Private equity firms are gaining popularity among passive investors for commercial real estate investments. So, passive investors can now invest in large commercial real estate (CRE) deals with private equity commercial real estate partnerships, without directly being involved in the deals themselves.
What is Private Equity commercial real estate?
Real estate private equity firms raise capital from private investors and pool it to purchase, develop, operate, improve, and sell publicly and privately traded commercial real estate assets.
Hence, this generates great returns for their investors.
In other words, private equity real estate investing raises equity for ongoing real estate investment.
A sponsor or a general partner (GP) creates the fund. The sponsor then asks investors or limited partners to invest equity in the partnership.
This equity contribution along with some form of debt from banks and other lenders is then invested in real estate acquisition.
Using an active management strategy, a commercial real estate private equity fund diversifies the approach to property ownership.
The sponsors or GPs invest in a variety of property types in various locations, from new properties to the refurbishing of existing or distressed properties.
Investors in a real estate private equity fund
In a private equity real estate fund, the investors provide the bulk of the equity capital in the offerings made by the sponsors.
They are generally passive investors who are accredited or high-net-worth individuals, who have obtained their wealth from other domains.
Besides, passive investors can also include various institutions. These include public pension funds, private pension funds, endowments, insurance companies, family offices, funds of funds etc.
These accredited individuals want to partake in the long-term investment horizons with minimal evaluation and trading of every CRE deal.
They’re considered passive investors because their goal is to invest in CRE, but they lack the required time, expertise, or in-depth knowledge of the market.
Eligibility criteria for private equity commercial real estate investors
The minimum eligibility criteria for investing in private equity funds are quite high. As a result, it is not easily accessible for the average investor.
- Most private equity firms typically require accredited investors who are willing to commit $1000,000 to as much as $25 million. However now, some firms have reduced their minimum requirement to $250,000.
- If not accredited, an investor must be “sophisticated” in order to partner with CRE private equity funds. Sophistication implies that the investor “has sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment.”
Partnership in a Private equity Commercial real estate fund
These passive investors partner with CRE private equity fund in an attempt to seek a more diversified and balanced approach to CRE investing. The private equity firm will identify a property and create a limited liability corporation for purchasing that property.
The equity firm will also contribute a portion of its own funds and sell securities to the investors for raising the rest of the equity. The passive investors or the limited partners in the fund receive liability in proportion to their capital contribution.
Hence, these partnership between a passive investor and a CRE private equity fund is a combination of the liability protection of a corporation and the tax benefits of a partnership.
How does the partnership work?
In a private equity fund, the investors pool their money in a single fund to make investments.
The private equity funds generally have a manager or a management group. So, they are in charge of actively managing the equity fund’s investments.
The private equity fund’s primary role is to identify premium and seasoned sponsors, underwrite their deals and invest in them on behalf of their accredited passive investors. Hence, with a partnership with CRE private equity funds, investors can remain truly passive without the need of involving themselves in the day-to-day property tasks on a regular basis. They can simply provide the capital and let the private equity firm and its manager deal with the burdens of management with the added benefit of in-house expertise.
Limited partners or passive investors make an agreement for a specified time which can vary between four to six years. Once a portfolio investment is realized, that is, the underlying company is sold either to a buyer or to a strategic investor, the CRE private equity fund distributes the proceeds back to limited partners.
However, private equity funds and fund managers typically use a “two and twenty” fee model. This implies that they charge a 2% off of invested assets as an annual management fee and an additional 20% fee on the profits that the fund earns.
Acquisitions and Asset Management
Any CRE private equity fund has two primary roles: Acquisitions and Asset Management.
This includes conducting market research, pursuing, negotiating and managing deals. By acquisitions management, the private equity fund sets up financing, writes investment memorandum and convinces the decision-makers at the firm to invest in that particular commercial real estate property or property. The fees for acquisitions management are typically 1 to 3 per cent of the acquisition price.
This includes working with portfolio management to execute the business plan after the firm has acquired a property. By asset management, the dedicated team at the private equity fund improves the property’s operations, perform asset valuation, and financial performance. In some cases, it also requires performing due diligence on new acquisitions and selling properties. The asset management fees are generally 1.5% per cent of the value of assets on an annual basis.
