What steps should be taken to establish a partnership aimed at raising equity for continuous real estate investment?
This article provides a comprehensive overview of the existing framework surrounding private equity real estate funds and outlines the critical steps necessary for the establishment and efficient management of such a fund. It explores the underlying motivations for fund creation and highlights the critical factors to consider during the setup process. A subsequent article will delve into the implications of securities laws on the offering and management of a fund, in addition to discussing standard offering terms.
At its core, a private equity Real Estate fund functions as a partnership designed to gather equity for ongoing real estate investments. The general partner (GP), referred to as the sponsor, is responsible for the fund’s creation. The sponsor invites investors, known as limited partners (LPs), to contribute equity to the partnership. The capital raised, combined with loans from banks and other financial institutions, is allocated towards real estate development or acquisition ventures.
Generally, the limited partners provide the bulk of the equity capital and function as passive investors, choosing to engage in an offering put forth by the sponsor. LPs receive an initial return of their capital along with a preferred return on their investment. Meanwhile, sponsors contribute a portion of the equity capital, identify investment opportunities, oversee the management of the real estate and the fund, and earn fees that are generally linked to the fund’s performance.
A private equity Real Estate fund is fundamentally different from capital obtained through personal connections such as friends and family or through joint ventures. Investments from friends and family typically lack a comprehensive partnership agreement, and all equity contributions are regarded equally. In contrast, joint ventures are usually established for a particular purpose related to a single investment, with each partner contributing unique value.
For instance, a joint venture may involve a landowner, a developer, and a financial partner, where each party is essential for the completion of the investment, and the arrangement is limited to that specific project. Conversely, real estate private equity funds are designed to invest in multiple transactions, featuring a standardized risk and reward framework that governs the overall fund, with the sponsor and limited partners participating in an unequal manner.
Motivations of Sponsors: Private Equity Real Estate Fund
The 50 largest private equity firms have raised a total of $280.8 billion, while the 20 largest real estate private equity firms have each secured over $4.5 billion in the last five years, as reported by the PERE 50 2017, an annual ranking by PEI Media of the world’s foremost private equity real estate firms. It is important to highlight that the real estate fund structure is available to smaller investors as well. Establishing a real estate fund enables the sponsor to achieve several objectives.
Enhance and broaden funding sources: A sponsor with a pipeline of prospective investments can leverage a fund to capitalize on deal flow that may not be accessible otherwise. The capital-raising strategy should prioritize the sponsor’s track record, the team’s expertise, potential returns, alignment of interests, and clearly defined opportunities.
Broaden investment holdings: The most esteemed developers with exemplary track records can identify investment opportunities in their local markets that extend beyond their usual property types, opportunities outside their historical geographic focus, or a combination of both. A private equity fund can provide the necessary scale for the sponsor to seize these opportunities, thereby generating returns across a larger capital base and potentially mitigating the firm’s risk.
Engage in larger, higher-quality projects: A sponsor experiencing financial limitations can leverage a fund to invest in larger and more complex initiatives. Collaborating with additional partners allows the developer to distribute risks among investors, thereby achieving a more favorable risk-return balance on substantial, complex projects that the sponsor could not undertake independently.
Secure more favorable terms from financial institutions and other lenders: A fund distinguished by a robust capital base, diverse investment options, and lower-risk strategies can result in decreased expenses associated with debt and mezzanine financing for both the fund sponsor and its investors, ultimately improving equity returns for the sponsor and limited partners.
Consider alternatives to mezzanine financing: This benefit is largely contingent upon the specific nature of the investments and the creditworthiness of the sponsor.
Implement initiatives utilizing fund-level financing instead of financing on a project-by-project basis: This approach enables the sponsor to respond more swiftly to opportunities in a rapidly evolving market or dynamic environment. Establishing permanent or “take-out” financing in advance can ease discussions with construction lenders and landowners who may hesitate to engage in a project without a clear source of permanent financing.
Generate fees from the fund, including a promoted interest: The fund sponsor may reach a stage of maturity where it stands as a market leader. In such instances, the sponsor reaps all the aforementioned benefits, in addition to the opportunity to earn a promoted interest and fees from the fund structure as a recognition of its achievements.
Although the motivations of sponsors may vary, the private real estate investment fund structure can yield substantial rewards when executed effectively. The essential factor is to establish a well-defined strategy for fund creation and to diligently implement that strategy.
Three Essential Considerations
1.) In the process of establishing a fund, numerous factors warrant attention; however, three essential considerations are pivotal for achieving success in fund formation and effectively attracting capital from limited partners.
