How do I start a real estate investment fund?

25 Replies

Hello BP!

I own an LLC with a business partner doing residential filps. We are looking into opening up a real estate investment fund to raise private capital. We figured we could save money by opening up investment funds, than paying a lot of interests using a hard money lender. Hard Money Lenders cost about 12% per year, while our Investment Funds can pay a range of 7 - 12% depending on risks.

I've never done this before, but I'm hoping someone has in this forum has. How do I structure my investment fund? What are the typical items that we need to cover? Does anyone have any resource for me, on how to make this happen? 

I'm thinking we'd have two options - one secured, and one unsecured. I'm curious to know how others have structured their investment funds, equity partners, withdrawing their funds (is there penalty if they want out? etc.)

Can anyone point me in the right direction how we can make this happen! Thanks in advance BP!

@Benjie DeVera , @Brian Gibbons is right...it isn't simple but it's doable. 

First, you need an attorney. Not a wills/trust attorney, and not a real estate attorney (yeah, people really do make that mistake)...you need a securities attorney. This is someone who specializes in creating public and private investment offerings. You'll want to do a private offering--a public offering is cost prohibitive.

Next, you have to choose if this will be an equity fund or a debt fund. A debt fund would simply loan money to your flipping business and your flipping business would pay interest to your debt fund, which in turn would pay interest to its investors.

An equity fund would actually acquire title to the properties and the profits therefrom would be split in some fashion (there are thousands of ways to split the pie--you have to choose an arrangement that'll be compelling enough to attract investors).

This is a 30,000-foot level overview, your attorney would have to help you with the details, and there are many, many details to consider that are way beyond the scope of a forum post written by a non-attorney.  :)

All of that said...you'll need to consider the cost of setting up a fund versus the incremental interest savings. You'll pay $10K to $50K to set up a fund.  If you are doing a high amount of volume, fine. But if you're flipping a couple of homes per year there's no way that you can justify the cost.

If your volume is light, you are probably better off just borrowing money from investors. One investor, one loan per property. Don't put more than one person into any one deal.  Give them a first position mortgage or deed of trust with an equity cushion behind them and title insurance.  Basically the same thing you are doing with the hard money, but direct with individual investors. You can likely find capital in the 8%-10% range if you have experience and a solid track record.  Run the process by your attorney before pulling the trigger. If you don't follow the law you'll expose yourself to consequences, and the nuances in the law are complicated.

Originally posted by @Brian Burke :

@Benjie DeVera , @Brian Gibbons is right...it isn't simple but it's doable. 

First, you need an attorney. Not a wills/trust attorney, and not a real estate attorney (yeah, people really do make that mistake)...you need a securities attorney. This is someone who specializes in creating public and private investment offerings. You'll want to do a private offering--a public offering is cost prohibitive.

Next, you have to choose if this will be an equity fund or a debt fund. A debt fund would simply loan money to your flipping business and your flipping business would pay interest to your debt fund, which in turn would pay interest to its investors.

An equity fund would actually acquire title to the properties and the profits therefrom would be split in some fashion (there are thousands of ways to split the pie--you have to choose an arrangement that'll be compelling enough to attract investors).

This is a 30,000-foot level overview, your attorney would have to help you with the details, and there are many, many details to consider that are way beyond the scope of a forum post written by a non-attorney.  :)

All of that said...you'll need to consider the cost of setting up a fund versus the incremental interest savings. You'll pay $10K to $50K to set up a fund.  If you are doing a high amount of volume, fine. But if you're flipping a couple of homes per year there's no way that you can justify the cost.

If your volume is light, you are probably better off just borrowing money from investors. One investor, one loan per property. Don't put more than one person into any one deal.  Give them a first position mortgage or deed of trust with an equity cushion behind them and title insurance.  Basically the same thing you are doing with the hard money, but direct with individual investors. You can likely find capital in the 8%-10% range if you have experience and a solid track record.  Run the process by your attorney before pulling the trigger. If you don't follow the law you'll expose yourself to consequences, and the nuances in the law are complicated.

