Raising a Fund for Real Estate Investment

The team examines the complex topic of real estate investment funds from a high-level and in the context of their real estate investment business.

 

(Transcript below.)

 

Ep. 6 - Raising a Fund for Real Estate Investment - Transcript

 

Ben Shelley: [00:00:07] Welcome to the Brick x Brick Podcast where we take you from the ground up on all things real estate. I'm your host Ben Shelley. We are fortunate to have Ryan and John back with us today. The focus of this episode is about raising a fund for real estate investment. As you begin to build your real estate portfolio and gain experience in the business the opportunity can arise to rapidly expand your operation by raising money from outside investors and utilizing an increased capital base to scale up your business and generate returns. For this discussion we'll take a deep dive into how real estate funds can be structured when might be a good time for you as an investor to consider raising a fund and how the increase in capital resource can help you upscale your business. Gentlemen let's jump right into it. John, why don't we start with you.

 

John Errico: [00:00:55] Yeah. So I think I want to take a very high level perspective on this to start with and then we can delve into some specifics. But just as a sort of perfunctory statement I think raising a fund like we're gonna be talking about is something that is not appropriate for all real estate investors and even kind of advanced or experienced real estate investors might not ever do or might not be ever interested in doing. And I'll explain why that is as we go on. But from a very very very high level perspective raising a fund is related to a previous podcast episode where we talked about real estate financing and how to get money for deals. So the way that Ryan and I generally get money for deals is on what I would describe a deal by deal basis. So we'll see a property - you can call it an asset for for this world. You'll see an asset and you say how can I raise money? Well I'm going to go to my investor friend or my partner and get money in whatever capacity and whatever structure I want to do for that specific property. If you don't want to do that for some reason so maybe because it takes a lot of time to do that or maybe because you have a lot of deal flow or maybe because you have such a large asset that it doesn't make sense to go to one individual person it may make sense for you to raise what what we are calling in this case a real estate fund. And when you do that you're entering into the world of what I would say is private equity. So a real estate fund is the way that we're using the term is a pool of money. It could be provided by a single investor. It could be provided by a bunch of investors. But normally or frequently in the real estate world or the private equity world the way that they're structured is you pool people's money together. The people who operate the fund are called the sponsors or maybe the general partners of the fund. They're paid a fee and they control all of the investments that the fund makes. So instead of going on a deal by deal basis and raising money you sort of do it all upfront. You say, "hey friend, I'm raising five million, 10 million, hundred million, a billion dollars and I'm an investor in this type of asset class in this strategy and I want you to put in money to this fund and let me manage it for you. I'm gonna do it for you." And so you might be familiar with companies like Blackstone or maybe Brookfield or maybe any sort of company that you like could jeez I wonder what they do you know kind of in the finance banking world. A lot of them are private equity companies and a lot of them raise humungous funds. A lot of times to buy real estate. So Ryan and I are in the midst of raising money for our first fund and the details of that and how it structure we can get into right now. But that's a very high level overview of kind of what the world is. Ryan, do you want to touch maybe a little bit on the why we in particular raising a fund as opposed to deal by deal?

 

Ryan Goldfarb: [00:03:40] Yeah. So that was a great summary of high level what a fund is. Now you may ask yourself why you would want to do that when what you've already been doing has been working with some degree of success. For us it became a matter of scale and we were at a point where we were wasting a lot of time, or maybe not wasting, but we were occupying a lot of our time with trying to line up investors on a deal by deal basis. And at the same time we felt like we were missing out on opportunities to buy other properties because we didn't want to have to go through that whole song and dance to raise maybe 50, or 100, or 150 thousand dollars because of the amount of time required to make that a reality. So the logical next step for us was to figure out something with a little bit more scale, which in this instance turned out to be this fund. So the impetus for this, or the logic here, is let's front load all of the fundraising. Let's front load all of the work so that over the duration of this fund we have discretion over the investments that we're going to make. And the moment we see something that we would like to act upon we have the resources to make it a reality. Now there are still plenty of opportunities to get creative and to borrow money or put some type of unique capital structure in place either on a deal by deal basis or by employing some leverage with the fund itself.

