How Real Estate Funds Actually Work ($50M Example Explained)

If you've ever wondered how large real estate firms raise money, buy properties, use leverage, and split [music] profits, I'm going to break that down in this video. And we're going to walk through a clean $50 million real estate fund example so that every piece clicks. [music] So, what is a real estate fund? Now, at its core, down to the iPad here, a fund is just a pool of money. Investors are putting money into that pool. Fund managers over here are drawing from that pool to go make investments. In this case, we're buying real estate. We're going to go buy large buildings, apartment complexes, you name it. When money flows back to the pool, it gets split between the fund manager and investors, usually 80/20. 80% to the investors, 20% to the fund managers. Now, structurally, this is the same model used across private equity, venture capital, private credit, and this is now just applied to real estate. And I know this because we've helped hundreds of people launch these funds, and I run two of these funds right now. Our aggregate portfolio AUM between all of our port- folios is over $600 million between all these funds. So, yes, we've seen a bunch of these. I run two of these right now. I know how these run. Now, to go in a little more detail, they're not called a pool of money here. What it's actually called, if I zoom up to the Fund Launch Formula here, is the GP/LP structure. If you take that same example I just gave you, instead of calling it a pool of money, it's called a limited partnership, or the fund. Instead of being called investors, they're called limited partners. And limited partners are putting money into the limited partnership, and it's managed by the fund managers over here, which is the general partner and the management company. Both of these are actually usually LLCs. So, these are LLC entities. Each one of these boxes represents an entity. This is how, by the way, the largest funds in the world run, through this simple GP/LP structure. Now, all of this is governed by what we lovingly call the Bible. You can can it here. This is your LPA and PPM. It's limited partnership agreement and private placement memorandum. These are the governing documents of an investment fund. So, small funds, big funds, typically 99% of them run through the GP LP structure and they have an LPA and a PPM, the Bible, that helps govern what's going to happen inside of that fund. Now, in our case, this fund is going to go buy real estate and we're going to buy, let's call it multi-family properties in South Florida. We usually have a tight buy box that's written in your LPA and PPM. Now, one note, why this is a great structure. Many real estate people also do syndications and they'll do things through like an LLC. They set up an LLC, they syndicate money in, the money comes in and everyone is a business partner in the LLC and they all get a percentage ownership of that LLC. Now, that can work. The problem is when you do this, these people are business partners with you. They're not investors. They are actually business partners. And so, what happens, I've seen this in syndications, is people sometimes put their elbows out, they sue each other, lawsuits are much more prevalent in LLCs cuz control isn't managed as well. Most successful groups in real estate end up moving to the GP LP structure because it protects limited partners against each other if some of them want to get squirrely and do weird things. It gives control to fund managers to allow this group to scale. Funds are very good at scaling, hence why most groups use the GP LP structure. I've got other videos on this that go into way more depth, but that's why the GP LP structure is so awesome. So, now, how does everyone get paid in a real estate fund? How does it actually break down? Well, this is what's called a waterfall structure. So, if you see my iPad here, this again is how most funds run. Right here, what I got here is a timeline. You have This is return, 0% return, 10%, 20%. Let's say our project got a 23% return after fees and we'll keep it simple just in 1 year. Most firms charge a management fee and and typically 2% charged 0.5% per quarter. Okay, that's pretty standard. So again, this deal had a 23% return after fees in one year. Typically what a lot of funds do, they take a management fee, they'll do something like a preferential rate of return or pref. Now, what this means is the first 8% of all returns will go to the investors, okay? Which is a preference rate of return. After this, and this is what's called a waterfall, we typically see a 2% catch-up back to the fund manager. So to summarize, if our deal had only made a 10% return, we take a 2% management fee, 8% goes to the investors, 2% comes to the general partner, and we end at 10% after fees. Now, what happens beyond this is we usually split 80/20 after this hurdle rate has been met. That would be 80% to the investors, 20% to the fund managers, you can see here. So if I summarize this, this is what's called carried interest. So if we're doing the math on this, it's 23% net after fees, and it was in one year. If I did this together, we're going to split this down. We investors had a 8% pref, and if you split between here and here, 80/20, that's 10.4%. So 10.4 plus 8 gives a net result