How To Evaluate Private Equity CRE Investments


Key Takeaways

Get Instant Access to All of FNRP’s Real Estate Deals

For individual investors, allocating capital to commercial real estate assets can be an excellent way to diversify the traditional stock/bond portfolio.  However, the process used to analyze a commercial real estate investment opportunity is completely different than the process used for a stock or bond.  For those that aren’t familiar with it, the terminology and performance metrics used can be foreign, particularly when working with a private equity sponsor.  This document aims to solve that issue.

In the pages that follow, private equity commercial real estate investors will find a step by step guide that can be used to analyze potential investment opportunities.  Key topics of discussion include:

  • How to evaluate a private equity transaction sponsor
  • How to evaluate the critical elements of a private equity deal including the property: type, class, market, location, and features.
  • Identifying and calculating investment performance metrics
  • How to recognize the components of the “Capital Stack”
  • Identifying the key factors in the calculation of an equity waterfall 
  • Understanding the fees that are charged in a private equity transaction

Upon completion of this guide, readers should have all of the tools necessary to determine if a private equity commercial real estate investment opportunity is a good fit for their own risk tolerance and investment objectives.

What is a Private Equity Commercial Real Estate Transaction 

Individuals interested in investing in commercial real estate assets have two choices.  They can do it actively or passively.

In an active investment, one or more investors purchases a commercial property directly and they are responsible for managing it on a day to day basis.  Some investors prefer this approach because it gives them control over the property identification, underwriting, financing, and closing processes.  Other investors find an active strategy to be too time consuming.  In addition, some investors may lack the operational expertise needed to manage a commercial property effectively.  These investors may benefit from a passive approach.

In a passive approach, an individual investor places their money with an investment manager and outsources the property identification, underwriting, financing, and closing tasks to them.  In return for their work, the investment manager charges a fee and takes a percentage of the commercial property’s cash flow.  For busy investors without the operational expertise needed to run a property on their own, this approach gives them all of the benefits of ownership without the hassle.  However, it also means that they lose the control provided by an active approach.

There are many types of real estate investment managers through which an individual can make a passive investment.  For the purpose of this e-book, the focus is on private equity firms.

A private equity firm is a specialized type of investment manager who invests in the equity of other businesses (including those that own real estate) with the goal of earning a profit for themselves and their investors.  Private equity investments are only available to individuals known as “Accredited Investors” who are defined in Rule 501 of Regulation D as natural persons:

  1. Whose individual net worth, or joint net worth with that person’s spouse or spousal equivalent, exceeds $1,000,000;
  2. Who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse or spousal equivalent in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year;

For individuals who meet this set of criteria, there are dozens of private equity firms offering commercial real estate investment opportunities.  As such, it is critical to be able to determine which ones align with their own investment objectives and risk tolerance.  This process starts with the analysis of the firm/transaction sponsor.

How to Evaluate a Private Equity Real Estate Transaction Sponsor 

Private equity commercial real estate transactions are led by a “sponsor.”  In nearly all cases, the sponsor is the private equity firm and they are responsible for finding the commercial real estate property, underwriting it, performing due diligence, arranging the financing, getting the deal closed, and managing the asset once the transaction is complete.  

As an investor, your role is strictly passive.  In fact, one of the primary advantages of investing in a private equity transaction is that you have an opportunity to outsource these key activities to an expert.  But, each firm has a different approach and the success of the investment often depends on their ability to choose, close, and manage the asset wisely.  Thus, evaluating a private equity commercial real estate opportunity starts with the sponsor.  To understand their approach, track record, and philosophy, every potential should ask the following eight questions of their transaction sponsor.

Question 1:  What is your level of experience and what is your track record for delivering returns on your commercial real estate deals? 

Commercial real estate investment success is built upon years of transaction experience and the best managers have the track record to prove it.  Potential investors should actively inquire about the sponsor’s business and investment track record by actively reviewing the following attributes of it:

  • Length of time in business and the number of commercial real estate deals successfully originated and exited
  • Average returns delivered for all deals, both good ones and bad 
  • Their most successful deal and least successful deal 
  • Their commercial real estate investment strategy and philosophy 

The best sponsors don’t attract investors by advertising high returns and touting only their successes.  Instead, they are honest about their track record and set realistic expectations for future performance. 

