Real estate funds have several similarities to private equity and venture capital funds, but the regulatory requirements are often slightly different. Generally, real estate fund managers should be concerned with two regulatory requirements. One relates to the fund manager and the other to the fund itself, though both are very related to one another.
- The fund manager must comply with The Investment Advisers Act.
- The fund must comply with The Investment Company Act.
The fund structure, the types of investments in which the fund participates, and the applicable regulatory exemptions are key to answering those questions.How will the fund manager/adviser comply with The Investment Advisers Act?
An “investment adviser” is defined as any person who, for compensation, is engaged in the business of advising others or issuing reports or analyses regarding securities. This definition has two parts. First, an investment adviser receives compensation. This can take many forms such as management fees or carried interest (also known as promoted interest). Second, the advising must be regarding securities.
Fund managers usually meet the requirement for the first prong of the definition because they typically receive compensation. Many real estate fund advisers do not meet the second prong because the investments that the funds make are generally not “securities.” When this is the case, a fund manager is not an investment adviser and is completely exempt from registration as an investment adviser, including as an Exempt Reporting Adviser. Fund managers should always consider their situation on a case-by-case basis.What is a Security?
The Investment Adviser’s Act definition of a security is quite lengthy, but in general, the definition is what one might expect. A security includes: stocks, notes, debentures, options, and investment contracts. (see full definition here)
The inclusion of “investment contract” in the definition a security leaves room for interpretation because it is so broad. The courts have helped us understand what is considered an investment contract, and consequently also a security, in SEC v. W.J. Howey. This case gave us what is commonly known as the “Howey Test.” There are four prongs to the Howey Test, and all must be present to meet the definition of an investment contract. The fours prongs are:
- an investment of money (or its equivalent);
- an expectation of profits from the investment;
- the investment is in a common enterprise; and
- the outcome of the investment depends on the efforts of others.
In general, an interest in real estate or a loan or lien backed by real estate is typically not a security. Real estate interests can take the form of fee interests, installment land contracts, leaseholds, mortgage loans, deeds of trust, and other interests secured by real estate, condominiums, and cooperative housing loans.
For real estate fund managers this mean that they do not meet the definition of an investment adviser because they are not advising in relation to securities and so there are no registration requirements or needed exemptions to rely on. If, however, the fund does make investments into assets that would meet the definition of a security, then the fund manager must either register or find an applicable exemption from registration. When a real estate fund does invest in “securities” the fund manager usually relies on the private fund adviser exemption further described here.How will the fund comply with The Investment Company Act?
An “investment company” is an issuer which is, or holds itself out as being, engaged primarily in the business of investing or trading in securities or owns investment securities exceeding 40% of the issuer’s total assets.
Because many real estate funds do not invest in “securities” described above, these funds do not meet the definition of an investment company and do not need to register or rely on any exemptions.What if a Real Estate fund invests in securities?
When real estate funds invest in securities, such as a limited partnership interest in another real estate limited partnership, these funds can usually rely on an exemption from having to register as an investment company.Investment Company exemptions for Real Estate funds
Private equity funds typically rely on one of two exemptions from registering as an investment company. The first is 3(c)(1), which limits the number of beneficial owners of the fund to 100. The second is 3(c)(7), which requires that all investors are qualified purchasers. However, 3(c)(5)(C) is another exemption that many believe is more favorable than both the 3(c)(1) and 3(c)(7) exemptions because there is no investor limit and investors are not required to be qualified purchasers.
To rely on 3(c)(5)(C), a fund must not be primarily engaged in the business of issuing redeemable securities, face-amount certificates of the installment type or periodic payment plan certificates and is primarily engaged in purchasing or otherwise acquiring mortgages and other liens on and interests in real estate.
For a fund to meet the primarily engaged requirement for 3(c)(5)(C), it must allocate its assets as follows:
- At least 55% of the fund’s total assets are Qualifying Interests, which is defined as representing an actual interest in real estate or be a loan or lien backed by real estate. In general, the SEC has found that fee interests, installment land contracts, leaseholds, mortgage loans, deeds of trust, and other interests secured by real estate, condominiums, and cooperative housing loans, real estate and portfolios consisting of several different types of qualifying interests.
- Up to 25% of the funds total assets are in real estate related assets. Some assets that would be considered real estate related are:
- A loan if at least 55% of the fair market value is secured by real estate at the time the fund acquires the loan
- Securities backed by mortgages or other interests in real estate
- Interests in companies that invest in mortgages or other interests in real estate
- Up to 20% of the fund’s assets may be invested without restriction.
A real estate fund and its manager have various options on how to structure the fund and its investments. In general, it is much easier administratively for both the fund and the fund manager to only invest in real estate assets that do not meet the definition of a security. However, when a real estate fund does invest in “securities”, finding regulatory exemptions is a common practice and is usually not overly burdensome.About Assure
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