 Brian thank you so much for keeping it simple :)

Let's do a podcast about doing joint venture partnering to get started getting partners, doing some deals with partners, which 95% of people on this board need

Originally posted by @Brian Gibbons :
 Let's do a podcast about doing joint venture partnering to get started getting partners, doing some deals with partners, which 95% of people on this board need

 Great idea, Brian. That would be easy. In fact, I'll even write the script:

"Welcome to the podcast!  So you want to raise money for your real estate investments?  Hire a securities attorney!  Thank you for listening, this podcast was brought to you by...."  LOL

Ok, maybe there could be a bit more content than that, but it's definitely the key message. Raising money from investors isn't a do-it-yourself project. Some have tried and flown under the radar without a problem, others have gone to jail. Not a choice I'd want to see our BP friends on the wrong side of, that's for sure.

I'll keep my post short since Brian Burke has already covered most of what you need to see.  

1.  Hire a securities attorney.  Russ Fransden in LA would be a good resource for you.  PM me if you need an introduction

2.  I'm not sure your cost of capital will be at 7 - 12% without a very extensive track record.  If you're offering equity then your preferred return alone is likely to be in the 8 to 10% range.  With splits your cost of capital will be much higher than 12% in all likelihood

3.  Keep in mind that you have to pay for capital in a fund construct when you're not using it.  This is different from a syndicated offering where you only pay for capital while it is in use.  This doesn't sound like a big deal, but it is when you start to accumulate a lot of money inside the fund

You're likely going to be better off just raising money in some other fashion, like with first position trust deeds per transaction for what you're trying to do.  Financing growth out of profits from your operations will also allow you to grow at the correct pace and keep your financing from outgrowing your capacity to execute.  

Hope that helps.  I could write a whole book on this subject.  Reach out to me if you need a securities attorney referral.  

Bryan, I'll take you up on your offer re: referral. Do you happen to know anybody in New England you would recommend talking to? 

@Jaime Contreras

I'm not a New England guy, but most of the exemptions are national exemptions.  State laws do vary and you need blue sky compliance, but most competent securities attorneys can help with that.  

My business partner @Roland Wiederaenders is an excellent choice.  He has his own legal practice for stuff like this and he can't pay referral fees so please be kind BP mods ;-)

Be sure to consider Investment Company Act of 1940 implications and more importantly the Investment Adviser Act of 1940.  At first you will probably be regulated by the state where you reside, but each state has its own investment adviser registration regime.  There are exemptions that you might be able to use, and there is one in Texas (and in other states, and at the national level too) known as the "private fund adviser" exemption where essentially you are exempt if you are selling solely to accredited investors.  You could argue too that you aren't giving advice with respect to securities and thus don't have to register as an investment adviser, but once you combine more than one real estate asset in a single entity, you are determining valuations of the securities by reference to multiple assets, and in that case, I think that you become an investment adviser (and can't say that you are just giving advice with respect to real estate).

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Originally posted by @Jaime Contreras :

Bryan, I'll take you up on your offer re: referral. Do you happen to know anybody in New England you would recommend talking to? 

 Jaime, like Bryan said, you don't need someone in New England specifically as you really want to try to work with a federal exemption under the Securities Act of 1933. I am from Boston, but I live in so Cal. However, New England, particularly NH and MA, have BRUTAL securities laws. It is super important in those states to make sure you provide adequate disclosure to your investors because the securities board in those states will go after you with a vengeance.

@Brian Burke your advice is spot on, however, I tend to discourage people from starting a debt fund. I usually prefer to encourage an equity fund with a preferred return so that it looks like debt but doesn't put unnecessary pressure on the syndicator/manager. The pressure of HAVING to make an interest payment can ruin the deal for everyone (potentially) as opposed to paying a solid return in the event the cash flow is there to make the return. 

