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Chapter 19 discusses real estate private equity funds, which emerged as a capital source to fill the need for equity in the real estate business. Historically, real estate was purchased and developed with significant amounts of debt and very little equity.
Until 1986, U.S. income tax laws allowed property owners to depreciate structures over a 15-year period. These compressed depreciation schedules resulted in negative taxable income to property owners. Owners could sell these tax losses on a forward basis to people, such as doctors and dentists, who were looking to shelter their professional income, allowing the owners to easily raise equity without having to put much or any of their own at risk. Even real estate developers were able to sell the tax losses on a forward basis prior to the start of construction.
In 1986, Congress extended depreciation schedules and prohibited the sale of tax losses, except for low-income housing and historic preservation. As a result, the primary source of equity for real estate projects disappeared. In the early 1990s, real estate lenders realized that they were mispricing their loans and began offering only 50-70%, rather than 90-100%, loan-to-value mortgages. This meant that large chunks of equity were required to own or develop real estate. In this new environment, investors with equity certainty often had a distinct advantage, which led to the creation of real estate private equity funds. Such funds raised large pools of capital prior to investing to ensure ready access to equity.
The real estate private equity business started in 1988 with the first Zell-Merrill fund. Today there are perhaps 2,000 professionals working in the business (excluding accountants), versus approximately 50 in 1992. Today, the industry is mature, with up to $125 billion in equity commitments raised annually and generally invested over three-year periods.
Pension funds, foundations, university endowments, and high net worth individuals are the entities which invest in real estate private equity funds. The minimum equity investment commitment is at least $1 million and is drawn down from these funds on an as-needed basis during the 3-4-year investment period. Investors invest in a limited partnership managed by the fund sponsor, who serves as the general partner responsible for all operations. A typical return target for these funds is a 20% IRR and a 2.0x equity multiple over the life of the investment. However, in light of the 2008-2009 Financial Crisis, these returns have crept down significantly. The typical fund promises to liquidate all property holdings within 7 to 10 years, as investors like knowing that they will get their money back. However, to avoid selling into a bad market when the fund’s life ends, sponsors and investors generally can agree to extend a fund’s life up to a period of three years, pending a vote of the investors.
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Fund sponsors are generally permitted to raise a new fund after 85% of the existing fund’s capital is invested, enabling them to minimize or eliminate downtime between funds. The sponsor also invests its capital in the fund. The amount invested by the sponsor can range from 1 to 3% for first-time fund managers, to 25 to 50% of total equity commitments.
There are three broad groups of real estate private equity funds today: those associated with investment banks; those associated with investment houses; and dedicated real estate players. Brand recognition is a huge factor in the investing business and has become increasingly powerful in attracting limited partner investors.
A return waterfall details how cash is split between the investors and the sponsor. A typical fund will provide investors (including sponsors who invested in the fund) with an IRR-based preferred return on all commitments drawn. These preferred returns range from 7 to 11%. If the returns exceed the preferred return, then these additional profits are split 80/20 (with 80% of the profits going to the investors or “the money”). The 20% of the profits given to the sponsor is called a carried interest or promote. This structure provides an incentive for the sponsor to generate oversized returns.
The sponsor’s promote is typically structured in one of two ways. In the most common structure, the sponsor and the investors split profits 80/20, as long as the investor receives at least the annual preferred return. Alternatively, there may be an 80/20 split only on profits in excess of the preferred return. Obviously, the sponsor would prefer the first methodology but usually agrees to the second. Another option that many funds feature is a catch-up provision. Such a provision allows a sponsor to split cash flows 50/50 (or at some other accelerated rate) over the preferred return until they have received 20% of all profits, after which the economics return to the 80/20 split.
In addition to their promote, fund sponsors also receive an annual management fee. The fee is typically 1 to 1.5% of committed equity (whether the money is drawn or not). As money is returned to investors this fee declines; that said, the fee is hopefully replaced by the fees earned from the subsequent fund.
These are the types of questions you’ll be able to answer after studying the full chapter.
1. Why is ready access to equity helpful?
2. What are the three broad groups of real estate funds today and what are their comparative advantages?
3. Explain the purpose of a catch-up structure for a sponsor after a preferred return hurdle is met.
4. Assume a $100MM fund with an 8% annual preferred return, where the sponsor contributed 10% of the fund’s capital. Assume that the fund liquidates in one year after earning $32MM in profits. What would the sponsor earn assuming a 20% promote?
Real estate private equity funds versus syndications (7:16)
How real estate private equity funds have changed for the better and for the worse (5:19)
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A major source of capital for the real estate industry; among the largest owners of real estate in the country; raise large pools of equity prior to investing to ensure ready access to equity.
Small investment group (relative to the size of PE funds) that are put together for a single pre-identified real estate transaction.
A limited partner’s obligation to provide a certain amount of capital to a private equity fund for investments.
When a private equity fund calls for a portion of an investment commitment be transferred to the fund.
The company that raises the fund and serves as the general partner (GP) responsible for all operations.
The persons in a limited partnership responsible for the actions of the business, with the ability to legally bind the business, and who are personally liable for all the business’s debts and obligations.
A partner in a private equity fund whose liability towards the fund’s debts is legally limited to the extent of the partner’s investment.
A mechanism for how fund proceeds are split between the investors and the sponsor for the purposes of returning invested capital and paying out profits.
The minimum return to investors to be achieved before a sponsor carry is permitted; this preferred return is typically an IRR-based hurdle rate and is usually 7-11% annually.
The profit threshold above which the fund profits are shared according to the carried interest arrangement.
Pro rata/proportionate to the amount of one’s cash investment to the total investment amount.
The fund sponsor entity’s share of excess profit above the preferred return, with which no cash investment is associated. Also known as “sweat equity.”
Only the profits in excess of the preferred return distribution.
A method of truing up the payment of IRR-based profit splits based on measuring accrued earned amounts and funding these earned amounts with distributions.
A private equity fund distribution provision that allows for the sponsor to be caught up to the same rate of return as the Limited Partners.
A protection mechanism put in place by Limited Partners that returns any excess share of total profits to “the money” to comply with a percentage cap on distributions received by the sponsor.
- A Bit of History
- Who Are They?
- Investment Banks
- Investment Houses
- Dedicated Real Estate Players
- Return Waterfall
- Investor Protections