Question #2:  Do you invest your own money in the deal?

There is no better indication of a sponsor’s commitment to a deal than if they put their own money into it.  

In order to demonstrate their commitment to and belief in the transaction, a sponsor should invest a significant amount of their own money and the bulk of their earnings should come from the investment’s performance, not fees collected from investors.  The financial incentives of the sponsor and their investors should be aligned so that they both win when the investment does well.

Question 3:  How is your deal team’s compensation structured?  

There may only be one sponsor in a private equity CRE deal, but it takes a team of individuals working together to close the transaction.  Potential investors should actively inquire about how the deal team is compensated.  For example, are they paid based on the number of transactions that they close or on the performance of the investment?  In the first scenario, the team’s financial incentive is to close as many deals as possible without regard to the quality of the transaction.  In the second scenario, they are incentivized to do the best deals possible, regardless of how many they do in a month or year.

In addition, investors should ask their sponsor about any potential conflicts of interest in the deal. It is feasible for the sponsor to have some financial interest in the transaction that could benefit them when acquiring one commercial property over another.  These should be disclosed and understood so that investors can make an accurate risk assessment of the deal.

Question 4:  What Are Your Key Differentiators?  What Sets You Apart From the Competition?

There are many private equity commercial real estate firms and they all do essentially the same thing.  What separates the good firms from the not so good is how they do it.  Investors should ask their transaction sponsor how their strategy, business plan, and execution sets them apart from competitors.

For example, we are a vertically integrated firm, which means that we perform all property acquisition and management activities in house.  This is fairly unique in the industry, but we believe that this structure can reduce operating expenses for our investors and provide us with additional oversight of our properties to ensure they are managed to our high standards.

Question 5:  Collaboration and Communication – How Do You Manage Reporting and Property Updates?

A private equity commercial real estate investment is a partnership between the transaction sponsor and their investors.  In many cases, these partnerships can last up to 10 years so regular communication and commercial property updates are important.

Potential investors should ask their sponsor about how they manage property reporting, major updates, and the communication of major decisions.  The frequency and method of communication should be consistent with investor expectations.  For example, some sponsors may send out weekly email updates.  Others may send out formal quarterly reports.

Question 6:  What is your approach to underwriting a commercial real estate deal?  Is it conservative or aggressive?

One of the unique challenges to investing in commercial real estate is that it can take years to fully implement the business plan for a commercial real estate property.  However, income and expenses for the property must be estimated at the time of purchase for several years into the future.  Completing this task is part art and part science.  It requires a set of future assumptions about things like occupancy, rental growth, and real estate cap rates.  The best managers are realistic and conservative in their assumptions and take a data based approach with their underwriting models.

Specifically, potential investors should ask their deal sponsor about the assumptions used in their model and they should be compared to market data to ensure they are reasonable.

Question 7:  What is Your Best Deal?  What is Your Worst Deal?

Sponsors are often quick to tout their high historical returns, but these averages can be skewed by a handful of successes or failures.  Potential investors should ask their sponsors about their most successful deals and their least successful deals.  They should also ask about what the sponsor learned in these transactions and how this knowledge was applied to future deals.

While this knowledge is important, it should also be noted that these deals are outliers to a certain extent.  In some ways, the true measure of a private equity real estate firm’s success is a long string of deals that delivered a solid, if not spectacular return.  Consistency is difficult, but the best managers are able to demonstrate it over a long period of time.

Question 8:  Can You Provide References?

The best sponsors should not hesitate to provide references of other investors or vendors that they have worked with in the past.  Potential investors should call them to verify that the sponsor is a good business partner.

If the sponsor checks out as competent, the next step in the investment analysis process is to look at the specifics of the deal and the investment offering.