Which brings us to the biggest mistake first time syndicators make: offering too much to the investors. If you are confident that your returns will be 10% ROI, that doesn't mean you offer 10% ROI to your investors - instead, offer a number you KNOW you can reach. When you offer 8% and pay 9%, everyone is happy. However, if you offer 10% and only pay 9%, everyone is angry. Managing expectations is key.

Last try on giving you the chart! I hope this helps. I hope this doesn't get removed. Let me know if you have questions. 

@Jillian Sidoti , you nailed it!  I couldn't agree more with all of those points.  When I first started in this business I loved to borrow because that meant that all of the profits were mine.  But let me tell you, removing the stress of the debt payments is worth the price that you pay by giving up a piece of the deal in exchange for equity.  Not to mention that equity opens up so many more doors than debt.  Lender's hate it when you are loaded up with debt, but they love it when you bring a lot of equity.

And yes, under-promising and over-delivering is key--it's hard to grow a business that raises capital if you aren't properly managing your investor's expectations.  Some people wonder why it is that so many syndicators have short careers.  The answer is in their projections and assumptions.  This is a word-of-mouth business and reputation is everything.  Don't blow it by overshooting, just to project an ultra-high return that will attract capital but will fail to be delivered even if the market cooperates.

@Brian Burke @Jillian Sidoti @Bryan Hancock Thanks for the excellent responses, they have been very helpful. Doing private loans for each individual property as you go seems like the best and simplest way to do it, as you say. I assume that many investors become interested in setting up funds because they don't have a single investor who can finance the entire purchase price, and are looking for a solution. 

For example, in my market the average purchase price of my properties is ~$175,000, so it's common for people to want to invest ~$50,000+, but much less common the higher up you go obviously. Is there a solution for combining multiple private individuals into a single note for the first lien? Is it as simple as drawing up a separate document outlining the terms of the combined investment (e.g. who invested what amount)? I appreciate any insight you could give!

@Chip F. this depends on your state's laws. For example, in California a multi-lender note can be considered a security and you'd have to comply with all securities laws. There is an exception if the loan is originated by a licensed lander and certain procedures are followed. This may vary in other states and you should get the advice of an attorney knowledgeable in your states laws.

Another route would simply be to go to a licensed private money broker to arrange the loan. They might even have one lender that will fund the entire loan, and they do all of the sourcing. You just pay the points. 

Raising money in a fund is most useful for the part of the capital stack that isn't funded by the acquisition loan such as down payment, closing costs and rehab costs.

@Chip F. - there are very few states that have what is called a "self-executing exemption" for the sale of notes secured by real estate. Washington state is a horrible state that actually goes through the clerk records to find "non-traditional lenders" and then tracks down a borrower to hit the borrower with a fine. BEWARE. 

It can get costly to get an attorney involved in drafting something and helping with the form D filings, but it is the best insurance policy you will ever buy. What I always say to people "you can pay me a little money now and have a little stress or you can pay me a lot of money later and have a lot of stress." 

However, there is hope. In the next month, I hope to be launching a "Legal Zoom" type software for this very purpose. If you would like to be a beta tester, please let me know. 

@Jilli

@Jillian Sidoti - It's good to see your comments, Gene Trowbridge has given me consultation in the past. Now that i'm looking to take the next step, i'll be reaching back out to him.

@Jillian Sidoti I'm not sure what you mean by "Washington State is a horrible state that goes through clerk records to find non traditional lenders and then tracks down a borrower to hit the borrower with a fine". Could you elaborate?

@Julian Buick - in other words, they are all about the penalties and fees. They have harsher laws and the enforce them. So, in the case of one client, they had found their brother in law listed as a lender on a deed of trust in the clerk's records. Knowing that brother in law wasn't an institutional lender, they looked up the borrower (my client) to see if they had filed a FORM D. They had not. So they hit him with a subpoena for all his records and eventually, a fine for not following securities laws. 

@Jillian Sidoti was that a loan to an owner occupant? I.e. If it's a loan to an investor is a Form D required?

@Julian Buick - the loan was a rehab loan. The borrower (my client) borrowed money from the lender. The property was rehabbed, then rented, then sold. 

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