 

Ryan Goldfarb: [00:05:15] But we are no longer beholden to finding a new investor for every single deal every time something comes across our plates.

 

John Errico: [00:05:23] And one aspect of our decision to raise a fund as well is the idea of diversifying returns and risk so we will have deals that come through our doors that range from extremely speculative, very high risk but hopefully are usually very high return to quite conservative, quite middle of the road, but correspondingly quite modest returns relatively, and some of those deals might be appropriate for certain types of investors. Some investors want to do really high risk. Some investors wanted to conservative stuff but if you're raising money on a deal by deal basis that investor doesn't really have the luxury of saying, oh I don't. It may be awkward to say I don't invest in this, you know, low risk, low yielding deal but I would want to deploy money more aggressively. It's hard to to say like well just wait a couple of months and then I'll have another deal for you. In the fund structure we can say look we're doing all of that together, it's diversified, right. So we're buying stuff that's really high risk and we're also buying stuff that's conservative. But the blended return to an investor is hopefully a healthy return at a risk portfolio that. Almost any real estate investor in this world would be happy to accept.

 

Ryan Goldfarb: [00:06:38] One other benefit to this strategy or to the fund path for our investors is, you know, in comparison to let's say an equity partner who might be on a flip with us, that flip is only going to hopefully last six months, nine months, or 12 months. So it's a shorter term play and while the investor's rate of return on that investment on that single project may be quite high by the end of it, they get their cash back plus their profits but they're left with the same problem that they faced at the beginning. What do I do with this extra cash? They now have to find another deal, another quality deal, whether it's with us or somebody else, and they need to try to recreate those same returns. So the benefit to them in this scenario is they make this investment upfront, and while they may not have access to the cash for an extended period of time as depicted by the limited partnership agreement and as outlined by the fund itself, the benefit is that theoretical high rate of return is achieved on that capital from the point of inception up through the dissolution of the fund, which in this case is going to be many years down the line.

 

John Errico: [00:07:59] Yeah, that's true of the the fund structure that we are putting together. It might be significant to understand that there are many many many different ways to structure funds, real estate funds, even a REIT is a type of real estate fund structure, which is unique and has unique advantages and disadvantages. I mean even putting together money for a single deal you could think of it in a way as as a fund. And frankly it is subjected to the same legal requirements as even what we're doing. We're sort of talking about a fund in the very traditional private equity world of a fund. If you went to say Blackstone and said "how do you structure your funds?" they would be similar to the way that we are discussing structuring a fund. So as Ryan alluded to the fund structure is such that we raised money at the beginning usually within a small period of time and that money is essentially illiquid meaning it cannot be withdrawn from the fund, maybe your interest in the fund can be sold to another investor. But basically if you need the cash you don't have access to it until the fund sunsets. There are funds that are "evergreen funds" which are around forever but generally the most common option in what we're doing is a fund with a set time horizon so you invest money at the beginning, the fund invests that money over a - could be 4, 5, 6, 7, 8 year period of time - and in our case for doing a six year fund - invest that money over that period of time and at the end of that period of time the fund operators liquidate those assets either by selling them to potentially another fund or by selling them to buyers or refinancing out of them or doing whatever. But at that point all the money that you've raised is returned to investors and the investors will receive obviously more than the amount of money they've initially raised. And that difference is their return on their investment. And as Ryan alluded to before the if you sort of backdate the amount that they've been returned you can get a pretty healthy IRR, a pretty healthy yearly rate of return, for the amount of capital that was initially invested.

 

Ben Shelley: [00:09:57] So John you took us a little bit through there...

 

Ben Shelley: [00:10:00] The capital structure both of funds generally and specifically the fund that you and Ryan are raising now. I do want to get also into the fund raising process itself from your guys perspective, both your experience and also maybe strategies for potential investors transitioning to creating a fund, but just out of curiosity could you maybe also talk about whether it's yours or funds generally, the corporate structure. So if I'm an investor and I own real estate under multiple LLCs and I'm ready to take that next step, is there a specific way I should go about structuring my legal ownership of my already owned properties to take that next step?

