Real Estate Private Equity: What It Is & How to Invest
Real Estate Private Equity: What it Is & How to Invest
Private equity real estate, also known as REPE, is comprised of privately raised, pooled funds being used for acquisition, financing, development and ownership of one or more real estate properties. REPE is a type of alternative investment class outside of the traditional, SEC-regulated investment arenas, such as REITs and the stock market.
Private equity real estate can be further subdivided into residential and commercial types:
Commercial:
- Construction or restoration
- Rental or Resale
- Hospitality (e.g., hotels and restaurants)
- Heavy industrial parks containing multiple factories
- Office blocks
- Medical centers
- Retail configurations
- Mixed-use options, where multi-family units, retail, and offices purposely co-mingle.
Residential:
- New construction
- Fix-and-flip
- Fix-and-rent
- Condos
- Apartments (A class to D class)
- Luxury
- Affordable living
- Numerous combinations of the above.
Geographical location strategies overlay the above sectors, extending to Europe, Asia, Australia, and within the US (e.g., East Coast, West Coast, and the Kona Coast in Hawaii).
Return perspective is another crucial method of assessing real estate opportunities:
- Fixed income real estate is the direction investors go when they want predictability. These properties facilitate property assets without the worry of performance volatility as values move up and down. A selection of private equity real estate funds offers project financing by adhering to themes such as senior/ mezzanine debt or preferred equity. These models generally establish:
- A maturity date
- A set interest (or coupon) paid on a predictable schedule.
- Core Real Estate embraces the highest quality real estate (commonly called Class A properties) because they focus on long-term tenants like CVS or Publix. Moreover, the debt involved is only a maximum 40% of the total investment. Returns are steady between 7 and 10% on a reliable pre-arranged schedule. It’s an option investors who want protection in recessions prefer, similar to bonds.
- Core Plus Real Estate is a category that’s distinctly more aggressive than “Core” above, but still with substantial tenants in good (but not iconic) locations. In addition, the debt percentage stretches to around 60%, thus uplifting expected regular returns to low double digits, capping at 13% annually.
- Value-Add Real Estate almost explains itself. The latter appeals to passive investors who follow a competent general partner buying low occupancy commercial real estate (semi-distressed), then stabilizing and repositioning it for a medium-term turnaround. The process often calls for substantial refurbishment and perhaps numerous renovation sub-projects. The attraction rests in annual returns of around fifteen percent once back on an even keel, with significant capital gains down the line on the possible resale of the asset. Debt levels on value add can go as high as 80%.
- Opportunistic Real Estate represents the riskiest class of alternative investments on the planet. There's no such thing as reliable and predictable cash flows. Still, there's an abundance of high expectations for outperforming returns (well above 20% IRR after all is said and done) under the right general partners. Heavy debt funding with refinancing rounds, and massive vacancy, alongside out-of-the-box thinking to reposition, are typical of this option. One must expect a lengthy new construction or challenging renovation in the mix, sometimes resulting in months (even years) of zero income. Capital gains on resale figure heavily into opportunistic real estate.
How Projects Raise Funds in “Real Estate Private Equity” Investing
The top real estate private equity firms traditionally raise funds for their ventures from Limited Partners (LPs), who invest passively on the understanding that only their equity is at risk.
In other words, suppose bank debt supports the project. Aside from sizing it up in their decision-making, Limited Partners know that if the loan arrangement falters for any reason, the subsequent liability doesn't extend to them. General Partners (GPs) function at the opposite end of the spectrum to Limited Partners. Indeed, they're the people who sponsor and manage the property's operation.
If we had to nail down what makes one private fund better than most, we’d say it’s five things:
- Exceptional General Partner capabilities and past achievements
- Projecting an extraordinary but realistic IRR (Internal Rate of Return)
- Outstanding project features in the proposal
- Unique tax benefits to be gained aside from the expected ROI
- Transparent exit options.
The General Partner’s investment offer should cover all contingencies from end to end. In so doing, you can expect it to:
- Stipulate the investment unit size in dollars and the maximum number of units any private equity investor is entitled to. For example, $100,000 x five units per investor.
- Present details about the:
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- Investment cycle (generally in years)
- Payout schedules
- Perceived risks
- Internal Return Rates (IRRs)
- Operational strategies and missions.
This is the right moment to introduce a groundbreaking competitor to private equity real estate, namely, public Real Estate Investment Trusts (REITs), pinpointing some stark variances and providing a better feel for the real estate investing landscape.