How to Evaluate A Private Equity Commercial Real Estate Deal 

The transaction sponsor is only part of the investment puzzle.  The deal itself is just as big, if not a bigger, component of measuring an investment’s potential success as the firm running it.  For potential investors, the first major consideration is whether the offering is in a fund or a deal.  There are important differences.

Funds vs. Deals   

Some private equity sponsors offer the opportunity for investment in a “blind fund” while others offer an opportunity in a specific commercial real estate property.  

In a blind fund structure, sponsors raise investment capital for general acquisition purposes.  At the time an individual investor allocates money to the fund, they may not know how or where it is going to be deployed.  Instead, they place their trust in the fund manager to use it for the most promising investment opportunities.  For many investors, this is not an issue.  However, there are others who want to have a little bit more control and knowledge about how their capital is used.  For these individuals, investing in an individual deal may be a more suitable option.

An individual real estate deal, sometimes referred to as a “syndication” is one where a sponsor is raising money for the purchase of a specific commercial property.  The structure is similar to a fund in the sense that there is a General Partner (GP) who is responsible for identifying, financing, leasing, and managing the commercial property and a group of Limited Partners (LPs) who contribute capital to the investment and play a passive role in its management. The major benefit of this structure is that potential investors can perform their own due diligence on the asset, the market, and the existing tenants prior to making an investment decision.

We believe that specific deals offer investors the best balance between control and knowledge.  In the remainder of this section, the focus is on how to evaluate a specific deal offered by a private equity firm, starting with the commercial real estate property type.

Property Type

With regard to the specific property, there are two major assessments to make: commercial real estate property type and class.

In commercial real estate, there are four widely recognized commercial real estate property types, each with their own strengths and weaknesses:

  • MultifamilyCommercial multifamily assets are characterized by properties with five or more units.  Investors like them for their relative stability in all phases of the economic cycle and their widely available financing with good terms.  However, they can be management intensive and it is a highly competitive space so it can be difficult to find well-priced opportunities.
  • Industrial:  Industrial properties are those with an “industrial” purpose.  Typically, they include warehouses, factories, and flex spaces.  Investors like industrial assets for their relatively low maintenance requirements and the long term leases.  However, they can be particularly vulnerable to economic downturns.
  • Office:  Office properties house businesses and they range from central business district high rises to suburban campuses.  Investors like them for their long term leases and the ease of dealing with corporate tenants. However, suitable office properties can require expensive tenant build outs and rental prices can change dramatically based on market supply and demand.
  • Retail:  Retail properties are home to consumer facing businesses that sell goods and services.  They can range from single tenant properties to strip centers and shopping malls.  Retail investors like these properties for their long term leases and visibility.  However, retail demand is closely tied to consumer discretionary income and is particularly vulnerable to the rise of e-commerce driven disruption.

Each commercial real estate property type can be further subdivided into a “class” which can provide quick information about the property’s location, condition, and amenities.  There are also four widely accepted commercial property classes.  The boundaries between them can be somewhat murky, but the general parameters of each class are as follows:

  • Class A:  Class A buildings are the newest and highest quality.  They tend to be less than ten years old and are typically located in or near the Central Business Districts and/or most desirable locations of major cities.  They also have the most luxurious finishes, newest technology, and strongest amenity packages.   

Class A properties tend to be in new, or like new, condition and don’t require any major renovations.  As a result, they command the highest rents and are typically only affordable to the most profitable companies or highest income earners.  For these reasons, they are also considered to be the least risky investment class due to their physical condition and stable cash flow.

  • Class B:  Class B properties are well maintained, but may be slightly dated and in need of light renovations. They are usually between 10 and 20 years old and typically located in good, but not great markets.  They usually have average finishes that may be slightly dated.   

Class B properties tend to be in good condition with fully functioning mechanical and HVAC systems, but may need light repairs or modernization.  Class B rents are lower than Class A and are typically within reach of small to medium businesses and median income earners.

  • Class C:  Class C buildings are older, dated, and in need of moderate to significant repairs.  They are between 20 and 30 years old and are typically located in less desirable areas that are far from major highways, shopping districts, employment centers, and public transportation.  

