Private Equity Real Estate

Real estate investors are always looking for new opportunities to build wealth. This is especially true when it comes to investment opportunities that allow them to build wealth passively. That’s why investing in private equity real estate is quickly becoming the newest frontier in the world of real estate investing.

What is Private Equity Real Estate?

Private equity real estate investing involves a group of investors putting capital into a fund to acquire real estate assets and then selling them off quickly after the assets appreciate. Private equity real estate funds can be used to buy land and then develop an asset from the ground up or find undervalued assets and increase revenue through a combination of remodeling, improving management and increasing rents. 

Real estate developers are increasingly turning to private equity to fund deals. Private equity can be used to fund the down payment on a project when traditional financing is being used to fund the rest. It can also be used to completely finance a deal when the project doesn’t meet the criteria of a traditional lender. 

Most traditional banks only finance real estate deals under certain circumstances. When it comes to a preexisting or already built asset, such as an underperforming or poorly managed apartment building, banks don’t like making loans secured by properties with low occupancy rates and may only be willing to finance a smaller portion of the deal. Investors bet on upside; banks typically don’t. 

The type of value-add opportunities with the most upside usually carries too much risk for banks to finance at the same loan-to-value as stabilized properties. If they do, the interest rate will likely be much higher and debt service will eat up profit. 

The same thing holds true on development projects built from the ground up. They only have a Pro-forma budget that forecasts what revenue the asset will generate, but the asset still has no track record of performance. 

The cost of developing assets like retail properties, office buildings and industrial parks converged with tight lending standards to create a gap between developers and the capital they need to do deals. Increasingly, private equity real estate funds are bridging that gap. Developers and project sponsors trade equity for capital and minimizes the amount of money they have to borrow. 

Traditionally, access to private equity funding opportunities has been limited to institutional investors like hedge funds, mutual funds or private real estate investment trusts (REITs). However, the traditional private equity model has been turned on its head. The advent of real estate crowdfunding platforms and the fact that there are more real estate opportunities than there are funds looking to finance them has opened the private equity world to a whole new group of investors.

You might think a private equity real estate fund sounds a lot like a real estate investment trust, and you’re right. The basic structure and the business model of real estate private equity funds and REITs are similar. Private investors contribute money in exchange for equity in real estate with the goal of generating income and diversifying their portfolios. 

Investors usually become limited Class B partners in a limited liability company (LLC) or limited partners in a real estate limited partnership. They take a back seat to their fund’s general partner (or managing member), who manages assets on a day-to-day basis and receives distributions based on the income the asset generates. At their core, both REITs and private equity funds are passive investments where investors get direct equity without making management decisions. 

If the asset appreciates, both the private equity fund and the REIT will sell it off, which produces profit for the investors. However, there are significant differences between investing in a private equity real estate fund and a REIT. Chief among them is the fact that most REITs are publicly traded, which offers shareholders higher liquidity. By contrast, exiting a private equity real estate deal early (or without penalty) is almost impossible. 

Second, and perhaps more importantly, is the minimum investments. Although there are numerous publicly-traded REITs open to virtually any investors, private equity funds are almost exclusively available to accredited investors. Because private equity real estate funds try to buy assets and move them in short time periods, they typically have buy-ins in the low to mid-six-figure range. Publicly traded REITs, by contrast, have share prices ranging from $5 to $500 and non-traded REITs typically have buy-ins ranging from $1,000 to $5,000. 

If you were to imagine REITs and private equity real estate offerings as luxury cars, a REIT would be a Lexus, while a private equity fund would be a Bently or Rolls Royce. They’re both luxury cars, but one of them is in an entirely different stratosphere when it comes to price and accessibility.

Pros of Private Equity Real Estate Investing

The most tangible and obvious benefit of private equity real estate for individual investors is the upside. If you can afford the buy-ins, you not only have direct ownership of the asset (proportional to your equity share), you participate fully in the profits generated by the asset. The size of your buy-in only increases the potential returns. 

