Private equity real estate is a new favorite of the investment world. Investors regularly see the numerous advantages of private equity real estate. Those who might otherwise be contemplating alternatives to investing in large commercial real estate ventures can now do so via a private equity real estate fund, enabling folks to diversify their portfolios. Furthermore, a single fund can present the options to invest in multiple assets rather than in one commercial deal.
Private equity real estate is also tax-efficient. Most funds are structured to last several years, so unless one of the fund’s assets is sold inside a one-year period (which is rare), the profits are taxed at the long-term capital gains rate rather than short-term capital gains. This is before the privileges of pass-through depreciation. Bundled, these tax benefits can save an investor 20% or more on the profits earned each year.
Are you taking notice? Great! Here is a cursory guide around buying into private equity real estate.
What is private equity real estate?
Private equity real estate points to the pooling of funds deployed to acquire public and private commercial real estate assets.
· What it means
Capital is typically raised through private real estate equity funds, and those funds are usually restricted in terms of which sorts of assets they can invest in. Some funds are highly targeted; for example, they may only invest in value-add multifamily apartment buildings. Other funds may be more versatile, permitting the fund manager to invest in multiple product types, such as multifamily, office, retail, hospitality, or industrial.
Notwithstanding the fund’s target investment type, the fund is ordinarily accountable for all real estate activities, including acquisition, financing, redevelopment, repositioning, stabilization, ongoing asset management, and, ultimately, disposition of the property.
· When it became popular
Commercial real estate has long been viewed as an “alternative investment,” and as a result, institutional investors would typically only invest a small portion (if any) of their portfolio in this asset class.
The feeling toward commercial real estate began to change in the mid-1990s as CRE property values began to fall. Private equity real estate funds were founded during this time to extend capital into undervalued and underperforming sites.
Who can invest in private equity real estate?
Investing in private equity real estate is ordinarily limited to private investors, institutions, and select other third parties, as outlined below:
· Private investors
Private equity real estate is generally only open to a select group of private investors; usually, high-net-worth individuals or others are deemed accredited investors. To be considered a qualified investor, a person must have at least $1 million in assets (excluding their primary residence) or have yearly earnings of at least $200,000. Duos with joint incomes of $300,000 or more over the past two years are also qualified to invest in most private equity real estate funds. The expectation among private investors is that they will contribute significant capital (e.g., $100,000 to $250,000 or more) in a single deal or fund.
· Institutions
Institutions tend to be the leading investors in private equity real estate. Institutional investors encompass hedge funds, pension funds, mutual funds, endowments, banks, and insurance companies.
· Third parties
Handpicked third parties, such as asset managers, can frequently invest in private equity real estate on behalf of institutions like those listed above.
Private Equity Real Estate vs. REITs
There’s a crucial contrast to be made between private equity real estate and public real estate investment trusts (REITs). Public REITs are primarily publicly traded stocks of existing real estate companies. Shares of REITs can be bought and sold with the click of a button. Private equity real estate is much more illiquid. It can often take years to recover initial capital contributions and profit to private equity real estate investors. This is one of the reasons why private equity real estate limits who can invest. Contrast this to REITs, who allow any investor with a brokerage account to buy or sell shares. REITs continuously raise capital, whereas funds tend to be more limited when open, usually with a precise fundraising goal outlined in advance. It’s a wholly different business model.
Another key differentiator is that private equity real estate funds tend to be less regulated than public REITs. For example, REITs must comply with strict stipulations regarding the percentage of real estate-related assets they own, how they combine capital, and from whom, how, and when dividends are distributed to investors, etcetera.
One exception to the above: private equity real estate investments can be pooled and structured in many different ways, including private REITs, though this tends to be less common than structuring as an LLC, S-corp, or other legal structure.
Should you invest in private equity real estate?
Let’s say you’re an accredited investor and are considering investing in private equity real estate. What determinants should you be contemplating before making that decision? Typically, you’ll want to analyze three fundamental factors: the amount of upfront capital required, level of risk, and potential returns.
· Upfront capital
Before investing in private equity real estate, gauge how much upfront capital will be required by the fund. Some private equity real estate funds mandate a minimum investment, such as $50,000 or $100,000. Others require an initial offering of at least $250,000. That is not an insignificant amount, regardless of how wealthy the investor. This is also why private equity real estate tends to be narrowed to accredited investors, institutions, and related third parties. The presumption is that these parties have the capital required to make that initial investment and understand the risks connected with doing so.
It is important to keep top of mind that, unlike a REIT or other investments, the upfront capital investment in private equity real estate is illiquid. It could take years for that money to be returned to investors. Are you comfortable knowing that you cannot touch that money for some time?
· Risk
One reason commercial real estate has long been viewed as an “alternative investment” is the risk associated with these projects. The industry has matured dramatically over the past few decades. Still, the downside is that investors can lose their entire investment if the fund fails to meet expectations.
That said, there are ways to alleviate risk. You’ll want to vet the fund’s sponsor thoroughly – what level of expertise do they have? How long have they been investing in private equity real estate? What is this fund’s business model? What is their intended exit strategy?
Knowing the ins- and outs of how a fund is structured and how the fund will use your capital is critical for any investor looking to lessen potential risk.
· Returns
Although profits are rarely guaranteed, private equity real estate can produce significant returns for investors. The annual rate of return principally depends on the arrangement and nature of the fund. For example, a fund that invests in Class A properties in core markets should be expected to generate 6-8% returns annually. Core-plus strategies, including Class A/B properties located in secondary markets, are considered somewhat riskier but will usually make annual returns of upwards of 10%. Value-add and opportunistic real estate deals can have double-digit or more returns, but again, these initiatives tend to carry the most risk. Any investor will want to consider their risk tolerance, economic climate carefully, and extraneous events like a pandemic, i.e., COVID, before investing in a private equity real estate fund.
Conclusion
Private equity real estate is an attractive way for high-net-worth individuals and accredited investors to produce passive income. They also present a unique opportunity to expand one’s portfolio without taking on the day-to-day management of direct ownership.
Yet, as is the case with any significant investment, you’ll want to learn the nuances of any fund. Be sure to pick through the documents carefully, and of course, confer with your financial advisor as appropriate.