Real Estate Private Equity (REPE) Benefits vs. Publicly Traded REITs
In contrast to REPEs, traditional REIT options are SEC-registered and traded on public exchanges like the NYSE. As a result, REIT manager activities travel a significantly tighter path, with the SEC in the driver's seat. Still, there are pros and cons, so consider the following:
- A massive plus attracting investors to REITs is their exemption from corporate taxes on net income. Thus, they can pass it through untaxed as a dividend to their investors. That's the good news.
- The less engaging message is that the only way REIT investors receive income is via dividends. The latter is taxable at standard federal rates in the investors' hands, thus cutting off any chance of claiming special tax dispensations that seamlessly go with REPE options (e.g., depreciation and capital gains allowances).
- Also, REIT managers must distribute 90% of net earnings annually, leaving only 10% for asset reinvestment. Thus, growth largely depends on new investor funds flowing into the REIT.
- Conversely, the SEC exempts private equity real estate funds from registration, holding the GPs to fewer operational protocols and compliance than a public REIT manager. Thus, it provides considerably more flexibility to borrow, reinvest, and diversify. Accredited investors see this as an advantage, while traditionalists may view it as giving the general partners too much latitude.
- Private equity real estate firms are not public entities on a stock exchange like REITs. Therefore, it’s not a matter of GPs offering their equity to the public with its price flashing on the NYSE or NASDAQ boards. As a result, REPE investment memorandums should lay out robust exit strategies. Indeed, this is a vital aspect of an active management proposal connected to every private equity offering.
In a nutshell, private equity real estate investments, no matter how you look at it, converge on developing, operating, or improving properties for income or possible resale and capital gains. Because the discretionary latitude is so broad, the GPs must set out their value proposition and explain why it’s meaningfully different from REPE competitors and REITs.
Who Invests in Private Equity Real Estate?
Accredited Investors:
Individuals who can show a net worth of $1 million (excluding the principal residence) or verify a $200,000 net income for the current year, and each of the past two, get the nod. If it's a couple, the income benchmark rises to $300,000 (i.e., all yardsticks of high net worth individuals).
Aside from the above, company insiders or knowledgeable investors (both situations of an investor candidate working closely with the asset class), possessing defined SEA or FINRA certifications, or being a famously wealthy person fit the accredited investor checklist.
The net income and net worth methods are tedious and sometimes frustrating. The quickest way to get accredited is via a recognized financial advisor (e.g., an attorney, CPA, registered agent-broker) providing a 3rd party verification letter. Lastly, note the GPs have the final say in approving your qualification.
Qualified Purchasers (QPs)
The best performing real estate private equity funds welcome a broad investor category called qualified purchasers, such as pension funds, endowments, insurance companies, and family offices. These all reflect the connotation of massive wealth that traditionally flows into registered asset classes. However, in many cases, the QP managers pursue portfolio diversification (generally up to 10% of their holdings), and real estate private equity acquisitions fit the bill perfectly.
Viable Structures for Private Equity Deals?
The goal here is not to drown the reader in legalese but provide a layperson’s overview. The most common vehicles for underwriting real estate private equity are Limited Liability Partnerships (LLPs) and Limited Liability Companies (LLCs). The advantages of both categories are that:
- They both represent a direct connection to the operations.
- Thus creating a legal pass-through system, which means that the LLP or LLC doesn’t pay any federal tax. Instead, income and capital gains flow down to the GPs and LPs to pay the taxes personally.
Indeed, these features are a tremendous attraction to accredited investors and qualified purchasers; it’s the primary reason they follow the lead of the best private equity real estate firms. It presents latitude for special tax reductions (e.g., capital gains, depreciation), an advantage versus publicly listed REITs. To reiterate, the latter can only distribute dividends, a straightforward, fully taxed income stream.
The primary difference between LLP and LLC lies in who the GPs can invite to the party:
- The Limited Partners of an LLP are individuals (not corporations) who make up the partnership with the GPs to form “a collaboration of people.''
- On the other hand, LLCs have more scope, inviting equity members (i.e., not partners) that include individuals (i.e., like LLPs) but also entities such as companies and qualified purchasers (e.g., insurance and pension fund institutions).
- MMs (Managing Members) are the equivalent of General Partners in the LLPs.
- LLCs are similar to S-corps, which also contain pass-through accommodations, guaranteeing their members the tax advantages described above.
