How to price a seed asset bought before first close into a real estate fund, who carries the risk under each rule, and what each does to the first-close investors.
The price most investors will accept for an asset warehoused before first close is cost plus a carrying charge, net of the income the asset earned, capped at appraised value. On an illustrative 50.0 million asset held for nine months, that is 22.15 million for the equity, against 24.00 million at appraisal. The 1.85 million difference is a day-one gain for the first-close investors, and the cap moves any fall in value back onto whoever warehoused the asset.
Worked in full in Raising a Real Estate Fund by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A first-time or emerging manager raising a blind pool is asked the same question in every meeting: what will you buy? A seed asset answers it. The manager buys before first close with its own balance sheet, a partner's or a short-term facility, and transfers the asset to the fund once it has capital. The difficulty is that the seller and the buyer are on the same side of the table: the manager or an affiliate sells, the fund the manager controls buys, and the investors are the only party not in the room. The transfer price is therefore a term investors negotiate directly, usually alongside an advisory committee consent.
All figures in millions and illustrative.
| Item | Value |
|---|---|
| Purchase price | 50.0 |
| Acquisition costs, 3% | 1.5 |
| Senior debt, 60% LTV, at 5.5% | 30.0 |
| Equity from the warehouse provider | 21.5 |
| Months held before transfer | 9 |
| Net operating income yield on price | 5.0% |
| Carrying charge on the provider's equity, simple | 8% |
| Appraised value at transfer | 54.0 |
1. Income earned in the warehouse. NOI for nine months is 50.0 × 5.0% × 9/12 = 1.875; interest is 30.0 × 5.5% × 9/12 = 1.237. The provider has already pocketed 0.638 of net income.
2. Cost plus carry, net of income.
Carrying charge = 21.5 × 8% × 9/12 = 1.29
Transfer price for the equity = 21.5 + 1.29 − 0.638 = 22.15
Excel: =Equity*(1+Rate*Months/12)-(NOI-Interest)
Netting the income matters. Without it the provider is paid its 8 per cent twice over: once through the charge and again through the rent it kept.
3. At appraised value. The asset is appraised at 54.0, 8.0 per cent above the price. Less the 30.0 of debt the fund assumes, the equity is worth 24.00. The acquisition costs do not survive an appraisal; they are already spent.
4. The cap. Lower of 22.15 and 24.00 is 22.15. The fund pays cost plus carry and books the equity at 24.00, a day-one gain of 1.85, 8.3 per cent of what it paid and 1.54 per cent of the NAV of a 120 first close.
| Party | Cost plus carry | Appraised value |
|---|---|---|
| Price paid by the fund for the equity | 22.15 | 24.00 |
| Day-one gain to the fund | 1.85 | 0.00 |
| Warehouse provider's profit, income included | 1.29 | 3.14 |
At appraisal the provider earns 3.14 on 21.5 over nine months, 14.6 per cent, or 19.5 per cent a year on a simple basis, for an asset whose buyer it controlled. That is the number investors see when they object, and it is why the manager who argues for appraisal value tends to lose the argument and the time spent on it.
The cap is the part managers resist, and it is the part that does the work. Without it, cost plus carry hands the warehouse a free put: it is paid cost whether the asset has done well or badly, so any fall in value lands on the fund.
| Appraisal | Equity value | Cost plus carry | Lower of the two | Provider P&L, lower-of rule | Fund day-one, pure cost rule |
|---|---|---|---|---|---|
| 49.0 | 19.00 | 22.15 | 19.00 | -1.86 | -3.15 |
| 51.5 | 21.50 | 22.15 | 21.50 | 0.64 | -0.65 |
| 54.0 | 24.00 | 22.15 | 22.15 | 1.29 | 1.85 |
| 57.0 | 27.00 | 22.15 | 22.15 | 1.29 | 4.85 |
Under the lower-of rule the provider's upside is capped at its carrying charge, 1.29, and its downside is open: a 2.0 per cent fall in appraised value against price costs it 1.86. A manager who warehouses on its own balance sheet is therefore writing a put to its future investors. That is a real cost of seeding a fund and belongs in the manager's budget, next to the cash burn in whether a first close covers the management company.
Treating the day-one gain as the manager's to claim. When the fund books the asset at 24.00 having paid 22.15, the 1.85 lifts the fund's early NAV and, eventually, the carry base: at 20 per cent, 0.37 of carry on value the investors did not pay for. Some investors ask for the warehoused uplift to be excluded from carry for that reason; others accept it as the price of a seeded portfolio. The point is to decide it in the LPA rather than discover it in the first quarterly report. The second mistake is forgetting transfer costs: a fund that buys the asset rather than the holding company may pay a second round of transfer taxes, which belong in the comparison.
The book takes a manager from strategy and track record through terms to first close, and the free workbook for this case times the raise month by month.
Buying assets before the fund has closed, with the manager's balance sheet, a partner or a short-term facility, then transferring them into the fund once it has capital. It gives investors a seed portfolio to underwrite. On the illustrative case a 50.0 asset is held for nine months on 21.5 of equity before transfer.
Because they pay for value created before they committed, by a party related to the manager, on a valuation the manager commissioned. In the illustrative case appraisal transfer pays the warehouse 3.14 over nine months, 14.6% on its equity, against 1.29 at cost plus carry. The difference, 1.85, comes straight out of first-close investors' NAV.
Under a lower of cost-plus-carry and appraisal rule, the warehouse provider. If the illustrative asset is appraised at 49.0, the fund pays 19.00 for equity that cost 22.15 with carry, and the provider loses 1.86 after the income it earned. Under a pure cost rule the fund would absorb a 3.15 day-one loss instead.
This article is one calculation from Raising a Real Estate Fund. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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