CRE private equity investment strategy
CRE private equity firms typically formulate their strategies based on specific characteristics of the investments:
1. Risk Profile
Many CRE private equity firms organize their strategy according to the risk profile and the returns associated with the investment. There are generally four types of risk-adjusted funds in the CRE private equity industry.
- Core: This type of fund has the lowest risks/lowest returns. It offers well-occupied, stable, high-quality assets in primary markets and locations. Leverage for core strategies lies in the 0% to 30% range.
- Core-plus: This type of fund contains high-quality assets in secondary markets/locations or moderately risky assets in primary markets/locations. It requires some value-added elements. Leverage for core-plus strategies lies in the 30% to 50% range.
- Value-add: This is a value add medium-to-high risk/medium-to-high return strategy. These funds involve purchasing of assets with management or operational issues. These are improved and sold for profits. These include re-leasing, operational efficiencies and/or redevelopment and/or new development. Leverage for value-add strategies lies in the 40% to 60% range.
- Opportunistic: These funds offer high-risk / high-return strategy, opportunistic investments. They involve repositioning and redeveloping properties that require massive improvements. These include poorly operated, vacant or outdated buildings or old buildings on vacant land. Further, Market/location is secondary in the opportunistic funds. Leverage for core-plus strategies can be 60% or higher.
2. Property type
- Multifamily: These comprise both garden and high- rise apartments containing 5 or more rental units. They are generally one of the least risky forms of commercial real estate investment.
- Office: Office buildings include everything from skyscrapers to small single-tenant office buildings in suburban or urban locations. However, it depends on a tenant’s credit quality due to the length of office leases and the sector’s economic importance.
- Industrial: Industrial properties are used for storage purposes, warehouses and/or distribution of materials, goods, and merchandise. As a result, with the growth of e-commerce, industrial properties are emerging as the most profitable asset class. Moreover, They require less than 15% of office space. Hence, they are the least operationally intensive asset classes due to their simple design.
- Retail: This commercial real estate asset class includes shopping malls, neighbourhood and community shopping centres, and other house retailers. Due to the rising popularity of e-commerce, this asset class is losing its value and has become the least favoured.
- Hospitality: Hospitality properties include hotel accommodations, restaurants and other service providing properties for travellers and tourists. As a result, this can also include casinos and resorts. Unlike other asset classes, hospitality properties are the most operationally and capitally intensive asset class due to the number of employees involved, the large area and the focus to beautification.
It is the riskiest asset class as it is a volatile sector that depends on seasonal crowds of tourists and travellers. For instance, with the outbreak of the COVID-19 and consequent lockdowns and travel restrictions, the hospitality sector is facing huge losses and has become the least favoured asset class for investors.
3. Geographic focus
CRE private equity funds acquire properties in a certain location based on the client requirements and time required for travelling to these locations. In order to effectively manage smaller properties, acquiring holdings in its proximity makes more sense and is more efficient. In such cases, investing in specific core markets like New York, Los Angeles, San Fransico etc is profitable. For instance, from an operational perspective, it makes more sense to acquire offices in close proximity to the company headquarters. Many small private equity firms focus on the small geographical arena. On the contrary, larger firms tend to cover more geographies due to clients that are more geographically focused. In such cases, private equity funds will target submarkets within a market, eg- inner-urban cities and towns outside major metropolitan areas.
4. Capital Structure
CRE private equity firms are considered equity investors. However, some CRE private equity firms also pursue debt investment strategies. Hence, they invest in different parts of capital structure:
- Common Equity: It provides ownership of the position and the greatest potential returns. However, it is considered to be the riskiest.
- Preferred Equity: Here, the rights vary between equity-like and ‘Mezz-like’, and the returns are not fixed.
- Mezzanine Debt: This is the bridge between senior debt and equity. However, it provides higher interest rate than senior debt, but lower than equity.
- Senior Debt: It is the least risky, largest debt piece with the lowest interest rate.