The initial consideration pertains to the total equity capital required, inclusive of organizational expenses. Typically, the minimum fund size is regarded as $20 million, although certain crowdfunding platforms have allowed for lower thresholds. While organizational costs scale with the size of the fund, the baseline for these fees is approximately $400,000. Although the sponsor can recover these expenses from the fund post-capital raising, they must initially bear these costs during the formation phase. These expenses encompass the establishment of legal entities, filing fees, accounting services, regulatory brokerage fees, clearing costs, and the creation of marketing materials.
Furthermore, while the fund’s equity capital will be supplemented by debt capital to form the total investment pool, a well-structured fund must align potential deal flow with its size to ensure sustainable returns for the limited partners. It is also crucial to consider the timing of capital inflows and outflows. Generally, limited partners begin to earn a preferred return on their investments as soon as the funds are deployed. Therefore, in addition to securing commitments from each limited partner for the total investment amount, prudent sponsors should schedule the capital contributions to correspond with the fund’s expected investment timeline.
2.) Sponsors must possess a realistic understanding of the time, effort, and initial capital necessary to establish a fund. The sponsor bears the responsibility for all facets of the fund’s operation, which encompasses the creation of a partnership agreement, the preparation of offering and subscription documents, the identification of investment opportunities, the acquisition of loans and other forms of financing, the management of the fund, the operation of properties, the preparation of tax returns for partners, and the handling of accounting and audit issues, among other responsibilities.
Although many seasoned real estate firms engage in these activities as part of their regular operations, the private equity fund context imposes strict adherence to the partnership documents and offering memorandum, making meticulous attention to detail essential. Furthermore, the fund’s structure necessitates that the sponsor conduct regular, well-organized meetings with limited partners (LPs) and maintain a consistent reporting framework, a process that is increasingly supported by software solutions.
3.) Sponsors are required to establish a well-defined investment fund strategy. This approach differs from the conventional real estate investment evaluation, which primarily focuses on market fundamentals, property types, and geographical locations. Although seasoned sponsors and larger funds may successfully attract capital for a blind pool—where specific investments are not predetermined—first-time sponsors typically need to specify particular investments within the fund’s offering memorandum.
Five Forms of Investment Funds
Sponsors must clearly define the operational position of the fund within the risk/return spectrum and remain committed to that objective. Within the private real estate investment fund sector, there are five distinct categories of risk-adjusted funds, typically arranged according to their associated risk and potential returns. Limited partners (LPs) primarily focus on several key metrics, including overall returns, equity multiples, and sheltered income. The returns encompass both cash-on-cash returns and the net internal rate of return (IRR) for LPs.
Core: This category of fund is characterized by the lowest levels of risk and reward. It generally provides limited partners with a net equity internal rate of return (IRR) ranging from 6 to 8 percent, utilizing minimal or no leverage. The properties are generally fully leased, reliable, and of superior quality, located in key markets and prime areas. The annual income yield is comparatively high when measured against appreciation.
Core-plus: This category includes premium assets situated in secondary markets or assets that carry a moderate level of risk in primary markets. It provides limited partners with a net equity internal rate of return (IRR) ranging from 8 to 12 percent. Moderate leverage, reaching up to 50 percent, is utilized to enhance the equity IRR.
Value-add: These funds comprise assets that have been enhanced through re-leasing, operational improvements, and/or redevelopment initiatives, in addition to new developments. They utilize moderate leverage, reaching up to 70 percent. The significance of market or location is diminished in favor of the potential for value enhancement. Appreciation plays a crucial role in the overall investment returns, with these funds providing limited partners (LPs) an internal rate of return (IRR) on net equity ranging from 11 to 15 percent.
Opportunity: These funds present a high-risk, high-return profile. They focus on the repositioning and redevelopment of poorly managed, vacant, or outdated properties, as well as new constructions on undeveloped land. Similar to the value-add strategy, market or location is secondary to the potential for value creation. Appreciation is the primary driver of returns, with a substantial portion realized at the conclusion of the holding period. Typically, these funds aim to deliver an IRR exceeding 15 percent to LPs.
Distressed debt/mezzanine: These funds acquire senior loans, mezzanine loans, or non-rated commercial mortgage-backed securities (CMBS) tranches, or they may extend mezzanine loans. They employ leverage to enhance equity IRR and are willing to assume ownership in the event of loan defaults. The expected net equity IRR for LPs ranges from 8 to 12 percent.
It is essential for sponsors to clearly define their fund’s strategy and ensure that their investments align with this strategy. LPs anticipate returns in exchange for committing their capital for several years, during which they have limited control over fund operations. Sponsors who can effectively address specific inquiries regarding the timing and scale of LP returns tend to be more successful in capital raising than those who cannot. Most sponsors are only able to establish a fund after demonstrating prior success, which often includes maintaining a robust portfolio.
