U.S. real estate fund’s activities, a U.S. real estate investment fund rarely changes its investment strategy midcourse, barring unforeseen circumstances, such as a radical shift in asset values.  Often a fund will not be able to change its investment strategy without investor consent, since investors invested on the basis of that strategy.  Thus, when the real estate investment landscape changes significantly after a fund is formed, the sponsor typically will simply cease making investments from one fund and form a new fund rather than try to change the direction of an existing fund.

The same peculiarities of real estate investment also require that a sponsor heavily regulate the cash flows into and out of a fund to manage the fund’s liquidity and valuation.  A typical real estate fund will raise funds through subscriptions made by investors in one or more closings of limited partnership interests (or limited liability company membership interests) over a limited period, once the sponsor identifies an investment strategy and makes his business case to potential investors through the offering materials (e.g., the “Private Placement Memorandum” or PPM).  The PPM lays out the terms of the offering.  The PPM is often presented to potential investors at meetings and presentations – called “road shows,” subject to the applicable requirements of the securities law (e.g. the general solicitation and advertising rules).

The first one or two investors often get preferential treatment and are called “seed investors.”  Investors coming in through later closings typically pay an interest factor to compensate the early birds for footing the bill for the first investments.  New investors will not be allowed into the fund after the investment-reinvestment period has ended.

Investors will not fund all of their capital commitments in their subscriptions upfront.  Instead, they gradually fund the investments as they are identified and purchased in accordance with the fund’s investment criteria.  Once invested, investors typically will not see the bulk of their funds until the back end and, therefore, typically will expect a minimum rate of return to compensate for the time value of their invested money, generally known as the “preferred return.”

An investor generally will not be able to receive distributions, or redeem its interests in the fund, or withdraw from it, ahead of other investors, unless a compelling legal or regulatory justification (often the tax status of the investor being jeopardized without the withdrawal) exists.  An investor will not be able to sell or otherwise transfer its interest in the fund without the consent of the sponsor.

While there are a myriad of ways to “slice and dice” the way investment proceeds are distributed among the investors and the sponsor, often a real estate fund will allocate cash pursuant to a distribution “waterfall” (either on a per-investment or the aggregate basis) that identifies the timing, amount, and priority of each distribution.  Generally, a fund will pay investors, first, a preferred return on the invested capital, then a return of capital, and then divide the remaining funds between the investors and the sponsor.

The sponsor’s share of these remaining proceeds is often called “carry” or “promote,” which sometimes is subject to a “holdback” or “clawback” obligation to ensure appropriate promote sharing based on the economic performance of a fund during its entire life cycle.  This right to carry or promote often is called “carried interest” or “promote interest” or “sweat equity” and, in tax jargon, “profits interest.”

Often, because of the complexity of tax rules, actual tax liability of an investor for an investment in a U.S. real estate fund will differ from the investor’s actual amount and timing of cash receipts.  Therefore, frequently, a fund will build in the concept of a “tax distribution” to help investors pay their taxes on taxable income allocated to them ahead of the actual receipt of corresponding cash.  Such tax distribution is generally structured as an advance against the recipient’s share of regular distribution that will come later, similar in concept to loaning to self-employed individuals to pay their estimated taxes during the course of a year before reconciliation through the year-end tax return.

A sponsor typically will earn this promote, plus a management fee (to pay for and reimburse its management and operating expenses).  The management fee is typically computed as a percentage of the capital commitment during the investment-reinvestment period and, afterward, as a percentage of the invested capital, which may or may not include any leverage employed in making the investments.  In addition, investors may ask the sponsor to make its own capital investment on the same terms as the investors, to have some “skin in the game.”

3 Hypothetical Example.

Let’s assume a hypothetical example.  Alejandro Java, a 35-year-old graduate of the Michigan Ross School of Business, wants to leave his job at Blue Corners Capital to launch his own U.S. real estate fund – “the Coffee Fund.”

Alejandro has identified 30 properties in Illinois and Michigan under long-term leases with Dunkin Donuts tenants.  Alejandro believes he can add immediate value by the purchase and consolidated management of all 30 properties.  To do so, Alejandro needs capital.  Specifically, he needs $150MM because he has valued the 30 properties at an average of $5MM each.  Assuming that he can finance the acquisition price with 60% bank debt, Alejandro needs to raise $60MM of equity capital.

Alejandro prepares the PPM and other offering materials and travels on a road show around the world to meet with select investors.  He meets privately with potential investors and finally reaches commitments with the following three investors, the “seed investors,” for the first closing of his offering:

  1. Jay Gatsby, a resident of Long Island, NY – $24MM
  2. Silvio Bellini, a resident of Italy – $24MM
  3. Maple Leaf Pension, a Canadian pension fund – $12MM

Because of his stellar presentation, Alejandro will not be required to contribute his capital to the Coffee Fund (thus, no “skin in the game”) and will receive a 20% promote and a 2% management fee.

The Coffee Fund will have a life of 10 years, with two 1-year extensions at the sponsor’s disposal.  The first 3 years will be its investment-reinvestment period, during which it intends to acquire the 30 Dunkin Donuts properties.  The fund will hold the properties for appreciation due to traffic increase in their geographic areas and plans to start their sales in year 8 of the fund’s life until all of the investments are sold and the fund is liquidated in year 10.

Alejandro is elated, but does not want to pursue further capital through additional capital commitments at this point and wants to begin working right away.  How should the Coffee Fund be structured to make his business case as enticing as it was? Let’s look at the most often used legal structure for U.S. real estate funds.

Part Two posted 3/21/2017.


[1] This writing was prepared for marketing purposes and does not constitute tax opinion or advice to any taxpayer.  Each taxpayer should consult its own tax advisor for the application of the tax laws to its own facts.  In addition, this writing is based on current U.S. federal income tax law, and the authors will not update any reader on any future changes, including those with retroactive effect, in U.S. federal income tax law.  This article does not address any state, local, foreign, or other tax laws, except as used in the writing for illustrative purposes only.



Michael Bloom is counsel in Venable’s Tax and Wealth Planning Group, where he provides tax advice on all types of corporate transactions, such as mergers & acquisitions, restructurings, and venture capital investments. He is based in New York. In particular, Michael’s tax practice focuses on advising emerging fund managers on fund formation and portfolio acquisitions.

Sung H. Hwang

Sung Hyun Hwang is a partner in Venable’s Tax and Wealth Planning practice, based in New York. He focuses on the full spectrum of business tax law, from complex structured financial products to multi-partner business joint ventures. Mr. Hwang has significant experience in domestic and cross-border transactions involving real estate partnerships and funds, private equity funds, hedge funds, asset managers, family offices, and financial institutions. Mr. Hwang also has significant experience in the tax credit space, including the energy-based tax credit area.

Venable LLP

Venable ( has taken a two-pronged approach to building its global reach, one which delivers superior value, and maximizes the quality lawyering and client service that its clients expect. In many cases, it provides counsel directly to U.S. and foreign-based companies, institutions and individuals. Venable frequently deliver value to its clients in a number of very specialized areas where international recognition and scope are imperative. Examples include: FCPA; Tax; Privacy, Data Protection and Internet; International Trade; Intellectual Property; Advertising, Marketing and New Media.

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