 

John Errico: [00:10:35] Yeah, it's a great question and it's important to understand that underpinning or overpinning all of what we're discussing is a large legal apparatus and a large legal structure. Even to the extent of raising money for a specific deal which is something we discussed in a previous episode there is a legal structure that overlays that. And as Ryan was alluding to before, that's part of the time going through it because it's important to, for example, structure your purchase in an entity like an LLC. But to answer your direct question, funds are structured in a partnership model and partnership is - frankly not entirely sure of the current legal reason why it's done this way - but historically it has been done this way. You can think of it similar to an LLC. Basically there will be a pool of people that invest who are called limited partners and limited partners have certain enumerated rights and those rights might be things like the formation of the entity, the disposition of the entity, what happens if the the other partner is gone or dies. The other partner is called the general partner and the general partner will be the entity that controls the fund. The fund itself being the partnership. So if you're raising money for a fund, limited partners will be your investors, and general partners will be you or your entity and one of the great things about the fund's structure is that that general partnership can itself be its own thing. It can survive the lifespan of the fund and because that general partnership is making management fees, which are another component of the fund and making profit on the back end carry or carried interest after the fund is over, the general partnership can become quite lucrative and quite solvent and can go on to raise itself. Other funds. So when you hear these big companies, you say well how did Blackstone, for example, which is the largest, I believe, the largest private equity firm in the country, how does Blackstone operate? How does it become what it is? Well Blackstone, maybe through its subsidiaries, is a general partner in many funds and they make money by management fees and by carried interest. So if you want to build a real estate company that that sort of has a legacy that is beyond you as a person, this is one way to do it because you're not tied to individual assets, not tied to individual investments. You're really creating a business. A company that can survive and become quite large, you know, you can approach even an asset class that maybe right and I don't even know about yet commercial industrial whatever.

 

Ryan Goldfarb: [00:12:56] John, correct me if I'm wrong but I believe one other ancillary benefit of the limited partnership structure is that the LPs are shielded from certain liability, right?

 

John Errico: [00:13:05] So similar to an LLC, the LPs are shielded from personal responsibility for the debts of the the overarching fund.

 

John Errico: [00:13:13] One counter to that is that when raising money from partners that are purely passive whether it be for a specific house specific asset or in a fund structure there are federal securities laws and even state securities laws that are significant. So most people that raise funds consult an attorney and frankly it's a very expensive attorney to set this up. In our specific case, I'm an attorney and my wife Shannon happens to be a private equity attorney which is a humungous advantage to us because we don't have to pay a very large New York City law firm to put together this private equity fund structure. But having said that most investors who are passive must be accredited investors which is a quite large burden for structuring deals or getting investors. We can get into some of the legal complications and aspects of it, iff you're just doing a single deal essentially raising money for a single property but in a structure where you have purely passive partners generally they're going to have to be accredited investors.

 

Ryan Goldfarb: [00:14:14] And speaking to your point about creating a legacy and speaking to your point about why it is that we would want to start a fund, I think you hit the nail on the head when you brought up the Blackstones, the BlackRocks, the Brookfields, all of those players are behemoths. But at one point they started off in some capacity doing what we are striving to do today. And our secret sauce may not be the same secret sauce that they have. But at the end of the day, the value that these firms bring to the table is their ability to identify deals and investment opportunities and their ability to execute on those deals and investment opportunities. And while we may be playing in a different arena - we're not, you know, we're not raising a five or ten billion dollar fund, the thesis is still the same. And the underlying goal is still the same. It's to put forth a plan to execute on that plan and to make ourselves and our investment partners happy with the end result.

 

John Errico: [00:15:18] It's a great point in the way that I think of it as the difference between being an operator and being something else. So I actually love being an operator of real estate like I love just getting stuff done in the real estate space. However I think that the perhaps highest and best use of our skills is to one day no longer be just an operator but to be someone who sort of sits above it and controls the financing and gets money from people that we might even hire as operators. And that's what these humungous funds and companies do. So you are out there listening as an investor you know you are an operator right. You're the person, you're your boots on the ground. You're buying assets. You're doing the work. You're renting it out you're doing all that sort of stuff. The way to make the transition from being an operator to kind of the next level is the way that we found it is to be doing this fund. I think we're gonna be operators for a very long time. Because I actually love doing it but I also love the idea of building something that's bigger than just me or just on a deal by deal basis.