for investors 18.84% return net rate of return after fees for their investment. The fund managers made 6.6% if you total up 2 plus 2 plus 2.6, that totals 8 6.6% return to investors. This is a basic waterfall structure. Now, this makes sense with a real-life example. So let's break down a $50 million fund and what it would look like. All right, so here we are. Let's assume we raised a $50 million of equity for our fund. That's dollars in from investors. And by the way, this is a spreadsheet we share with people at Fund Launch. If you talk to one of our team members, I think we can actually provide this to you. You can go play with the numbers yourself. So let's say we raised $50 million of equity in our fund. Well, that allows us to go borrow debt. Let's call it 75 million for a total purchasing power of 125 million dollars cuz we're going to lever up. In this example, again, we can play with the numbers, but we'll do 125 for this example. So, again, these things in blue here are just assumptions that we can change, but I'm going to say a grow- our growth multiple is 1.5 x over 3 years. We'll come back and play with this in a second cuz I want to show you the numbers of how it plays out, but let's just plan that for the over 3 years. We're going to get essentially a 50% return on our purchase price, okay? On this, 125,000 of purchasing power, maybe we're going to buy it for 115, and we're going to put 10 million to value add. I'm just bucketing together for simple math, 125 million is the total outlay from our fund. Now, down here, like I said before, 2% management fees, charge 0.5% per quarter, okay? So, over 3 years, and we're going to do an 80/20 split. So, that's 0.2 is 20% carried to us. Let's say we talked to the bank, we got a 6.5% interest rate on this debt, okay? Which brings us down which our debt service is going to be 4.8 million per year on the 75 million and and 14 million over the 3-year life of a project, okay? See my math how it's breaking down here? So, let's play this out. Let's say we bought it, it all worked out. How do the numbers work at the end here? And then we'll play with some of the numbers. Okay, so total value at the end of the period, we put in 125 million, we're up 1.5 x over 3 years. The end means we could sell this for 187.5 million dollars. We got to pay back our debt service, so 75 million plus 14 million brings us to 89 million after fees and debt payment. 94 million is back, which is, you know, we only put 50 million of equity in, and we end up with 94 million, pretty good. So, we got to return our capital first, we return the 50 million, we pay our management fees. I'm just doing that in a conglomerate. Again, more complex version would be it sparsed out over every quarter, but I'm just doing it in aggregate here. 3 million is paid out. Total gains after return of capital and fees is 41 million dollars of gains. We're going to split those 80/20, so 80% of the limited partners, limited partners made $33 million. The general partner, us, we make 8.3 million just on this. So, total LP payback, if you do the 50 million plus 33, is 83 million. Total GP earnings, look at this. You and me and the fund managers would have made 8.3 plus 3 million, which would be 11.3 million bucks. Not bad. There's a reason why fund managers are, you know, usually pretty wealthy people. Okay? This is my check validation. So, multiple on invested capital for the limited partners, they got a 1.67x. And our simple annual, you know, and our rate of return was 56% rate of return over 3 years. Not too bad. You kind of see how the numbers play out. Now, if we did this, let's say we did this over 5 years. Okay, you can see the erosion a little bit. Still it erodes down, and you can see our our multiple went down cuz rate of return is an annual number. So, that's now only 29% per year. Let me put this back to three like we started with. Let's say our growth multiple though was a 2x. We did a little bit better. We doubled our money. Well, look at the change here. As a fund manager, you literally make double the money. That's $23 million you would make as the GP. Now, again, you can get drunk with a calculator here, and sometimes it's not helpful, but it's actually good to see the number breakdowns of how this would play. Now, we're looking at the upside. Let's Let's look at the downside. Let's say this property, we bought it for 125. It didn't do as well as we thought. We only, you know, we actually had no growth multiple. It broke even. Well, what happens is, because of the debt service over 3 years, we have to pay that back first. The equity is the first money lost in this example. Debt sits on the capital stack above equity, meaning, if this loses money, the equity loses 100% of their money first, and then, and only then, the bank loses money. That's why banks will lend on this. They're like, "Yeah, even if the property falls, it won't fall more than 50 million bucks, and we'll still get our 75 million back plus our interest rate." So, that's how you can see the following. Um there, you can kind of see how the numbers play out here. If I go back to growth multiple though, if we, you know, crush it, did a 3x again, the numbers scale, which is pretty darn fun. Again, if you want a copy of this, you can book a call down below with our fund launch team, and