General Partners are unlikely to relinquish the LLC or LLP advantages in favor of opting for C-corp status, as the latter pays its own taxes before distributions as dividends.
Outside of LLPs and LLCs
You have two unique structures that are alternative and unregistered with the SEC - Collective Investment Trusts (CITs) and Private REITs.
- CITs are investment pools, generally under the auspices of a bank or trust company that manages the assets for organizations as part of their employee 401(k) plans to keep costs down:
- They’re also accessible via insurance institutions offering retirement planning options.
- According to pension fund protocols, these vehicles frequently take on real estate-centric themes and are tax-exempt.
- One disadvantage is that, although connected to bank fund management, CITs don’t enjoy Federal Deposit Insurance Corporation (FDIC) insurance.
- The audience for these options isn't necessarily accredited. Instead, they're simply employees of the entities offering a 401(k) option or buying into it through an insurance policy.
- Private REITs get confused with public REITS in many respects. The divider is that the SEC exempts the private category from registration, and they can’t trade on national stock exchanges. This sets off a chain reaction of added differentials as follows:
- Like private equity real estate via an LLP or LLC, they’re reserved for institutional consumption (i.e., qualified purchasers in most cases) and accredited investors, generally with unusually high minimum investments.
- They deviate from their public cousins in distributing earnings, leaning closer toward the best performing real estate private equity funds.
- If structured under an LLC with pass-through leverage, investors can get the best of both worlds - sound dividend income taxed only once and capital gains tax advantages.
In short, the LLC themes discussed above and Private REITs have much in common, and it's unnecessary to spend time debating minute differences.
How to Invest in Private Equity Real Estate?
The steps are not complicated:
- Ensure you’ve equipped yourself with the expected qualification as an accredited investor or qualified purchaser (see above).
- Approach the General Partners or Managing Members of an LLP (or LLC) offering investment units to interested parties. In some cases, they’ll only meet with you if introduced through a third party (like a banker).
- Having crossed these hurdles, the due diligence kicks in to confirm that you’re comfortable with the sponsors, their management know-how, and the other items described above.
- Keep in mind that real estate private equity is exempt from SEC registration. Therefore, the government expects high net worth individuals in the accredited arena to do their own evaluations on what they term “alternative investments.”
One of the Best in Private Equity: Kona Development Partners, LLC
Kona Development Partners, LLC (Kona) in Hawaii exemplifies all the compelling features of a private equity fund operating in the luxury, new construction real estate sector. Kona Development Partners, LLC checks all the boxes of the type of opportunity accredited investors look for when searching for those rare diamonds in the rough. Here we are with a package that makes ultimate investment sense:
- The Kona coastline is one of Hawaii’s iconic locations in a state famous for spectacular vistas. It offers remarkable beaches and a surfing paradise, supported by welcoming island hospitality.
- It’s no secret that Kona’s recent capital appreciation of over 30% represents a 50% premium on the state’s average.
- The zero mortgage funding in the investment formula is unique in the real estate arena, where core properties (see above) leverage around 40% of total investments.
- As one would expect, in a long-term investment scenario with spectacular growth, IRR projections over 25% are realistic. And that’s excluding the extraordinary tax advantages that LPs can look forward to.
- Sounds too good to be true? Look no further than the Managing Members’ record that highlights an impressive accomplishment touching one billion dollars in the private equity arena.
- The current positioning appeals to the current trends of wealthy Hawaii visitors and residents chasing an unsurpassed SF lifestyle.
- When you invest here as a passive Limited Partner, you can watch the progress with peace of mind because the Managing Members do all the heavy lifting expected of a professional general contractor.
- And there’s a lot more:
- The Managing Members guarantee they won’t draw fees until the LLC returns investors' total capital. How’s that for a confidence gesture?
- Limited Partners should appreciate that something this compelling is long-term. Optimal returns will reward patience.
- Don’t expect to peruse a complicated memorandum that baffles the brain. It’s straightforward and transparent.
- Accredited investors can invest as low as $100,000 (the entry unit price) and buy any number of units. There are additional incentives for investments over $200,000.
- Versus REITs, there's no consistent dividend flow right now, but ongoing investment promises stupendous growth. And as actual owners, the capital gains that are sure to flow down the line will bring tax smiles to our faces.
- Exit strategies are reasonable and fair considering the Kona development's conservative financing.
The bottom line is that Kona represents everything accredited investors and qualified purchasers identify as top-notch to complement their registered portfolios. Few opportunities - publicly traded or not - compete with such a compelling scenario.