Hedge Fund Investments in Real Estate Legal and Tax Issues
Client Alerts | April 30, 2007 | Hedge Funds
As hedge funds continue to grow, the market’s demand for investment returns has sparked an increasing interest in direct real estate investments – traditionally the domain of private equity funds. There are a number of issues that a hedge fund manager should carefully consider prior to investing fund assets directly in real estate. This Newsletter discusses some of these issues.
Although fund managers recognize the importance of making disclosures to potential investors, they may not be aware of the kinds of disclosures a fund investing in real estate assets should make. A simple disclosure such as “the fund intends to invest in real estate assets” does not really protect the fund manager. The less specific the disclosure, the better an investor’s claim that the fund manager did not adequately represent the risk profile of an investment in the fund.
First, the fund’s offering memorandum should carefully describe the types of real estate investments the fund manager intends to make on behalf of the fund, such as:
Whether the fund will invest primarily in residential properties or in commercial properties;
Whether fee or leasehold interests will be obtained, or whether the fund intends to be a lender;
Whether the fund will enter into joint ventures and, if so, the extent to which the fund will take management positions in those ventures;
If the fund will lease out portions of the property, whether the fund will have significant involvement in leasing activities (and earn commissions or other fees) or if third party professionals or affiliates of the fund manager will be retained;
If development is contemplated, whether the fund will act as a developer or whether development will be done by a third party or an affiliate of the fund
manager (and what the fees will be); and
Whether investments will be limited to a certain defined geographic area.
The fund’s offering memorandum should also describe the particular risks associated with those types of investments and real estate investments in general, including the following:
Real estate is an asset class that typically requires significant ongoing investment for the payment of real estate taxes, insurance premiums, brokerage commissions and other costs. Additionally, as each real estate investment is typically made with a newly-formed, wholly-owned subsidiary of the fund in order to compartmentalize liability, the formation and maintenance of such entities will result in additional fees and expenses for the fund;
Since real estate investment returns are typically not realized until assets are sold, investments in real estate are likely to be significantly illiquid and difficult to value, often leaving the fund manager with significant discretion in valuing such assets unless outside appraisals are obtained or “side pockets” are used (see “Side Pockets” below);
All management, disposition, lending or other fees to be paid to the fund manager (rather than the fund) in connection with the fund’s investments should be thoroughly disclosed as such fees create a conflict of interest for the fund manager;
Real estate investments raise certain tax risks which should be described, such as doing business in the jurisdictions where the real property is located and withholding (see “Taxes” below);
If the fund will act as a lender, the risks of such activities should be described, including lender liability, interest rate risk and the delays associated with foreclosure;
Real estate assets are subject to environmental risks that are not always under the control of the fund or even the owner of the real estate, and cannot always be insured against;
Certain losses of a catastrophic nature, such as wars, earthquakes, terrorist attacks or other similar events, may be either uninsurable or insurable at such high rates that to maintain such coverage would impracticable; and
The effect that local conditions may have on real estate investments made by the fund, including the effect of local market conditions, weather conditions and other local phenomena such as earthquakes, erosion, zoning and building code issues, especially for residential properties.
These disclosures are only examples used to illustrate the uniqueness of real estate assets. Identifying the disclosures necessary for a particular fund requires fund managers to have detailed communications with their attorneys during the formation phase and throughout the fund’s life regarding the nature of the fund’s planned investments and any associated risks.
Fund managers should be aware of the federal, state, local and foreign income tax issues regarding direct investments in real estate, and disclose this information to investors in their funds. Funds that have investors who are non-U.S. persons or U.S. tax-exempt investors face special tax considerations when investing directly in real estate. Investors should be encouraged to consult their own tax advisors to ascertain how their investment in the fund might affect their tax positions.
Real estate assets are generally treated somewhat differently under the Internal Revenue Code than other assets. In addition, fund activity in a state or other jurisdiction might subject its investors to local taxation. The fund manager should carefully consider whether the investors in the fund will be required to file income tax returns in different states or jurisdictions where real estate is owned, whether the fund will be permitted to file composite returns on behalf of its investors and whether the fund will be required to withhold taxes with respect to such investments, as well as what methods, if any, are available to minimize the effects of such issues on investors and the fund manager. The fund manager should also consider what effect these issues will have on its ability to market the fund to its target investors.
Also, even if the fund does not directly own real estate, if it engages in lending (i.e., loan originations), tax issues arise under the “doing business” rules, which has been one of the most significant tax issues facing hedge funds in recent years.
A fund manager should consider placing the fund’s direct real estate investments in “side pockets,” if the fund’s governing documents allow for this, to address the lack of liquidity and the difficulty in valuing these investments. Fund managers must be careful to comply with any limits on the use of side pockets contained in the fund’s governing documents such as a limit on the amount of the fund’s capital that the fund manager may allocate to side pockets or a limit on the amount of time that an investment may remain in a side pocket.
If a fund’s governing documents do not permit the use of side pockets, the fund manager should consider whether it can use any provisions in the documents regarding deferred withdrawals or the temporary suspension of withdrawals to deal with the issues that arise from making illiquid real estate investments.