Private equity real estate funds allow high-net-worth individuals and institutions like endowments and pension funds to invest in equity and debt holdings in property assets. Using an active management strategy, private equity real estate takes a diversified approach to property ownership. General partners invest in a variety of property types in different locations. Ownership strategies can range from new development and raw land holdings to complete redevelopment of existing properties or cash-flow injections into struggling properties. (For more, read: What Is Private Equity?)
Here is a look at how investors can participate in private equity real estate, and an overview of the industry's opportunities, risks, and restrictions.
Finding the Ideal Private Equity Real Estate Fund
First, the average person is incapable of taking part in private-equity real estate investments. The traditional private-equity fund requires investors to inject a minimum of $250,000 into a fund, although most managers are seeking individuals or institutions that are willing to provide upwards of $20 million to $25 million into a long-term collective investment scheme with other investors. (For more, read: Exploring Real Estate Investments: What Is Real Estate?)
Since there is little regulation over private equity real estate funds, opportunities are traditionally limited to “accredited investors.” This means that the investor must have personal or joint assets of at least $1 million (not including the value of their primary residents) or the individual’s yearly income must be at least $200,000. Couples who have combined income of at least $300,000 over the previous two years – and have a “reasonable expectation” that their income levels will remain at this level in the current year – are also eligible.
Individuals or couples seeking to invest in private equity real estate should locate a firm that specializes in the discipline. Upon examining a private equity firm's options of funds, they should understand the nature of each private equity fund’s structure, which is typically a limited partnership.
When joining a fund, outside investors will become limited partners, meaning they accept liability for the money they invest in the fund and have no veto control over the properties selected by the general partners (GPs). A limited partner’s money will be pooled with other participating investors, and fund managers will build a portfolio of properties aimed at maximizing profitability and minimizing financial risk.
Understanding the Fund’s Costs and Investment Structure
Private equity real estate funds have a number of management and performance fees that must be paid by investors. It's common that private equity funds require an annual fee of 2% of capital invested to pay for firm salaries, deal sourcing and legal services, data and research costs, marketing and additional fixed and variable costs. However, there are no limits to these investor fees.
Individuals should have a good grasp of these costs before investing because that will limit the total return on investment. For example, if a private equity real estate fund raised $500 million, it would collect $10 million each year to pay associated expenses. Over the duration of its 10-year cycle, a fund would collect $100 million in fees, meaning that only $400 million would actually be invested during that decade.
Private equity managers also receive a “carry," which is a performance fee that's traditionally 20% of excess gross profits for the fund. Investors are traditionally willing to pay these fees due to the ability of the fund to help mitigate corporate governance and management issues that might negatively affect a public company.
Most private equity real estate funds are considered “need-based” investments, meaning that partners commit capital to general partners in installments on an as-needed basis. As GPs locate potential investment properties, the fund will send a formal request for capital that limited partners pledged to the real estate fund at the beginning of the cycle. Known as a “capital call," it's a legal obligation that the limited partners must fulfill. (For more, read: Learn The Lingo Of Private Equity Investing.)
Should a limited partner fail to meet a capital call, a fund may force that person or institution into default and forfeit their entire ownership share. Other limited partners typically receive the opportunity to purchase any forfeited shares in the event of such a default.
Types of Private Equity Real Estate Strategies
When investing in private equity real estate, there are traditionally four types of investment strategies:
- Core is the most conservative strategy, and might only include properties offering lower-risk and lower potential returns because they exist in well-populated or well-traveled locations. This strategy might also focus heavily on investment in high-quality, high-value properties that require very little redevelopment or maintenance. These properties offer predictable cash flows and are commonly comprised of fully leased, multi-tenant structures.
- Core-plus requires a bit more risk, but can offer a higher return than the core strategy. These properties require modest levels of value-added activity or enhancement to the location.
- Value added is a medium-to-high-return, moderate-risk strategy that centers more on property development and market timing. In this strategy, portfolio managers purchase properties, engage in some level of redevelopment, and sell when the market is performing. Value-added properties typically require changes to management, physical improvement, or the addressing of capital constraints. These steps include building renovations and seeking ways to increase rental rates in improving markets. Value-added strategies also include the turnaround of failing operating companies or assuming debt for control of underlying properties.
- Opportunistic provides the highest level of return but assumes the most risk. With this strategy, managers purchase properties that include undeveloped land or in markets that are underperforming or lightly trafficked.
Accepting Risks and Long-Term Outlook
Investors in private equity real estate should understand that by investing in a fund, they must be willing to accept that their capital may be tied up for a predetermined period that could last many years.
In addition, multiple risks exist in the real estate market and a large amount of investment could be required during capital calls at a time when an individual has low cash flow. Many GPs structure their funds as decade-long investments or longer and they provide little or no opportunities for investors to withdraw or redeem their money. The illiquid nature of private equity funds requires investors to understand the risks of keeping their money tied up for an extended period.
The nature of private equity fund structures makes it very difficult to evaluate a fund’s financial performance or the properties it holds. Since limited regulation of private equity real estate funds exists, general partners aren't required to offer any updates to investors on potential investments, valuations of the portfolio, or any other additional information related to the investments. Investing in private equity real estate requires limited partners to commit significant capital and fully trust that the fund manager will meet his or her investment goals without having any required level of transparency. Fund managers, however, do typically send updates to their investors and may choose to be transparent about performance in order to instill confidence in any current or future fund.
The Bottom Line
Prior to investing in private equity real estate, individuals must determine if they're qualified to take part in the process. Those who are qualified will want to explore their personal investment objectives, liquidity requirements and tolerance for risk in the real estate markets. After speaking with a financial adviser, investors should study a variety of different funds to obtain a better understanding of the management strategies of the general partners and the past performances of other property funds.