What is private real estate?
Private real estate, commonly referred to as real estate private equity is a specific segment of the real estate investment universe. It is called private equity because the capital is raised from private real estate investors rather than public markets like REITs. At a minimum, the target investor base is high net worth (accredited investors, $250k min) or institutional investors such as endowments, trusts and insurance companies etc.
The above description is a broad brush of the sector. Due to the unlisted nature of the capital base and funds, it isn’t easy to directly compare the different private real estate managers (called sponsors) and funds due to the bespoke investment terms each group of investors will have with the manager.
Private real estate only comes into its form today over the last 2 decades. It is only recently that the real estate private equity style of real estate investing has gone global, and the largest managers such as Blackstone and Brookfield established truly global real estate platforms. For the biggest players in the industry, the typical fund size can span $20 billion plus.
Private Real Estate Fund Strategies
Private real estate funds can be broadly segregated by their styles characterized by the risk and return trade off. These common investment styles are split into the following categories.
- Real Estate Core Funds – core funds form the base of most real estate portfolios. Core assets represent stabilized and leased properties that can provide consistent cashflow. Core funds also predominately focus on prime locations in the main metropolitan markets to ensure sufficient liquidity and underlying tenant demand.
- Real Estate Core Plus Fund – Core plus funds take a slight degree of higher risk such as leasing or real estate market risk. Eventually, once the assets are past the reposition or transition phase, it will be considered as a core asset.
- Real Estate Value Add Fund – Value add involves taking a higher degree of risk to secure an elevated fund return. This can include completely repositioning a building after being vacated by a single tenant, upgrading a building to include additional floors (construction risk) or modernizing to the market standard.
- Real Estate Opportunistic Fund – Opportunistic funds represent the most flexible capital in the real estate investment space. Opportunistic fund’s mandate is far and wide but at a significant cost with the highest return. Opportunistic fund basically takes contrarian positions in markets and are designed to take risks either in sectors or markets where no other investors are willing to go. Development deals are usually undertaken by opportunistic or value add fund depending on the permitting risk and risk allocation in the fund it self.
- Distressed Real Estate Fund – A slight variation of the opportunistic funds are distressed funds that focus on areas of the market suffering structural or cyclical changes.
Private Real Estate Fund Structure
Private real estate funds are comingled funds, where the sponsor will approach a group of investors during the capital raise phase and the group of investors will decide to join in the fund. All of the capital will be pooled together where the investors are the limited partners and the sponsor is the general partner. The sponsor will have sole discretion in managing the capital with regular reporting and LP committees to update the investors on the fund’s progress and ongoing performance. To this end, all investors are passive in nature.
The axiom of investing is the higher the risk, the higher the return and the above private real estate strategies follow that trend. As the rate of return increase from core real estate strategy to opportunistic funds. The higher return fund will generally take more risks through investing in higher risk assets and deploy higher leverage.
The fund returns are typically reported on an absolute basis, focusing on IRR and Equity Multiple as the primary performance metrics.
Private Real Estate Fund Return Example
For example, a value add fund will have a 12% IRR hurdle, which means it has to return 12% after fees and taxes for the LP. In conjunction with IRR, equity multiple is also used to ensure that the amount earned are worthwhile. There is no use to get 20% IRR, but the capital is only out the door for 3 months. Using an example EM target of 1.3x to 1.5x means for every dollar invested, at exit, the investor should get 1.3x of the equity amount invested in conjunction with earning at the hurdle rate agreed. If you combine the two return metrics this means using the same example that if the capital is fully deployed in a deal which earns 10% per annum after fees. After 3 years the LP will earn 10% and then 1.3x and if it meets the hurdle then thats great. If the hurdle rate was say only 8%, then the sponsor will share all of the returns above the hurdle as a promote (~20% of the return between 8% and 10%).
The mix of the return also changes as you move up the risk curve. For core funds, income should make up a large portion of the total return and as the degree of risk increases, the return is more weighted towards capital appreciation.
The value add, and opportunistic real estate fund is the most well known group of real estate private equity funds. These take on a significant level of risk to hit their double-digit teen hurdles. It is also notable that they deploy a high degree of leverage 60% to 70% as the result.
Notably, the private equity real estate funds are structured as drawdown funds. This means investors make a binding commitment during the capital raise phase, say for a period of 10 years. There is an investment period for the capital of typically 3 to 4 years so, and during this period the capital is called as the manager secures investment opportunities. Any capital not invested by the end of the investment period is foregone. The limited partnership agreement usually requires all assets in the fund to be liquidated by the end of the fund life (around 10 years from inception).
These binding commitments have sufficient penalty clauses that it is complicated to get out of once signed. This is to ensure the sponsor has certainty when looking for deals.