they actually, I think, can send this to you. Now, most these funds aren't buying one deal. Most funds are buying usually eight to about 20 deals per fund. The reason for this is diversification. Yeah, typically, if you do 20 deals, yeah, one or two are probably going to lose money. And one or two are going to make tons of money. And the other 18 or 16 deals are going to have a blended average return and gives your investors diversification across a portfolio. Now, how does this timeline break down and actually work? Now, most funds follow a closed-ended model, which is painted out here. I'm going to use a 10-year time frame to illustrate this. So, a lot of funds will do, "Hey, we're running a 7-year fund. We can extend plus one and plus one, but a total of 10 years where we will pay back all of your money." At the beginning, they are raising capital. They're bringing capital into the fund. Now, if you notice, capital raising also overlays deployment. They're going to hold closings, like a first closing, a second closing, a third closing, maybe a final closing. And while they're doing closings, they're actually buying an asset, buying an asset, buying an asset, buying an asset. This is the deployment period. So, you're buying, buying, buying. And again, while you're buying, you start the value add part. So, you're buying and you're starting val- and I'm assuming this is a value add real estate fund. You're value adding your portfolio. This is usually happening for the first couple years in a firm. You're doing value add, and then you're disposing or selling. These are all fancy finance words, but selling properties maybe at year four, five, and six. You have your disposition period. Now, if the market is really good, it's a great time to sell. Awesome. Speed ramp this and sell all your assets here. But maybe the market's pretty lousy. That's okay. It gives you flexibility. You can delay and maybe sell your assets here or here. Maybe there's a great depression that happens. We can extend and sell the assets here here to get the best price possible. Again, if you can sell earlier, that's better cuz it gets you a better IRR back to investors. So this is a typical close ended fund model. Now, what is happening here? Let's call this uh multi-family fund one. Well, what happens is many funds after they raise this capital, they open up multi-family fund two, which you can see here. So I'll call this fund two. And if you notice on the timeline, as soon as we're done, you know, middle of deployment here, we're raising capital for fund two. Does that make sense? So you're now on market. This is usually like 18 months later. You're raising your fund two. And now as fund one is deploying, fund two is raising capital. And once fund one is done deploying, fund two is deploying. Meaning as an investment firm, you're always deploying, right? You can see that. You're deploying here, you're deploying here. Once you start selling here, you're now selling here. And I'll go down. Then you build a about 18 months later, 24 months later, you go and build a fund three. And again, if you notice these timelines kind of line up. Meaning if you summarize this, once you start and you're going, you're building out a firm, an investment firm here, and you're going to be always raising capital. You're always deploying capital. Now, you might be deploying in fund one, then you're deploying fund two, and then you're deploying fund three, but you are always deploying. As a firm, you're like, "Yep, we're an investment firm. We're always looking for good real estate deals." And once you get started here, you're always selling deals. So over time as a firm, you're building a capital markets team that's raising capital, an acquisitions team that's always buying and looking at new deals, a disposition team that's always selling deals, and then a fund management team that's kind of queuing up the next product. Maybe you're going to do a fund four. This works by the way for venture capital, private equity, real estate funds. They'll be running four to five funds at the same time at any given moment. Those funds are just at different periods of the life cycle of their firm. That's how these big massive firms start accumulating billions of dollars of assets under management in their firm. Now, to summarize all this, this is what we teach with the fund launch formula. We've got other videos that go through a lot of these other subsets, but in general, a real estate fund is simply just a structured pool of money that acquires property, uses leverage strategically, and improves performance and splits profits through the GP LP model. Now, once you understand that structure, the entire industry becomes a much clearer. When you're selling to funds or negotiating with them, you can understand a little bit about the life cycle and what's happening behind the their scenes of what they're trying to do for their investors or limited partners. Hopefully, this was useful. Comment down below if there's any other things I should add to this video or do future videos on. Please like, subscribe, send this to somebody else that maybe you're going to go build a real estate fund with. And by the way, at Fund Launch, we help people do this all the time. So, go check us out down below, and we'll see you in the next video. Bye-bye.