Your Complete Guide to Real Estate Private Equity
The more capital available, the easier it is to obtain favorable loan terms and other perks for real estate investment. This is the basis of how real estate private equity firms work. Rather than deal with per-project financing, projects are developed using private equity fund financing. This allows funds to invest in big, high-quality projects. Private equity provides scale.
How Does Real Estate Private Equity Work?
At its basic level, a real estate private equity fund is a partnership designed to raise money for ongoing real estate investment. A general partner creates the real estate private equity fund. Investors are asked to invest equity. It is this equity that is invested in real estate opportunities.
Most limited partners are passive investors. Sponsors are firstly, charged with providing additional capital. Secondly, as selecting investment opportunities. And further, managing the real estate investments and the fund. For their part, the limited partners receive an early return of their capital. In addition, they receive a preferred return on their investment capital. The sponsors earn fees based on performance. There is also an annual of between one and two percent charged to investors for managing the capital.
The History
In the late 1980s, the demand for real estate equity capital was overwhelming. The creation of real estate private equity funds met this need. Previously, leveraged buyout (LBO) funds as private equity investments allowed the LBOs of companies with solid cash flows. LBOs, however, did not focus on real estate.
In 1988, Sam Zell realized such excessive property leveraging was unsustainable. Lenders would eventually have to foreclose on non-performing real estate. He knew that large amounts of equity were necessary to acquire these foreclosures from lenders. He founded the Zell/Merrill Lynch real estate opportunity fund. Zell raised $409 billion. And in using the partnership structure of private equity, was able to develop a real estate private equity fund. Eventually, the use of this fund transformed private real estate financing.
Tax Advantages
Private equity real estate provides tax advantages. The real estate private equity fund structure almost always lasts multiple years. And returns are based on long-term capital gains. A short-term capital gain is subject to tax at ordinary income tax rates. A long-term capital gain is either 15 or 20 percent. This is in regards to assets held over one year.
Real Estate Fund Strategies
Real estate private equity funds base their strategies on risk levels. The lowest risk strategy is the core. And this focuses on multi-tenant properties in strong markets. These properties are generally fully leased. And this means less leverage is required and cash flows are steady.
Slightly higher on the risk level is that of the value-add property. These parcels need a little improvement. The opportunistic, riskier strategy involves buying properties. This requires a great deal of investment for improvement.
Of course, strategies also involve real estate type and location. Some focus on specific classes of real estate. This includes:
- Agricultural
- Commercial
- Hospitality
- Industrial
- Multi-family
- Retail
- Single-family
Location, location, location is the real estate mantra. And these funds may focus on certain areas of the U.S. or international regions.
Real Estate Private Equity Funds vs. REITs
A real estate private equity fund differs from a Real Estate Investment Trust (REIT). Both are methods of investing in real estate. However, the funds are not traded publicly. The average investor can put money into a REIT. However, the funds are usually available only to high-net-worth individuals.
REITs are structured like a mutual fund. This means investors can sell shares easily. That’s not the case with real estate private equity funds. It can take a long time to sell an apartment complex or shopping center. Due to this lack of liquidity, real estate private equity fund investors receive a higher rate of return.
There is no particular tax advantage to REITs for investors. While private REITs do exist, they are sold to institutional investors. Similar to the funds, private REITS are not traded publicly.
How The Firms Raise Capital
As noted, real estate private equity firms raise capital from limited partners. These private equity investors expect to inject significant amounts of capital into the fund. Institutional investors, such as hedge funds and pension funds, are leading players in the world of real estate private equity. Certain third parties, such as asset managers, may invest on behalf of some of these institutions. The same holds true for professional wealth managers working for very rich families.
Top Real Estate Private Equity Firms
The top 10 real estate private equity firms, focusing on managers attracting the most institutional capital over the past five years, are:
- The Blackstone Group
- Brookfield Asset Management
- Starwood Capital Group
- AEW Capital Management
- BentallGreenOak
- Lone Star Funds
- Rockpoint Group
- Cerberus Capital Management
- GLP
- Angelo Gordon
Accredited Investors
Real estate private equity funds require serious capital. However, if you are an accredited investor, you can participate in such offerings. Accredited investors are those with either an earned income exceeding $200,000 for each of the two previous years. And they expect the same for the current year. Or, someone with a net worth of over $1 million excluding the value of their primary residence. Married people may have a combined income of $300,000 for each of the two previous years. And again, expecting the same for the current year.