The Ultimate Guide to Private Equity Real Estate Investing
By Ed Rogan, Owner, Co-Founder
Private equity real estate is a new darling of the investment world. Investors increasingly see the many benefits of private equity real estate. Those who might otherwise be locked out of investing in large commercial real estate deals can now do so via private equity real estate, which allows them to diversify their portfolios. Moreover, a single fund can provide the flexibility to invest in multiple assets instead of in one single commercial deal.
Private equity real estate is also highly tax efficient. When structured as funds, private equity investments might last several years, so unless one of the fund’s assets is sold within a one-year period (which is rare), the returns are taxed at the long-term capital gains rate instead of short-term capital gains. This is before the benefits of pass-through depreciation. Combined, these tax benefits can save an investor 20% or more on the profits earned each year.
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Read on for your ultimate guide to investing in private equity real estate.
What is private equity real estate?
Private equity real estate refers to the pooling of funds, typically from institutional investors but also from others as we shall see, that are then used to purchase public and private commercial real estate assets. Institutional investors, having to deploy hundreds of millions of dollars, if not billions of dollars, simply don’t have the bandwidth to be able to evaluate every single real estate deal that might be worthy of their investment.
Enter private equity funds, that sit between the large institutional investors and real estate sponsors with individual deals out in the market. These private equity funds charge a fee to their investors for managing the invested capital, usually between 1% and 2% a year, while also taking compensation based on performance.
The private equity fund’s primary role is to identify high caliber real estate sponsors, underwrite their deals, and invest in them on behalf of their institutional capital providers.
What has changed dramatically over the last few years, transforming the way to private equity world works, is that while access to the best sponsors was historically the domain only of private equity funds, it has now opened up to all accredited investors anywhere. Sponsors on are no longer restricted to seeking capital from private equity funds but can now raise money online from anyone and this all stems from changes in the law that now permit general solicitation. Put another way, sponsors can now come to individual investors directly whereas before this was prohibited.
The impact of these changes is primarily at the lower to midrange of the investment scale i.e. up to around $50 million in deal size. Anything larger than that still remains typically in the private equity fund world, but even there so there are exceptions.
In short, private equity real estate is less about the real estate itself, and more about the way that real estate is financed.
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What it means
Private equity capital is generally raised through funds, rather than into individual deals, that are typically restricted in terms of which types of assets in which they can invest. Some funds are highly targeted, for instance, they may only invest in value-add multifamily apartment buildings. Other funds may be more flexible, allowing the fund manager to invest in an array of product types, such as office, retail, hospitality or industrial.
Regardless of the fund’s target investment type, the fund is generally responsible for identifying competent sponsors and then for ensuring that all real estate activities, including acquisition, financing, redevelopment, repositioning, stabilization, ongoing asset management, and eventually, disposition of the property, are conducted as originally promised.
Private equity funds will often invest with multiple sponsors, sometimes creating programmatic relationships with sponsors they have particularly high confidence in. This means that a private equity fund might agree to finance multiple deals with one sponsor that fall within a predefined type of investment.
When it became popular
Commercial real estate has historically been considered an “alternative investment,” and as a result, institutional investors would typically only invest a small portion (if any) of their portfolio in this asset class.
The sentiment toward commercial real estate really began to change in the mid-1990s as commercial property values began to fall. Many private equity real estate funds were established during this time as a way of deploying capital into undervalued and underperforming properties so they could capture untapped value for institutional investors who wanted to capitalize on market dislocation.
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Who can invest in private equity real estate?
Investing in private equity real estate funds has generally been limited to private investors, institutions and select other third parties, as outlined below:
Private equity real estate is generally only open to a select group of private investors, usually extremely high-net worth individuals though this has changed in recent years, as mentioned above, and now mere mortal accredited investors can also invest. To be an accredited investor, a person must have at least $1 million in assets (excluding their primary residence) or have consistent annual income of at least $200,000. Couples with a combined income of $300,000 or more over the past two years are also eligible to invest in most private equity real estate funds.
The expectation among private investors has historically been that they will be able to contribute significant capital (e.g., $100,000 to $250,000 or more) in a single deal or fund, but in recent years, with the advent of new regulations, these requirements have been reduced substantially. Here at Penn Capital, for example, our minimum investment requirement is only $25,000.