A highly effective approach for a sponsor is to establish two distinct funds: a core-plus fund that focuses on acquiring stable assets from the sponsor’s current portfolio, This approach can provide prompt returns for investors, alongside a value-add fund designed to generate capital for new development and acquisition projects. This structure allows the sponsor to present two well-defined strategies and varying risk/return profiles for potential investors, who may opt for one of the funds or allocate different amounts of capital to each, based on the limited partners’ requirements.
Sponsors must clearly define the operational position of the fund within the risk/return spectrum and remain committed to that objective. Within the private real estate investment fund sector, there are five distinct categories of risk-adjusted funds, typically arranged according to their associated risk and potential returns. Limited partners (LPs) primarily focus on several key metrics, including overall returns, equity multiples, and sheltered income. The returns encompass both cash-on-cash returns and the net internal rate of return (IRR) for LPs.
Core: This category of fund is characterized by the lowest levels of risk and reward. It generally provides limited partners with a net equity internal rate of return (IRR) ranging from 6 to 8 percent, utilizing minimal or no leverage. The properties are generally fully leased, reliable, and of superior quality, located in key markets and prime areas. The annual income yield is comparatively high when measured against appreciation.
Core-plus: This category includes premium assets situated in secondary markets or assets that carry a moderate level of risk in primary markets. It provides limited partners with a net equity internal rate of return (IRR) ranging from 8 to 12 percent. Moderate leverage, reaching up to 50 percent, is utilized to enhance the equity IRR.
Value-add: These funds comprise assets that have been enhanced through re-leasing, operational improvements, and/or redevelopment initiatives, in addition to new developments. They utilize moderate leverage, reaching up to 70 percent. The significance of market or location is diminished in favor of the potential for value enhancement. Appreciation plays a crucial role in the overall investment returns, with these funds providing limited partners (LPs) an internal rate of return (IRR) on net equity ranging from 11 to 15 percent.
Opportunity: These funds present a high-risk, high-return profile. They focus on the repositioning and redevelopment of poorly managed, vacant, or outdated properties, as well as new constructions on undeveloped land. Similar to the value-add strategy, market or location is secondary to the potential for value creation. Appreciation is the primary driver of returns, with a substantial portion realized at the conclusion of the holding period. Typically, these funds aim to deliver an IRR exceeding 15 percent to LPs.
Distressed debt/mezzanine: These funds acquire senior loans, mezzanine loans, or non-rated commercial mortgage-backed securities (CMBS) tranches, or they may extend mezzanine loans. They employ leverage to enhance equity IRR and are willing to assume ownership in the event of loan defaults. The expected net equity IRR for LPs ranges from 8 to 12 percent.
It is essential for sponsors to clearly define their fund’s strategy and ensure that their private real estate investment fund aligns with this strategy. LPs anticipate returns in exchange for committing their capital for several years, during which they have limited control over fund operations. Sponsors who can effectively address specific inquiries regarding the timing and scale of LP returns tend to be more successful in capital raising than those who cannot. Most sponsors are only able to establish a fund after demonstrating prior success, which often includes maintaining a robust portfolio.
A highly effective approach for a sponsor is to establish two distinct funds: a core-plus fund that focuses on acquiring stable assets from the sponsor’s current portfolio, This approach can provide prompt returns for investors, alongside a value-add fund designed to generate capital for new development and acquisition projects. This structure allows the sponsor to present two well-defined strategies and varying risk/return profiles for potential investors, who may opt for one of the funds or allocate different amounts of capital to each, based on the limited partners’ requirements.
Sponsors must clearly define the operational position of the fund within the risk/return spectrum and remain committed to that objective. Within the private real estate investment fund sector, there are five distinct categories of risk-adjusted funds, typically arranged according to their associated risk and potential returns. Limited partners (LPs) primarily focus on several key metrics, including overall returns, equity multiples, and sheltered income. The returns encompass both cash-on-cash returns and the net internal rate of return (IRR) for LPs.
Core: This category of fund is characterized by the lowest levels of risk and reward. It generally provides limited partners with a net equity internal rate of return (IRR) ranging from 6 to 8 percent, utilizing minimal or no leverage. The properties are generally fully leased, reliable, and of superior quality, located in key markets and prime areas. The annual income yield is comparatively high when measured against appreciation.
Core-plus: This category includes premium assets situated in secondary markets or assets that carry a moderate level of risk in primary markets. It provides limited partners with a net equity internal rate of return (IRR) ranging from 8 to 12 percent. Moderate leverage, reaching up to 50 percent, is utilized to enhance the equity IRR.