 

Ryan Goldfarb: [00:16:17] This really hits close to home because day in and day out over the past six or so months I've seen the extent to which John really loves being an operator and I often find myself trying to prod him in the other direction and taking a step back and saying you know John you're you may love doing this and this may be very helpful in the moment but there's a bigger picture here and I think to an extent we're selling ourselves short by getting bogged down by some of these tasks.

 

John Errico: [00:16:48] So I think it prefigured the larger conversation you can have in this podcast about what it is to mature as a real estate investor. And I think we are I myself certainly am learning and struggling even with that transition at times.

 

Ryan Goldfarb: [00:17:00] I think, the the way that I've thought about it over the last few months, is that we're trying to transition from being real estate investors and owner operators as you have specified before, we are transitioning towards becoming business owners who operate in the real estate space. Right. And what that entails is putting the systems in place and putting the mechanisms in place to execute on these strategies whether it's us or those who we put in positions to do so.

 

John Errico: [00:17:27] Right. That's a great way to put it.

 

Ben Shelley: [00:17:28] So when it comes to the fund itself what I'm curious to know from you guys and they think this will be a good way to to sort of wrap this conversation up is when an investor looks at any investment opportunity they're still weighing the similar risk factors when it comes to what's going to happen to my money. And so whether they're looking at a general S&P 500 or Nasdaq stock, a REIT investment, private equity real estate fund, they tend to look at similar risk factors and trying to make their decision of whether or not they should invest. So it doesn't necessarily have to be a pitch for Liberty Hudson, although it can be, but why should a individual investor invest in a real estate fund like you guys?

 

John Errico: [00:18:07] Well I think if you look broadly at the returns as you laid it out there are many many ways to invest money. If you look broadly at the returns that private companies generate it's outsized. It's much higher than you can get even doing I suppose doing very speculative stock trading maybe you can do some crazy things but you're investing in like an index fund or something moderately conservative investing private companies way way way a general outperforms that. As to why you would invest in a real estate fund specifically for me it comes back to faith in the asset class of real estate and what we do specifically is residential real estate. So faith in that specific asset class. I think if you look at all real estate and all of the country over the last 200 years or whatever it is has been real estate does not appreciate very well it appreciates maybe at inflation or something akin to that. However, if you look at certain pockets of real estate over certain times with certain investment theses it performs extremely well. So my pitch as to why somebody would want to invest in a private equity real estate fund would be that it's a way to diversify your portfolio in an asset class that has proven to be very high performing and that hopefully will outperform what you might be able to do were you to deploy your money elsewhere. And if you can find operators or fund managers that you trust and have demonstrated performance in the past so much the better.

 

Ben Shelley: [00:19:37] Ryan?

 

Ryan Goldfarb: [00:19:38] The way I think about it harkens back to what I was talking about before about this being a business. The two main focuses of the business are scale and efficiency and having an investment fund and having all of these funds pooled together makes the whole greater than the sum of its parts. So that scale leads to certain advantages in terms of efficiencies is in the sense that as a fund you are able to do things that as a singular investor you may not be able to do. You are providing a service to your investors and that service is returns. That service is providing an investment vehicle that would otherwise be unreachable for you as a solo investor. So if you are a wealthy professional, if you're a doctor, or a lawyer, an entrepreneur in a field other than real estate, and you have cash sitting around, more than likely the best use of your time is not to go and plunge a toilet or paint a ceiling or clean up someone's apartment after they just moved out and trashed your place. The best use of your time is what you are good at. What most fund managers and what most investment funds are good at are real estate investments - or investments in their specialized asset class. So for us we try to focus on that each and every day and we try to build a business around that core competency. And we try to open the door to others to kind of ride the coattails of that experience and that success.

 

Ben Shelley: [00:21:18] I know I appreciate this I know our listeners appreciate this and guys thank you for your time and your expertise as always.

 

Ben Shelley: [00:21:33] And thank you for listening to the Brick x Brick Podcast where we take you from the ground up on all things real estate. We will continue to bring you the best and brightest the real estate world has to offer as we leave no stone unturned in helping you the everyday investor. Thanks for listening.