Institutions tend to be the most prominent investors in private equity real estate. Institutional investors include hedge funds, pension funds, mutual funds, endowments, banks and insurance companies.
Select third parties, such as asset managers, are generally able to invest in private equity real estate on behalf of institutions such as those listed above. Another group of individuals fall into this category, though they could equally be at home in both the private investor or institutional categories – the group of ultra-high-net-worth individuals or family offices.
Family offices comprise of professionals who are hired to manage the wealth of families, as the name suggests, who have come into their wealth through either inheritance or through having made money in an industry other than real estate. These teams of professionals look to create diversified portfolios for the families whose wealth they manage, in much the same way as the professionals who work for pension funds or insurance companies, for example, look to diversify portfolios for their beneficiaries and members.
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Best types of investments for private equity real estate
The overwhelming majority of capital deployed by private equity real estate funds is into commercial projects. Historically, very few private equity funds invested in residential real estate. However, since the last downturn, a new asset class has been born – that of the large-scale single-family home for rent portfolio. Although traditionally not considered commercial real estate, when pooled into portfolios and run with economies of scale and financed by lending institutions, even this asset class has come to be recognized as a form of commercial real estate.
Commercial real estate
Private equity real estate is almost exclusively concentrated in the commercial sector, i.e. multifamily apartment buildings, office buildings, retail, hospitality, industrial, self-storage, land development and the like. There are several reasons for this, including the barriers to entry to these property types. Few individuals are able to invest in commercial projects of any scale, which is where private equity funds have traditionally filled the gap. Often, private equity real estate funds will invest in both the debt and/or equity needed to finance a commercial real estate development.
Residential real estate
Private equity is much less likely to invest in residential real estate – with the exception of the new asset class of single-family homes for rent, given above. Simply put, most funds do not want to be in the business of owning an individual’s home. Owning hundreds of single-family rentals is also much more operationally complex than owning a single, larger asset such as a 200+ apartment building or office tower. As mentioned, however, there are occasions where private equity will invest in residential real estate. Blackstone and Starwood are two of the most notable players in this space.
Private equity real estate vs. REITs
There’s an important distinction to be made between private equity real estate and public real estate investment trusts (REITs). Public REITs are essentially publicly-traded stocks of existing real estate companies. Shares of REITs can be purchased and sold with the click of a button. Private equity real estate is much more illiquid. It can often take years to return initial capital contributions and profit to private equity real estate investors.
This is one of the reasons why private equity real estate limits those who can invest. Compare this to REITs, that allow any investor with a brokerage account to buy or sell shares. REITs are continuously raising capital whereas funds tend to be more limited in when they are open, usually with a specific fundraising goal outlined in advance and deadlines for when funds can be accepted.
Another key differentiator is that private equity real estate funds tend to be less highly regulated than public REITs. For example, REITs must comply with strict requirements regarding the percentage of real estate-related assets they own, how they pool capital and from whom, how and when dividends are distributed to investors, etc., whereas private equity funds are free to decide entirely for themselves how they will be operated – provided their investors are in agreement.
One exception to the above: private equity real estate investments can be pooled and structured in many different ways, including as private REITs, though this tends to be less common than structuring as an LLC, S-corp or other legal structure.
Should you invest in private equity real estate?
Let’s say you’re an accredited investor and are considering investing in private equity real estate. What factors should you be considering before making that decision? Typically, you’ll want to consider three basic factors: the amount of upfront capital required, level of risk, and potential returns.
Before investing in private equity real estate, gauge how much upfront capital will be required. Some private equity real estate funds require a minimum investment, such as $25,000, $50,000 or $100,000. Others have an initial contribution of at least $250,000. That is not an insignificant amount, regardless of how wealthy the investor. This is also why private equity real estate tends to be limited to accredited investors, institutions and related third parties. The assumption is that these parties have the capital needed to make that initial investment and understand the risks associated with doing so.
It is important to remember that, unlike a REIT or other investment, the upfront capital investment in private equity real estate is illiquid. It could take years for that money to be returned to investors. It is important, therefore, not to invest money in a private equity deal that you may need for any other purpose before the deal matures and you get your money back.
One of the reasons commercial real estate has long been considered an “alternative investment” is due to the risk associated with these projects. The industry has matured greatly over the past few decades, but it is still risky enough that investors can lose their entire investment if the fund or individual investment fails to meet expectations.
