Private equity firms are gaining popularity among passive investors for commercial real estate investments. Passive investors can now invest in large commercial real estate (CRE) deals with CRE private equity partnerships, without directly involving in the deals themselves. With such partnerships, passive investors can reap several benefits. These include portfolio diversification, multiple asset flexibility, tax efficiency, risk dispersion and many others. Therefore, for investors who prefer a passive approach in terms of property and deal management but still want great returns and direct commercial real estate ownership, private equity partnerships can be the perfect alternative to enter the wealth-building asset class.
What is CRE Private Equity?
A real estate private equity refers to firms that raise capital from private investors and pools it to purchase, develop, operate, improve, and sell publicly and privately traded commercial real estate assets. Hence, this generates great return for their investors. In other words, a real estate private equity is a partnership established to raise 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 alongwith some form of debt from banks and other lenders is then invested in real estate acquisition.
Using an active management strategy, a CRE private equity funds diversifies the approach to property ownership. The sponsors or GPs invest in a variety of property types in various locations, new properties to refurbishing of existing or distressed properties.
Investors in a CRE private equity fund
In a private equity 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, fund of funds etc.
These accredited individuals want to partake in the long-term investment horizons with minimal evaluation and trading of every CRE deals. They’re considered passive investors because their goal is to invest in CRE, but the lack the required time, expertise, or in-depth knowledge of the market.
Eligibilty criteria for investors
The minimum eligibility criteria for investing in private equity funds 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 CRE private equity 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 purcjhasing that property. The equity firm will also contribute a portion of their own funds and sell securities to the investors for rasing 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 partnerships 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. 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 the passive investors make an agreed commitment 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 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.
Acquisitions 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 properties. The fees for acquisitions management are typically 1 to 3 percent of the acquisition price.
Asset Management: 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 sector’s economic importance.
- Industrial: The 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 emergin 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 the ownership of the position and the greatest potential returns. However, it is considered to be the most risky.
- 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.
- Senio Debt: It is the least risky, largest debt piece with the lowest interest rate.
Why CRE private equity partnership is beneficial for passive investors?
Passive investors, institutions or businesses choose to invest their capital in a CRE private equity partnership for the following reasons:
1. Passive involvement
In CRE private equity partnerships, investors truly stay passive. The transaction sponsor or the private equity firm takes care of identifying and acquisition of an investment, performing its analysis and sealing the deal in the end. In the absence of these firms, all the burden of property acquiring to post-purchase maintenance would have been the responsibility of the investor. However, due to partnership with the CRE private equity funds, an investor can realize the benefits of property ownership without the hassles of management and physical involvement.
2. Partner with expert professionals
CRE private equity firms consist of experts with experience and proven track records in every aspect of commercial real estate transactions. As a result, when passive investors partner with investing veterans, they are able to leverage the latter’s knowledge, expertise and industry relationships to unlock the best deals. From market analysis and site selection to underwriting, due diligence and property management, the experienced team handle every aspect of the investment on behalf of the investors.
Since passive investors do not need to commit the entirety of the equity in a given transaction, they are able to invest in various other smaller deals. These deals can be diverse in the sense of asset class types, which provides the investors to diversify their commercial real estate portfolio. Moreover, not only can the investors diversify their portfolios based on multiple investments across different asset classes, but also based on geography, business plan and different sponsors. Hence, CRE private equity partnerships pave the way for passive investors to make limitless small investments.
4. Wider access to quality assets
Private equity firms pool investor funds and hence unlock various lucrative commercial property deals and property types. Under normal circumstances of individual investing, identifying such assets would be difficult for their size, capital constraints and complexity. However, the private equity firms constitute vast networks of broker and experienced staff who have a vast network of developer relationships that help in identifying quality assets and properties at investor-friendly rates, that others can’t. Hence, CRE private equity partnerships enable passive investors to access a large number of quality assets.
5. Tax benefits
Passive investors use CRE private equity partnerships to gain financial benefits than can be leveraged for tax purposes. It is a known fact that even though assets can decline over time it does not affect the market value of the property. Hence, the investors can use this depreciation to show a passive loss that will offset their taxable income. As a result, this lowers their overall tax burden and increases their yeild after taxes.
6. Risk Dispersion
Since private equity funds house multiple equity partners, it disperses the risk of losses. As a result, any single investor does not have the bear the entire burden of risk and loss themselves. For instance, in a direct ownership scenario, when a property needs additional capital, an individual investor provides the extra funds. However, in a partnership, the base of investors pool their money to raise the extra capital. Hence, this automatically decrease the individual contribution amount. Moreover, private equity fund managers carefully evaluate the underlying risks and fundamentals of an investment on behalf of the investor. As a result, passive investors can zero in on the right acquisitions after proper risk-evaluation which reduces risks, maximizes growth potential and offer risk-adjusted returns.
7. High returns on investment
Investing in private equity funds can provide high potential returns on investment through passive income and strong price appreciation. Further, annual returns for core strategies range from 6% to 8% and it ranges from 8% to 10% in the case of core-plus strategies.
Limitations of CRE private equity partnership
1. Capital Intensive
Private equity fund managers generally charge exorbitant fees for managing the property tasks. This makes it relatively more expensive than other options. Moreover, investing in private equity partnerships require a long-term outlook and a huge capital commitment of over $250,000 at the initial stages and more follow-up investments over time. Further, private equity funds also charge 20% of excess gross profits for the fund as a performance fee.
Private equity partnerships are made over the long term. This implies that the funds will be locked-in for five years or more years while the manager positions the property’s business plans and an exit strategy. In some cases, the lock-up periods can stretch for more than a dozen years. If an investor needs to liquidate an investment during that period, it becomes difficult or often quite expensive. As a result, during that 5-10 years, investment becomes illiquid. Further, investors have no right to demand instant liquidation during that time and distributions are paid from cash flow.
Therefore, CRE private equity partnerships are overall more beneficial than risky for accredited passive investors. Investors having long-term horizon, and higher risk tolerance may benefit tremendously from such partnerships if they are in no need of immediate liquidity. CRE private equity funds pave the way for portfolio diversification and greater returns on investments for investors without the burdens of property management and direct involvement. Hence, CRE private equity partnerships prove to be the perfectly suitable and cost-effective alternative to direct investments.