Bricks and Mortar: Real Estate Investments Provide Unique Challenges
Private funds that invest client money in illiquid real estate – true bricks and mortar as opposed to real estate securities – face unique challenges. Not least among them is scrutiny from the SEC’s Office of Compliance Inspections and Examinations.
Private fund advisers with more than $150 million in assets under management are required to register with the SEC. Despite the passage of years since this requirement, mandated by the Dodd-Frank Act in 2011, some of the unique aspects involved in managing real estate funds, as opposed to managing funds that invest in traditional securities, remain challenging.
OCIE’s private funds unit began what it called a "thematic review" of private equity real estate advisers in 2014, said then-acting director Marc Wyatt in a May 2015 speech. Among other things, the unit conducted examinations "based on the observation that real estate managers, especially those executing opportunistic and value-add strategies, tended to be much more vertically integrated than traditional private equity managers."
What’s wrong with vertical integration? In and of itself, of course, nothing. But OCIE, according to Wyatt, was concerned that it might lead to situations where real estate advisers were charging the funds they manage for property management or other services, but failing to disclose those fees. In addition, the unit wanted to be sure that advisers promising to charge market rates or lower for those services were, in fact, charging such rates.
"Unfortunately, we rarely saw that the vertically integrated manager was able to substantiate claims that such fees are ‘at market or lower,’" said Wyatt. "During some of our exams, we have seen that the manager collects no data to justify their fees at all. Other times, the data is collected informally through calls to other industry participants and is not documented. Or, when the information is collected, what is presented to investors can be misleading."
"I hope that private equity real estate managers who have promised to provide their investors with ‘rates at or below market rate’ review their benchmarking practices to ensure they can support their claims," he said.
The unique challenges
The problems with service fees brought about, at least in part, by vertical integration are just one in a thicket of hurdles that managing real estate brings. The list includes:
Allocation of broken deal expenses. The SEC wants to know what the real estate manager does with the deal break-up fee after it is received, especially if the real estate manager has multiple funds and/or co-investment vehicles seeking to participate in the deal, said Morgan Lewis attorney Steven Giordano. "How is it allocated among the funds or accounts? What is the real estate manager’s policy on allocating and/or offsetting other expenses with the break-up fee and how do you apply it? Were the real estate manager’s policies followed?"
Overhead expenses. Any splits or sharing of expenses between the real estate manager and the fund must be spelled out clearly in the fund documents, Giordano said. If a real estate manager cross-charges the fund for its own personnel for services provided to the fund, that must be disclosed. For instance, he said, a real estate manager might use an in-house attorney and in-house accountants to handle leasing or the collection of rent payments. "The SEC’s concern is that the real estate managers may be looking for ways to pass along costs that the real estate managers should otherwise bear. The SEC is hitting private equity firms pretty hard on this issue already."
Affiliate services. As discussed above, advisers must disclose fees paid to any affiliates, not only property managers, but construction managers, leasing agents, developers, contractors and others, and must be able to show that they paid market rates or below, if that is what they promised. "It’s not inherently wrong to hire your affiliates," said Mayer Brown attorney Adam Kanter. "But are they the best party and can you demonstrate that? How are you paying them?" Most firms have a limited partner advisory committee that can be used to provide a second check on such fees, Giordano said.
Allocation of co-investment opportunities. Consider this scenario: A fund purchases a large portfolio of real estate property, say $1 billion, but wants only half of it. The manager goes to friends and associates to sell the other half. The investors, however, want more than half the property, they want $600 million. This creates a conundrum. "You are forced to choose between selling more than you want to or less than your investors want," said Kanter. "If you sell more than you want to, you may not be acting in your client’s best interest, but you might also conclude that it’s better for the client to have 40 percent of the property rather than none or the whole thing. It ultimately comes down to an evaluation of the specific facts and circumstances."
Custody issues. If an adviser has control of his client’s assets – indirect custody, not actual physical custody – be aware that any cash or securities held in a subsidiary real estate investment trust for tax reasons may now need to be audited. The SEC, in a June 2014 Guidance Update, "Private Funds and the Application of The Custody Rule to Special Purpose Vehicles and Escrows," the SEC’s Division of Investment Management indicated that "special purpose vehicles" with third-party owners (which potentially include the preferred shareholders of a REIT) should be considered separate entities from the main client and therefore may require a separate audit under the Custody Rule, Kanter said.
Fair treatment for clients. Make sure that the same client is not always first in line when an investment property comes up, said Kanter. That would appear to be favoritism, especially if that client invests a lot of money through your firm. One solution would be to rotate clients in terms of which are first presented with new investment opportunities, he said.
Investments made through joint ventures. When multiple real estate managers joint venture on an investment property, it is important to establish and disclose how the joint venture will be managed and/or who is in control of the joint venture, said Giordano. Also make a point of disclosing how fees and expenses are divided among the joint venture partners, he said.