How Do Private Real Estate Funds Work?

Private real estate funds pool capital from investors to acquire, manage, and sell real estate assets. Unlike publicly traded real estate investment trusts (REITs), these funds are typically available only to institutional investors and high-net-worth individuals due to regulatory restrictions and high minimum investments. They provide access to large-scale properties that individual investors might not be able to purchase on their own.

These funds attract investors seeking diversification, income generation, and potential appreciation but come with challenges such as valuation complexities, liquidity constraints, and layered fee structures. Understanding their mechanics is essential for anyone considering an investment.

Fund Structures

Private real estate funds are usually structured as limited partnerships (LPs) or limited liability companies (LLCs). Investors participate as limited partners, while the fund manager acts as the general partner (GP), overseeing asset management and investment strategy. This structure limits investor liability to their committed capital while granting the GP decision-making authority. To align interests, the GP often invests a portion of their own capital.

Profits and losses are allocated based on the fund’s operating or partnership agreement, which also outlines governance provisions, voting rights, and investor protections. Most funds use a pass-through taxation model, meaning income and expenses flow directly to investors, avoiding double taxation.

Regulatory exemptions shape fund structures. Many operate under Regulation D of the Securities Act of 1933, allowing them to raise capital without SEC registration if they restrict participation to accredited investors. Some funds also qualify for exemptions under the Investment Company Act of 1940, avoiding stricter compliance requirements imposed on mutual funds.

Minimum Investments

Private real estate funds require significant minimum commitments, often starting at $250,000 and reaching several million dollars, depending on the fund’s strategy and target assets. Core property funds, which focus on stable, income-generating assets, may have lower minimums, while funds targeting distressed or opportunistic investments typically require higher commitments due to increased risk and capital demands.

Investment minimums also depend on the fund’s structure. Open-ended funds, which continuously accept capital, may offer lower entry points, while closed-ended funds, which raise a fixed amount during a set fundraising period, often require higher minimums. Some funds allow co-investment opportunities, enabling multiple investors to pool resources to meet the minimum commitment.

Investors do not contribute their full commitment upfront. Instead, capital is deployed through periodic capital calls as the fund acquires properties. Investors must maintain liquidity to meet these obligations, as failure to fulfill a capital call can result in penalties such as forfeited investments or diluted ownership.

Valuation and Reporting

Valuing assets in a private real estate fund is challenging since these properties do not trade on public exchanges. Fund managers rely on third-party appraisals, discounted cash flow (DCF) models, and comparable sales analysis to estimate fair value. Appraisals typically occur quarterly or annually, though significant market shifts or property-specific events may prompt more frequent evaluations. Since valuations depend on assumptions like projected rental income, capitalization rates, and occupancy trends, reported values may differ from actual sale prices.

Private real estate funds follow accounting standards such as Generally Accepted Accounting Principles (GAAP) in the U.S. or International Financial Reporting Standards (IFRS) globally. GAAP requires disclosure of investment valuations, rental income, and property management expenses. IFRS often mandates fair value reporting, which can introduce more volatility in financial statements compared to historical cost accounting.

Since private funds are not subject to the same disclosure requirements as publicly traded entities, transparency is a concern. Many funds provide quarterly reports detailing net asset value (NAV), cash flow distributions, and portfolio composition. NAV calculations incorporate property valuations, outstanding debt, and operational income, but since real estate is illiquid, NAV may not reflect actual liquidation values. Some funds also report internal rate of return (IRR) metrics, though these figures can be influenced by cash flow timing and assumptions about future property sales.

Tax Implications

Private real estate funds generate taxable income from rental revenue, capital gains on property sales, and interest from financing activities. Rental income is taxed as ordinary income, with federal rates reaching up to 37% in the U.S., depending on the investor’s tax bracket. However, deductions for depreciation, mortgage interest, and operating expenses can reduce taxable income, sometimes creating paper losses that offset other passive income.

Depreciation offers a significant tax advantage. Under the Modified Accelerated Cost Recovery System (MACRS), residential properties are depreciated over 27.5 years, while commercial properties use a 39-year schedule. Many funds conduct cost segregation studies to accelerate depreciation by identifying short-lived assets—such as fixtures and landscaping—that qualify for shorter recovery periods. The Tax Cuts and Jobs Act (TCJA) also introduced 100% bonus depreciation for certain asset categories, allowing immediate write-offs.

Capital gains taxation depends on the holding period. Properties held for over a year qualify for long-term capital gains tax, which ranges from 0% to 20% federally, plus applicable state taxes. Short-term gains, from assets held for a year or less, are taxed at ordinary income rates. Funds may use 1031 exchanges under Section 1031 of the Internal Revenue Code to defer capital gains taxes by reinvesting proceeds into like-kind properties, though strict reinvestment timelines and identification rules apply.

Distribution Waterfalls

Private real estate funds use structured payout mechanisms, known as distribution waterfalls, to allocate profits between investors and fund managers. These frameworks dictate the order and proportion in which returns are distributed.

The first tier, called the preferred return or hurdle rate, ensures that limited partners receive a minimum return—typically between 6% and 10%—before the general partner earns a share of profits. Once this threshold is met, distributions enter the catch-up tier, where the general partner receives a larger portion until their share aligns with the agreed-upon split. The final tier, known as carried interest, allocates remaining profits based on a predetermined ratio, commonly 80% to investors and 20% to the fund manager. Some funds use a tiered carried interest structure, increasing the manager’s share if returns exceed higher benchmarks.

Clawback provisions protect investors from overcompensation of fund managers. If early distributions favor the general partner due to strong initial returns but later investments underperform, clawback clauses require the manager to return excess profits to ensure investors receive their full preferred return.

Fee Arrangements

Private real estate funds impose various fees to compensate fund managers for their expertise and operational oversight. These fees impact net returns and typically include both fixed and performance-based components.

Management fees, usually 1% to 2% of committed or invested capital, cover fund operations, due diligence, and asset management. Some funds charge these fees on committed capital during the investment period, while others transition to a fee based on net asset value (NAV) once the portfolio is fully deployed.

Performance fees, known as carried interest, reward managers for generating strong returns. The industry standard is 20% of profits above the preferred return, though some funds use tiered structures where the percentage increases if returns exceed predefined benchmarks. Many agreements include high-water marks, ensuring managers only earn carried interest if the fund surpasses previous peak valuations.

Additional costs include acquisition fees (typically 1% to 2% of the purchase price), asset management fees (0.5% to 1% of NAV), and disposition fees (0.5% to 1% of the transaction value). Investors should carefully evaluate these expenses, as excessive fees can erode returns.

Redemption and Liquidity

Private real estate funds have limited liquidity, making it difficult for investors to exit their positions before the fund’s termination. Liquidity constraints stem from the long-term nature of real estate investments, as properties cannot be quickly sold without affecting valuations.

Closed-ended funds typically have fixed lifespans, often seven to ten years, with capital locked in for the duration. Investors receive distributions as properties are sold, but early withdrawals are generally not permitted. Some funds offer secondary market options where investors can sell their interests to other qualified buyers, though pricing is often at a discount due to illiquidity. Fund managers may also provide periodic liquidity windows, allowing limited redemptions under specific conditions.

Open-ended funds offer more flexibility, with periodic redemption opportunities, typically quarterly or annually. However, redemptions are subject to liquidity constraints, meaning investors may only withdraw a portion of their capital at a time. Some funds impose redemption gates, capping withdrawals to prevent forced asset sales, while others apply withdrawal penalties or require advance notice. Investors should assess these restrictions carefully, as limited exit options can impact portfolio rebalancing and cash flow planning.