Value-add: These funds comprise assets that have been enhanced through re-leasing, operational improvements, and/or redevelopment initiatives, in addition to new developments. They utilize moderate leverage, reaching up to 70 percent. The significance of market or location is diminished in favor of the potential for value enhancement. Appreciation plays a crucial role in the overall investment returns, with these funds providing limited partners (LPs) an internal rate of return (IRR) on net equity ranging from 11 to 15 percent.
private funds for real estate Opportunity: These funds present a high-risk, high-return profile. They focus on the repositioning and redevelopment of poorly managed, vacant, or outdated properties, as well as new constructions on undeveloped land. Similar to the value-add strategy, market or location is secondary to the potential for value creation. Appreciation is the primary driver of returns, with a substantial portion realized at the conclusion of the holding period. Typically, these funds aim to deliver an IRR exceeding 15 percent to LPs.
Distressed debt/mezzanine: These funds acquire senior loans, mezzanine loans, or non-rated commercial mortgage-backed securities (CMBS) tranches, or they may extend mezzanine loans. They employ leverage to enhance equity IRR and are willing to assume ownership in the event of loan defaults. The expected net equity IRR for LPs ranges from 8 to 12 percent.
It is essential for sponsors to clearly define their fund’s strategy and ensure that their investments align with this strategy. LPs anticipate returns in exchange for committing their capital for several years, during which they have limited control over fund operations. Sponsors who can effectively address specific inquiries regarding the timing and scale of LP returns tend to be more successful in capital raising than those who cannot. Most sponsors are only able to establish a fund after demonstrating prior success, which often includes maintaining a robust portfolio.
A highly effective approach for a sponsor is to establish two distinct funds: a core-plus fund that focuses on acquiring stable assets from the sponsor’s current portfolio, This approach can provide prompt returns for investors, alongside a value-add fund designed to generate capital for new development and acquisition projects. This structure allows the sponsor to present two well-defined strategies and varying risk/return profiles for potential investors, who may opt for one of the funds or allocate different amounts of capital to each, based on the limited partners’ requirements.
Sponsor Compensation: Private Equity Real Estate Fund
It is imperative for sponsors to thoroughly evaluate their compensation structures and ensure that their interests are in harmony with those of their limited partners (LPs). Sponsor compensation can be derived from two primary sources:
1) The Promoted Interest: Frequently known as the “promote” or “carried interest,” this arrangement generally includes a fee of 2 percent on the capital raised from limited partners (LPs), In addition, there will be a distribution of 20 percent of the profits generated by the fund. To ensure alignment of interests between the sponsor and the LPs, sponsors typically receive their profit share only after the LP investors have attained their preferred return.
2) Fees: In addition to the promoted interest, sponsors may also generate supplementary fees for various services rendered to the fund:
- The fees associated with asset management for overseeing the fund on behalf of investors are typically set at 1.5 percent of the total assets under management on an annual basis.
- Acquisition fees, which pertain to the purchase of properties for the fund, usually range from 1 to 3 percent of the purchase price.
- Additionally, fees for property management, leasing, construction, and development are applicable when the sponsor offers these services instead of engaging an external firm; these fees are generally aligned with prevailing market standards.
- Furthermore, finance and guarantee fees are charged for securing loans and providing guarantees for the fund, typically amounting to 0.5 to 1.0 percent of the funds secured or guaranteed.
- Finance fees are charged as a one-time payment, whereas guarantee fees are assessed annually for the duration of the guarantee.
Sponsors must not perceive their fund as a means to generate fees at the detriment of the limited partners; such a mindset is a guaranteed path to fund failure. Conversely, a sponsor that can enhance value through development, acquisition, and property management by leveraging superior management skills, local market insights, and extensive experience should be open to integrating fees associated with these services into the fund’s structure.
A critical evaluation for fee inclusion is whether the sponsor would be inclined to pay these fees if they were a limited partner in the fund. Sponsors ought to be prepared to illustrate that their primary motivation is the promoted interest, particularly the share of profits received after the limited partners have attained their preferred return, which aligns their interests with those of the investors. Additionally, sponsors should maintain transparency regarding the fund’s overall returns, both prior to and following the deduction of fees, as well as the gross and net internal rates of return for the limited partners.
Conclusion: The Path to Success in Private Equity Real Estate Fund
Creating a successful private equity Real Estate fund requires a clear strategy, careful planning, and a commitment to transparency and alignment with investors. By understanding the motivations behind creating a fund, considering the key factors involved, and structuring the fund to match your investment goals, you can build a strong foundation for long-term success in the private funds for real estate market.
Whether you’re looking to diversify your funding sources, access larger and higher-quality projects, or secure better terms from lenders, a real estate private equity fund can provide the tools and resources needed to achieve your financial goals. By following the guidelines outlined in this article, you’ll be well on your way to creating a profitable and sustainable investment fund that stands out in a competitive market.
