Why and how to invest in private equity real estate

A remarkable 42% of limited partners (LPs) have reported portfolio-lifetime annual returns exceeding 16% net, according to Coller Capital’s Global Private Equity Barometer.

If you’re interested in the opportunities that private equity real estate presents, then this article will provide you with invaluable insight into the investment process, various types of investments, and the advantages and disadvantages.

Key takeaways

• Private equity real estate involves investing in real estate properties through private equity firms or funds, offering alternative investment opportunities to accredited individuals and institutional investors.
• There are various types of private equity real estate investments, including core, core-plus, value-added, opportunistic, and debt investments, each with its own risk and return characteristics.
• Pros of investing in private equity real estate include higher returns compared to public market investments, passive income generation, and potential tax benefits.
• Cons of private equity real estate investing include management fees, high entry points, and long investment periods, exposing investors to market risks.
• Some of the largest real estate private equity firms include Blackstone, Brookfield Asset Management, ESR, Starwood Capital Group, and GLP.

What is private equity real estate?

Private equity real estate refers to the investment in real estate properties through private equity firms or funds, which are considered alternative investment vehicles, like mutual funds or hedge funds.

The process of private equity real estate investment:

1. Raising capital. Private equity firms raise funds from external investors, which can include accredited individuals or institutional investors.
2. Property investment. The money is then invested in commercial or residential real estate properties. This involves acquiring existing properties, financing development projects, or participating in joint ventures.
3. Property development and improvement. The private equity firm engages in effective property management, employing strategies aimed at maximizing the value of the properties under their control. This can include property renovations, operational improvements, or repositioning efforts to maximize equity returns.
4. Property sale. After a period of holding and value creation, the properties are sold. The objective is to sell properties at a higher price than the initial investment, generating substantial returns.
5. Distribution of capital. Once the properties are sold, the private equity firm distributes the profits to the real estate investors. This can be in the form of capital distributions or dividends, providing the investors with their share of the returns.

Private equity firms and outside investors find each other through real estate investment banking services. Within a real estate private equity fund, there are two main parties:

• Limited partners (LPs). These are accredited individuals or institutional investors who contribute capital to the fund. They entrust their capital to the fund manager and typically don’t participate in the day-to-day decision-making or operational aspects.
• General partners (GPs). These are the fund managers responsible for making strategic investment decisions on behalf of the fund. The GP’s asset management team selects and manages real estate properties that offer the potential for high returns and ensures that the properties perform well throughout the holding period.

Types of private equity real estate investments

Generally, there are five types of private real estate investments:

1. Core investments
2. Core-plus investments
3. Value-added investments
4. Opportunistic investments
5. Debt investments

1. Core investments

Core investments usually refer to the high-value commercial real estate property with the following attributes:

• High-quality tenants. Such buildings have responsible tenants generating stable income over long-term leases.
• Profitable locations. Core property is situated in densely populated, in-demand urban areas.
• Predictable income. Such property has a stable, predictable occupancy rate and generates a consistent net income.
• Minimal ongoing capital spending. These are new assets that require little to no renovation.

Core strategies involve minimal risk. However, they produce the lowest returns, from 6% to 9% at best, and have long holding periods, sometimes dozens of years. These properties include office buildings, shopping centers, student housing blocks, retail properties, and modern multifamily apartments.

2. Core-plus investments

Core-plus means income growth and refers to real estate that increases in value while adding minimal value. These types of properties commonly possess the following features:

• More renovation opportunities. Core-plus buildings are still in good condition but require minimal renovation.
• Good locations. Such property may be located further from downtown but still has reliable, high-traffic transportation hubs.
• Good tenants. Most tenants pay consistent, long-term rents. Yet, some of them may have expiring leases.

Core-plus strategies are known to offer higher returns compared to core investments, typically ranging from 8% to 12% returns. However, they still involve a moderate level of risk due to the potential for needed renovations and lease renewals.

3. Value-added investments

Value-added investments may need several improvements to produce better cash flow. These types of properties are often characterized by the following features:

• Capital-intensive upgrades. Value-add property requires costly and labor-intensive renovations to attract higher-quality tenants.
• Below-market occupancy. There is a high tenant turnover, and renters tend to avoid such properties due to poor conditions, bad location, and other issues.
• Management issues. These buildings may have failed inspections, lease problems, utility debts, etc.

Subsequently, value-add funds tend to develop properties to see profits. Value-add asset class can generate up to 13% annual returns as it offers higher value and generates better cash flows post-renovation. However, such property involves higher risk as anticipated profit may not beat renovation expenses due to hidden issues.