The typical size of private real estate funds now stretches into billions of dollars. That means for a deal to make a difference to the overall portfolio, it needs to reach hundreds of millions of dollars. This means that the deal sizes are getting bigger, and the funds have a global mandate to maximize the investment universe.
Like any investment portfolio, the private real estate portfolio will be diversified across multiple deals and locations. The deal sourced by the sponsor should be in conjunction with the total portfolio size. For example, if it is a $250 million equity commitment and target gearing of 75%, then overall assets will end up at $1 billion. If the fund is targetting to have a 10% max allocated in each deal, then the starting point should be $100 million transaction size deals plus or minus depending on opportunity scope.
Real Estate Private Equity Debt Strategies
An emerging subclass of the private real estate investment space sees an increasing capital deployment rate in real estate debt. Investors focused on income always saw real estate debt playing an important role and the best way to invest in real estate.
Suppose we look at the list of private real estate strategies outlined above. The real estate private equity funds are mostly focused on the higher end of the risk spectrum in investing in real estate debt. This means more value add and opportunistic real estate debt funds with an 8-15% target IRR. This is achieved through mezzanine loans secured against the real estate and equity like debt instruments like preferred equity.
Private Real Estate Funds Investments
The above outlines the broad investment style and risk profile the funds are marketed to investors. The list below highlights just some of the investment strategies the funds will deploy to achieve the hurdle rates. In general, the funds invest mostly in commercial real estate as, on a relative basis, it has the lowest real estate liquidity risk and the deepest investment universe. The funds are deployed according to a target property sector exposure, so the investing in commercial vs residential real estate debate is not as relevant in this context.
Direct Property Acquisition and Repositioning – This is perhaps the most common type of real estate investment made by private real estate funds. This is characterized by the buy, fix and sell model of the Blackstone funds. The acquired asset requires repositioning or transitioning works, high vacancy and additional capital work required to bring the asset to the market standard. The asset is priced at a discount based on the factors above. It will earn returns from buying at a discount, fixing it up within the budget and timeline, and selling at the target price based on comparable transactions.
This strategy is the private real estate industry’s bread and butter, with capital deployed in the mainstream real estate sectors like commercial office, mixed-use, industrial and retail. There has been limited alternative real estate investments by private real estate funds as given the size and specialized skills required, it can be not easy to reach sufficient scale to make it worthwhile.
The strategy sounds easy on paper, but it is harder than it looks. The best private real estate investors can execute and apply sound judgment in evaluating the opportunity.
Take Private a Publicly Traded REIT – sometimes the market can undervalue REITs for several reasons for example, the asset class is out of favor as seen in retail REITs, or the quality or performance of the asset is difficult to gauge in cases where there is a large development component. In this instance, the undervalued REIT is taken over by a fund and transition into an unlisted setting. The assets are then repositioned, sold individually or as a sub-portfolio or when the time is right. The portfolio is re-IPO at a higher fair value after 3 to 5 years.
Roll Up A Platform
Roll ups can be attractive when the individual assets are priced at a discount to a portfolio. The strategy is to buy as much as possible within the investment time period and exit by selling an already established platform for the buyer at a premium. Blackstone represents the best example of applying a roll up strategy in the industrial sector, private equity funds rolling into multi-family assets after the GFC.
Private Real Estate Carry and Fees
Private real estate is boxed in most allocators’ as an alternative asset class. The fees charged reflect this. Hedge funds are known for their 2/20 fee structure but only the best can charge this rate in the world dominated by index funds.
Fees in the private real estate space have largely been steady at 1.5 to 2%, depending on the manager’s pedigree. The fees will rise and fall depending on the point in the cycle and the negotiating position between the sponsor and the investors.
Most managers still predominately focus on the performance fee or carry as the primary means of compensation.
In addition to the asset management fees, there are usually other fees depending on the negotiations between the investor and the sponsor.
- Acquisition and sale fees paid at entry and investment exit
- property management or leasing fees if the manger does their own property management or lease deals
- A development management fee if the manager does their own developments or repositioning works in the fund
- Origination fees in securing debt facilities for the fund or project by project basis
How to Invest in Private Real Estate Funds
Large institutions and pension funds have traditionally supplied most of the capital for private real estate funds. Recently, investing in private real estate funds has been opening up to high net wealth investors and, eventually, individual investors.
The emergence of unlisted REIT or syndicated real estate funds is perhaps the closest to the real estate private equity funds. It is notable the fee structure for the private REITs are still high. Also, investors looking to invest in private real estate space should be aware of the biggest disadvantage: the limited liquidity available.
Investors should have an investment horizon of at least 3 to 5 years once committed as it can be expensive, and it is common to have a lock up period where the capital cannot be withdrawn.
An alternative approach to self creates a private real estate fund is to leverage up a portfolio of listed REIT. This is adopting a leveraged beta approach to real estate investing and can create a similar return profile.