Real estate private equity funds (REPE Funds) are structured as close-ended capital drawdown funds. We have seen multiple REPE funds structured and operated in our career, and while the detailed terms will change as the market changes. We have outlined a typical life cycle of a REPE fund from inception to liquidation for those trying to understand how real estate private equity funds work.
REPE Fund Capital Raise Phase
The real estate PE manager (sponsor) approach institutional real estate investors to raise capital for the next fund in the series of private equity fund it manages. It is much easier for established sponsors to raise the next vintage of the fund series as the track record or sponsor pedigree will open many doors compared to the first fund in the real estate private equity fund series.
Investor / Sponsor Due Diligence
Investors will evaluate the sponsor’s investment team, process and track record. The private real estate space is known to have a degree of opaqueness compared to the listed markets. During the due diligence process, the sponsors will provide a detailed investment track record to prospective investors undertaking a detailed investor due diligence process.
In addition to a detailed review of the real estate strategy (whether it is core plus, value add or opportunistic), the sponsor will highlight a pipeline of future deals to give confidence they can deploy the committed capital in a reasonable time.
Investors will also focus on the soft aspects of the REPE sponsor, such as senior management’s tenure, investment team qualifications, and increasingly the firm’s ESG capabilities.
REPE Fund Structure
Individual investors overwhelmingly prefer LLC in the LLC vs partnership for real estate. REPE Funds, on the other hand, are still predominately structured as a partnership where the fund sponsor is the general partner and the investors being the limited partner.
The general partner is responsible for managing the partnership, and the limited partner is passive in nature. Their interest is represented in the fund by an LP committee, making up the fund’s largest LPs.
Real Estate Private Equity Fund Returns and Fees
The return hurdle rate and the risk capacity of the fund are set based on investor feedback. As always in investing, the higher the return hurdle, the greater the risk tolerance the fund will have.
This includes setting out the real estate private equity fund framework in various primary, secondary markets, asset classes, and leverage targets for the portfolio.
On fees, given the minimum capital commitment and type of investors being institutional investors. The fees are lower than what the sponsor would charge for high net worth or accredited investors (these funds are not designed for those with 1000 dollars to invest in real estate).
The sponsor is compensated through numerous fees on the asset under management, and here are the most common set of fees.
Investment Management Fee
An investment management fee or asset management fee is the most basic fee a private equity sponsor will charge. The two main ways investment management fees are charged on are:
- A fee as a percentage of equity invested in the fund (capital called)
- Fee on the gross asset value of properties in the fund.
The fee will range between 1% to 2% on the fund’s gross value in either case. If fees are charged on equity, the percentage will be higher but will be equivalent to the range on a gross asset basis.
Committed Capital Fee
The committed capital fee is charged on investors’ total amount of commitment to the real estate private equity fund. Investors are paying fees to the manager from the final close. Either in committed capital fee or investment management fee once the capital is called.
We suspect one of the reasons why real estate sponsors look to increase the amount of capital raised vintage after vintage even though the utilization or the amount of commitment drawn has consistently fallen below the total commitment amount.
Acquisition Fees / Divestment Fees
The acquisition fee is charged on the deal’s total value, and it can be on a sliding scale, so the percentage will decline as the deal size increases. Some funds may also charge a divestment fee as it can be argued there is just as much work in selling an asset as buying since the fund or the sponsor need to manage the buyer due diligence and asset marketing at exit.
Fund Formation Fees
The cost of creating and setting up the fund is rolled into the fund it self at the onset. So in a sense, investors are actually paying the legal costs of setting up the fund entities and negotiating the partnership agreement between the sponsor and investors.
Administrative costs are charged and investment management fees and usually cover financial reporting, audits and other admin costs incurred by the fund.
Other REPE Fees
The above covers the most general fees charged by the sponsor, but there could be additional fees for the services provided.
- Debt origination fee and refinancing fees
- Fees charged by the operator if the REPE is a capital partner of a JV
The real estate private equity fund’s sponsor will focus on the promote hurdle and shares or carry as this is still the primary means of compensation and profit for the firm.
Real Estate Investor Makes a Binding Equity Commitment
A binding commitment from an LP means they are committed to the fund’s life, usually spanning 10 years .
The capital raising process is going until it reaches the various close dates (first close, second close and final close). Once the final close is achieved, the total binding equity commitment to the REPE fund is set, and the investment phase of the fund kicks off in full.
REPE Fund Life and Investment Periods
Capital can only be called in the fund’s early life, usually up to 3 to 4 years. During this period, the reinvestment of realized assets can be made and after which any sale proceeds must be distributed back to the investors.
Closed end funds are ideally designed to take a cyclical risk, transition or reposition opportunities and development opportunities.
As you can see with the capital investment period and fund life, a REPE fund investment’s typical turnaround should be between 3 to 5 years (matching the real estate liquidity risk). The tight timeframe means that the sponsor needs to hit the return hurdle by executing the underwritten business plan in a relatively short time. This means the more aggressive the underwriting, the lower threshold there is for things to go wrong.
Longer-dated investments that aim to take advantage of industry structural changes are more suited to core plus or core funds that match the investment horizon.
REPE Investment Phase
Given its market position, the real estate PE manager is always looking for new opportunities and committing the investors’ capital. Deals are sourced and priced in accordance with the investment style of the fund and the real estate risk profile and investment.
Portfolio construction will take into account the current market conditions and diversified across multiple residential portfolios and commercial real estate asset classes.
Acquisitions will be funded by a mix of equity draw and debt funding.
There are two primary divisions in a REPE sponsor.
- The transaction team originates and closes deals.
- The asset management teams implement the business plan once the real estate has been secured.
The business plan of the investment is executed, and hopefully, the return at realization matches the hurdle rate.
Mid Life of REPE Fund
By the mid life of the REPE fund in years 6 and 7, the fund should be in mids of execution mode of most of its investments business plan with an eye on the exit. As the fund’s investment period is over, any remaining capital committed by investors but not called is foregone, and the manager will focus on raising the next fund in the series.
Towards the end of the fund life in year 10. The fund will gradually wind down the investments, and most partnership agreements require the sponsor to liquidate all of the investments by year 10 completely. There is usually an option to extend the fund life of the fund by a year or two based on the negotiated outcome between the LP and GP, either through majority / unanimous approval by the LP or the GP has the option to extend the fund life by 1 year.
REPE Fund Summary
Hopefully, the above provides a good overview of how a real estate private equity fund works. The above is a general outline and the details will vary from fund to fund as all of the key investment terms are the result of the direct negotiation between the investor and the sponsor.
The negotiated outcome is based on the capital market conditions, the real estate cycle’s point, and investor demand/sponsor pedigree at the time of the capital raise.
As all of these factors will change at different times, the REPE fund’s terms will shift and change to reflect the market.