4. Opportunistic investments

Opportunistic funds primarily target industrial properties in poor condition, distressed or withered buildings in suburban areas, and other properties that may initially appear low in value. The following characteristics are common for such property types:

• Major repair requirements. Opportunistic properties typically require significant structural repairs or a complete renovation to bring them up to code, meet acceptable standards, and make them marketable.
• Repositioning requirements. Opportunistic buildings often require repurposing or repositioning to align with current market demands. This could involve converting an industrial property into a mixed-use development or repurposing an obsolete building for a new use.
• Undeveloped land. There may be no access road, parking, water, gas, electricity, and other infrastructure nearby.

Opportunistic investments involve real estate development and are the riskiest — investors can lose their entire investment if a fund underperforms. However, they may offer over 20% returns in the long run. 

5. Debt investments

Debt investments in private equity real estate involve various types of loans and securities:

• Senior loans. Debt funds may purchase senior loans, which have the highest priority of repayment, i.e., properties in default or facing liquidation.
• Bridge loans. Bridge loans are short-term loans provided by debt funds to bridge the gap between the purchase of a property and long-term financing.
• Mezzanine loans. These loans are subordinate to senior loans but rank ahead of equity in the capital structure. Mezzanine loans carry higher interest rates to compensate for increased risk.
• Non-rated CMBS tranches. Debt funds may invest in non-rated tranches of commercial mortgage-backed securities (CMBS). These tranches represent different levels of risk and return within a CMBS structure.
• Leverage. Debt funds often use leverage, or borrowed capital, to enhance equity returns. However, leverage also increases risk.

Debt investments offer 8 to 12% net equity IRR (internal rate of return) to a limited partner.

Pros and cons of investing in private equity real estate

Let’s discuss a few pros and cons of private real estate investing.

Pros

These are the most important benefits:

1. Higher returns. Private equity generates 11% average net annual returns based on 21 years of performance analyzed by the CAIA Association. For comparison, it’s 4.1% higher than public market investments.
2. Passive income. Investing in real estate private equity firms might be a preferable option for high-net-worth individuals or family offices seeking passive income. Once the money is invested into a private equity fund and it’s entrusted to a general partner, investors don’t have to worry about doing market research or property maintenance or dealing with the headaches of managing real estate-related assets.
3. Interest alignment. Private equity funds require general partners to invest around 20% of the total capital. Most importantly, general partners will not profit from the deal until investors receive 6–9% returns. This alignment of interests motivates both partners to maximize returns for all parties involved.
4. Tax advantages. Private equity real estate (PERE) funds enjoy favorable tax treatment in the form of pass-through taxation and potential tax deductions.

Cons

These are the most important drawbacks:

1. Management fees. Private equity real estate operating companies offer investors expertise, professional tools, and real estate brokerage. In exchange, private equity asset managers charge fees that may cut 0.5% to 2% of returns.
2. High entry point. Many private equity real estate funds require as much as $20 million in initial investment. However, some funds set entry deposits in the $250,000–$500,000 range. Additionally, such funds accept only accredited investors with substantial annual income, investing experience, or successful careers in the financial industry.
3. Long investment period. Institutional and individual investors should anticipate profits over a long investment period. Growing returns may take three to five years on average or, sometimes, decades. As a result, investors expose themselves to market risks, like falling property prices in rapidly changing economies.

Top five real estate private equity funds

Here is the list of the five largest real estate private equity funds (PERE), their specialization, and their performance.

1. Blackstone

Five-year fundraising total: $48.7 billion

Specialization: opportunistic, core-plus

Blackstone is a global private real estate investment firm founded in 1991 and headquartered in New York. It serves pension funds with over 31 million pensioners in the US alone, having over $319 billion in capital under management.

2. Brookfield Asset Management

Five-year fundraising total: $29.9 billion

Specialization: core, core-plus

Brookfield is a Canadian investment firm founded in 1899 and headquartered in Toronto. It delivers investing services to 2,000 investors worldwide and has over $750 billion in capital under management.

3. ESR

Five-year fundraising total: $16.6 billion

Specialization: opportunistic, core, core-plus

ESR is the third-largest REPE firm globally, established in 2016 in Hong Kong. It operates in 28 countries and has over $149 billion in assets under management. 

4. Starwood Capital Group

Five-year fundraising total: $21.7 billion

Specialization: opportunistic

Starwood Capital Group is an American private equity firm established in 1991 and headquartered in Miami. It helps investors from over 30 countries manage $125 billion.

5. GLP

Five-year fundraising total: $15.5 billion

Specialization: value-add

GLP is an Asian PERE firm founded in 2009 and based in Singapore. It operates in 17 countries, serving over 60,000 customers, and has over $120 billion in capital under management. 

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