That said, there are certainly ways to mitigate risk. You’ll want to carefully vet the fund’s sponsor – what level of experience do they have? How long have they been investing in private equity real estate? What is this fund’s business model? What is their intended exit strategy? Knowing the ins- and outs of how a fund is structured and how capital will be deployed is critical for any investor looking to minimize potential risk.
Although returns are rarely guaranteed, private equity real estate has the potential to generate significant returns for investors. The annual rate of return largely depends on the structure and nature of the deal. For example, investments in Class A properties in core markets may be able to generate 6-8% returns annually.
Core-plus strategies, which include Class A/B properties located in secondary markets, or Class B buildings in Class A locations, are considered slightly riskier but will usually generate annual returns of upwards of 10%. Value-add and opportunistic real estate deals can have double-digit or more returns, but again, these initiatives tend to carry the most risk. Any investor will want to carefully consider their risk tolerance before investing in a private equity real estate deal.
Strategies for successful private equity real estate
Commercial real estate can become distressed for several reasons, some of which are harder to overcome than others. With strong project management and oversight, an adept sponsor will find creative ways for turning these properties around. Yet that process can take time and is usually far from a slam dunk. Anyone contemplating investing in distressed real estate should be sure to go in eyes wide open. The five considerations outlined above will help you do just that.
As noted above, private equity real estate is generally concentrated across a few commercial property types: multifamily, office, retail, hospitality, industrial and land development. Before investing in a fund, an investor will want to understand the basic differences between these sectors. They will also want to understand a fund’s business model and what property type the fund intends to invest in. Be sure you have confidence in that market sector prior to investing.
The commercial real estate industry is hyper-local, and therefore, geographic location is important to the success of a private equity real estate deal. Some funds will only invest in specific locations, such as core markets (e.g., New York, Los Angeles, San Francisco) whereas others target submarkets within a market (e.g., inner-urban cities and towns outside of major metropolitan areas).
You’ll want to understand the dynamics of the local market prior to investing in any private equity real estate there. Specifically, look at what would be driving demand for this product type in that region and examine the sponsor’s analysis of the market.
Commercial real estate deals can be structured in a number of ways to allow for the intake of capital at inception, and the distribution of profits at conclusion. That structure is often known as the “waterfall.” Typically, private equity real estate funds invest equity into a deal, but that’s not always the case.
These funds, despite their name, may also invest in debt, including senior loans, bridge loans, preferred equity and mezzanine debt. Be sure to know how the fund intends to deploy capital. Where your money falls in the capital stack will influence where you land in the waterfall, i.e. how much you’ll be repaid and when.
Private equity is usually just one of many sources of funding that goes into a large commercial real estate project. A private equity real estate fund might comprise the LP (limited partner) equity, whereas the project sponsor might be responsible for a major chunk of the GP (general partner) equity. It’s important to know who has which capital in any given deal, including the debt-to-equity ratio and sources of bank or other financing.
Number of investments
Most private equity real estate funds are structured to allow for investment in a certain number of deals (usually a range, e.g., 8-10) during the lifetime of that fund. You will typically want the fund to have multiple holdings so as not to put all of investors’ eggs in one basket, so to speak.
When to invest
You’d have to have a magic 8-ball to predict with any certainty exactly when to invest. That said, some real estate funds have lock-up periods that last for a decade or more, which means that the fund may inevitably have to weather ebbs and flows in the market. Be sure to investigate the sponsor’s history to evaluate how well funds have performed previously, and how the sponsor has managed to endure during downturns or other periods of economic uncertainty.
Private equity real estate is a great way for high-net-worth individuals and accredited investors to generate passive income. They also provide a unique opportunity to diversify one’s portfolio without taking on the day-to-day management of direct ownership.
Yet, as is the case with any significant investment, you’ll want to understand the nuances of any fund. In addition to learning about the fund’s sponsor and the fund’s business plan, you’ll want to probe to better understand things like whether you’ll be able to get out of the fund early and on what terms. For example, some funds will allow investors to exit early for a 1-3% exit fee. This type of provision gives some investors the comfort they need to invest in a fund where their money may otherwise be tied up for years.
Be sure to consult with your professional investment advisor before investing in private equity real estate. You may also want to have a real estate attorney comb through the fund’s offering before making any capital contribution. These two steps will help safeguard your equity in what will hopefully be a highly lucrative investment.
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