If your private equity fund manager chooses quality assets and manages them effectively, you can reap incredible profits in a short time period on private equity deals. As long as the fund holds the asset for more than one year, your capital gains exposure is limited, or you can defer your tax exposure by investing with a self-directed IRA. In the meantime, you’ll have access to passive income. 

Additionally, private equity funds are usually highly diversified across several types of properties in different asset classes. Along with the upside potential and passive income, the investor can get equity in a number of different assets for a low price in comparison to scouting them out and buying them individually.

Cons of Private Equity Real Estate Investing

Private real estate investing is not without downsides. This is true of any investment, but you should do a lot of thinking before you buy into a private equity fund. The biggest potential downsides are buy-in costs and illiquidity. Although the hold period on a private equity real estate fund offering may be shorter than some REITs, you’re still pledging hundreds of thousands of dollars to the deal. 

Because it’s a private investment, the secondary market in equity funds will be limited  — if it exists at all. Getting out of a private equity deal early is basically impossible.  Once you’re in, you’re in. It’s also important to realize your initial investment may not be the only time you have to put money in. 

Many private real estate investment funds raise money on an as-needed basis, which means they could hit you up for more capital after your initial investment. This is known as a capital call, and some private funds call for investors to make extra contributions when necessary. The request is not optional. If you miss a capital call, you could lose your entire investment without seeing any gains. 

Another potential con of private equity real estate investing is fees. Private equity real estate investment funds have very little regulation or oversight, and there is no statutory limit on investor fees. While most funds charge a management fee for overseeing the asset, that may not necessarily be the limit of your out-of-pocket costs. Review your investment agreement carefully before pledging funds.

What Types of Private Equity Real Estate Funds Are There?

Most private equity real estate funds fall into one of the four following categories:

• Core: Of the four categories, core funds usually carry the lowest risk level. Core funds focus on Class A assets with stable tenant bases and a high resale value. Examples of core investments would be fully leased luxury apartment buildings or office parks in premium real estate markets. Core funds typically offer solid, stable returns, but because they are already fully leased and in premium markets, there is less upside.
• Value add: Value add funds look for properties with rental upside and unrealized revenue streams. The assets in value-add funds are usually directly overseen by the fund manager or general partner. They typically require an injection of capital for remodeling and upgrades with an eye on increasing rents and the asset’s overall value. Value-add funds usually have medium to high revenue potential but also carry comparatively more risk than core funds. 
• Core plus: Core plus funds offer a combination of core assets and value-add assets to give investors the best of both worlds when it comes to upside and risk. They offer higher returns than core funds but lower than value add. The extra upside in the investment also elevates the risk profile, but it usually carries less risk than value-add funds. 
• Opportunistic: Opportunistic funds look for the highest risk opportunities because they offer the highest potential upside. Examples of opportunistic fund opportunities include building from the ground up and underperforming properties in markets that have yet to emerge but are showing early signs of a rebound. If the assets hit their pro-forma targets, investors will reap huge profits from having added tremendous value to assets that were purchased relatively cheaply.

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Is Private Equity Real Estate Investing Right for You?

Private equity real estate investments can add significant value to your portfolio and generate income. The question of whether they are right for you depends on a number of factors. If you’re in a place where you are not only accredited but can handle the buy-ins that come with most private equity real estate funds, kudos to you. 

Even if you fall into this category, you will still need to proceed with caution. Remember, the buy-ins are usually high, and you’ll likely be prevented from liquidating your investment for the entirety of the hold period. Then there is the risk factor to consider. That’s why it’s advisable to consult with a reputable financial adviser about your investment goals, risk tolerance and available capital before going forward. 

If you complete your due diligence and you still like what you see from a private equity real estate fund, move forward and hope for the best. If all goes according to plan, a few years from now you will have made a tidy profit for yourself, all without having to act directly or do the elbow grease that comes with managing real estate assets.