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The term “private equity” can conjure images of rich old men sitting in front of a crackling fire in a study, lighting cigars with $100 bills. We all know this isn’t the case; however, commercial real estate private equity could probably stand to get a PR makeover to make it sound a little less “exclusive.” The truth is anyone (with enough capital) can be involved with private equity. The same fact is true for commercial real estate (CRE) private equity. The private associated with equity refers to the type of assets a firm manages and stakes their client’s capital into. Equity management firms buy private companies, restructure their operations, then sell them to gain a profit. With CRE private equity, it’s essentially the same process, except switch out companies for real estate properties. There are, however, some key differences, which we will dive into now.
Imagine you and a group of friends from your hometown always talked about how great an idea it would be to build a multifamily apartment complex where an old, dilapidated building always stood. As you all got older and became more successful, you decide to pool your capital and make that dream into a reality. This type of real estate investment would be a form of direct deal private equity, which we’ll dive into later. More commonly, private equity investing is handled by wealth management firms that allocate their clients’ capital into diversified portfolios. Think of the above example, except instead of investing with your friends, private equity firms take your money and pool it with capital from other investors you don’t know across many different commercial real estate funds. Both end outcomes are the same: a big ROI. But all the legwork of finding a property, buying it, developing it, then selling it is handled by the private equity firm. Because they manage everything from acquisition to day-to-day operations, the firm will charge a fee that is still negligible compared to your ROI, which can easily reach 6%-10% or higher depending on the strategy.
As mentioned above, the real benefit of private equity real estate investing is the excellent returns. Nonetheless, there are several other reasons to consider commercial real estate funds when building your portfolio.
Private equity investment strategies are very long-term, sometimes lasting 10-12 years at the minimum. Private equity deals usually have what are called “lockup periods,” where the investor’s funds are unable to be recalled or liquidated. These terms are set in place so private equity brokers can take their time and allocate funds in real estate in a way that sees the most returns. Because they aren’t rushing into deals, firms can provide higher, risk-adjusted returns. Also, every deal is equipped with a defined exit strategy and a more certain outcome.
Unlike other forms of commercial real estate deals like joint venture equity, private equity investing has more of an investor-first structure. Private equity firms are also invested in the deals they manage, so both the investor’s and the fund manager’s incentives align. In many cases, the firm must meet specific return benchmarks before starting to see its portion of the profits.
The great thing about real estate investing is that you own part of a tangible asset. Unlike some investments that can lose value overnight, the property will always retain some value because it’s a physical asset. Real estate values can fluctuate depending on the market, but you’ll never lose all your invested capital.
Another advantage of private equity real estate is that investors can further increase their net ROI by writing off the depreciation costs of their investment properties. The IRS allows investors to depreciate the building itself, as well as any additional capital investments. To learn more about real estate depreciation, check out this helpful guide from Nolo.
Many deals are structured to pay dividends derived from the accumulated profit of the property’s business activity. Dividends of this nature are more stable than the dividends paid out by REITs (Real Estate Investment Trusts). REIT dividends are often distributed from investor capital or debt — which can become depleted over time. Private equity dividends can be paid out annually, quarterly or monthly. Dividends provide additional returns in the form of cash and are an excellent incentive for investors to “stick out” their real estate investments in times when market values may decline.
Because private equity invests in private CRE properties, it doesn’t face the same strict regulations as REITs or funds. This freedom allows private equity fund managers to greatly diversify their portfolios and provide more risk-averse or risk-tolerant strategies, depending on the investor’s goals.
Commercial real estate private equity deals involve vast amounts of capital spread across multiple investments, so there are some barriers to entry to becoming an investor. There are three primary requirements for becoming an investor in private equity.
The first requirement to invest in private equity is to establish yourself as an “accredited investor.” There are several ways a person can become an accredited investor. The below list are the most common ways people become accredited investors; however, the SEC amended its previous definition of an accredited investor in a 2020 update to include more.
Private equity investors are required to have a high net worth because the investing requirements are immense. Most private equity firms require a minimum investment of $250,000, and they can range upward of $25M or higher.
As mentioned above, most private equity deals involve a long-term strategy to see the promised high ROI. Investors should be prepared to have their capital “locked up” for several years before being able to recall their investment. The period varies depending on the strategy, but an average of 10 years is common.
Depending on your investment goals and the amount of money you have to invest, there are a few options available to accredited and non-accredited investors. The important guideline to remember is that, like with any investment, working with a reputable sponsor and performing your due diligence is key to any successful investment plan.
The most common route for accredited investors when entering into CRE private equity investments is private equity funds. As mentioned above, these funds are managed by private equity firms that spread their client’s investments across many different asset classes. This is typically a very “hands-off” strategy for the investor because they leave all the decision-making up to the fund managers.
For a seasoned private equity investor, direct private equity deals are an option. These types of deals usually involve one asset. The benefit of direct private equity deals is that the investor gets to learn about the property inside and out. They research their financial statements, business plans, demographic data, local zoning ordinances, and everything else they need to make an informed decision. In these types of investments, investors essentially research and build their own portfolios. Investors can do all this work themselves, but often they will turn to reputable sponsors to broker deals. Direct private equity deals are also only available to accredited investors.
New to the private equity investment game are online crowdfunding platforms like Crowd Street. They make it possible for accredited investors to more easily track down private equity investment opportunities. An advantage to this route is that the crowdfunding aspect dramatically reduces the standard minimum PE investment amount from $250,000 to as low as $25,000. It also dramatically shortens the investment period to as low as three years. This investment path is a good option for newly accredited investors to get their feet wet in the CRE private equity market because it doesn’t involve the same levels of commitment. However, the level of risk remains the same, and investors should do extensive research before investing.
Funds of funds, such as mutual funds and ETFs (Exchange Traded Funds), are ways people can dip their toe into the private equity investment pool without having to be an accredited investor. Funds of funds are generally low risk, as investments are spread widely across many different other funds. Because of this structure, there aren’t any options to strictly invest in a CRE private equity fund. However, if working with a knowledgeable advisor, you can seek out CRE private equity-heavy funds.
As mentioned, a benefit of this investment strategy is that it’s relatively low risk with historically above-average returns. The downside to funds of funds is the layers of fees that come with them, which can negate some of the returns. You’ll likely have to pay a hefty upfront fee to your advisor, who will use that money to cover their management fee, plus the fee associated with the fund (which can be highly layered themselves because many analysts manage multiple funds).
To some, CRE private equity investing may seem a little exclusionary due to the requirement put in place by the SEC to become an accredited investor. Nevertheless, these requirements are put in place to protect investors and asset managers. If you’re willing to give it some time, CRE private equity is an excellent investment option that provides high returns, built-in loss mitigation, and several different investing avenues. Unless you’re a seasoned investor, it’s always a good idea to turn to a reliable firm with a proven track record to manage your portfolio.