They have dated finishes that likely need to be replaced because they are either obsolete or non-functioning.  They are in fair condition and likely require repairs or upgrades to mechanical systems like roofs, parking lots, HVAC, or plumbing.  Class C rents are lower than Class B and typically within reach for small companies and hourly workers.

  • Class D:  Class D properties are distressed assets.  They are functionally and/or economically obsolete and they need major repairs and/or a complete overhaul.  They have the least desirable locations, the lowest rents, and the highest risk profile.  They are likely not a very good fit for most individual investors unless they have a high risk tolerance and/or can afford to lose some or all of their investment principal.   

The reason that commercial real estate property type and class are important is because they give investors a quick way to parse investment opportunities based on their risk tolerance, time horizon, and personal preferences.  For example, investors who prioritize stability, safety, and preservation of principal may prefer Class A or B multifamily assets for their regular income and liquidity.  On the other end of the spectrum, investors who have a high tolerance for risk and who prefer growth over income may choose to invest in Class C Office properties.

The important point is that private equity investors should seek out firms whose strategy and investment offerings match their preferences for property type and class.

Market & Submarket 

A commercial property’s market and location are one of the most important factors in determining an investment’s success.  For this reason, it is critically important that potential investors understand the characteristics of the local market and how they can contribute to overall returns.  Each market is unique, but the best ones share the same general characteristics:

  • Net Migration:  There tends to be a correlation between the strength of a given market and the number of people moving to it.  For example, according to the US Census Bureau, the states with the highest numbers of net in migration from 2018 – 2019 are: Florida, Texas, Arizona, North Carolina, and South Carolina.  It is not a coincidence that these states also contain some of the hottest real estate markets over the same time period.
  • Jobs:  People follow jobs.  If a market is creating a high number of jobs, it is a promising sign that the market is strong.  To illustrate this point, the Bureau of Labor Statistics publishes the states with the highest rate of job growth and it should be no surprise that there is some overlap with the states that also have the highest numbers of net in-migration (Florida, Arizona, and Texas).
  • Transportation:  Strong markets tend to have good to great transportation networks, which includes roads, highways, bridges, subways, airports, trains, buses, and dedicated walking/biking/running paths.  The most attractive commercial properties tend to be located in close proximity to one or more of these transportation nodes, which allows for easy access to and from it.
  • Wage Growth:  Markets with strong wage growth tend to attract people who are looking to increase their earning potential, which in turn increases demand for the products and services needed to support a growing population, including commercial real estate.  Wage growth statistics are published by the US Bureau of Labor Statistics.
  • Supply & Demand:  Like any commodity, real estate prices are a function of supply and demand. The more supply there is, the less likely it is that prices will rise over time.  Conversely, if the supply is tight and the demand is high, it can be a promising sign for positive price growth.  But, it can also be a sign that builders and developers will rush to build new space in response to high demand.  On occasion, this can lead to an excess of supply, so it is important to review supply & demand from a historical perspective, not just a snapshot in time.

Specific market information can be difficult to come by without a subscription to a data service like CoStar.  However, the US government publishes helpful information through several agencies including the Census Bureau, Bureau of Labor Statistics, and the Federal Reserve.  In addition, investors can use free data aggregation websites like City Data, Best Places, and Property Shark to research the characteristics of a market.  Finally, the deal sponsor should have performed a significant amount of their own research and should summarize it as part of the investment’s offering materials.

Investors should review all available market data to gain comfort with the strength of the market in which the deal is located.

Property Level Features 

A strong market is only part of the location equation.  The commercial property level characteristics of the deal can also have a significant impact on the demand for space.  Potential deal investors should review the following characteristics of the property to ensure it is a place where tenants want to lease space:

The Property’s Visibility

By definition, commercial real estate properties are places where business is conducted.  As such, they need to be visible to those who are looking to live, work, or shop in them.  Properties with good visibility tend to have the following characteristics:

  • Frontage:  Highly visible properties have direct frontage on multiple sides of the roads that lead to it.  Ideally, this includes frontage on the main road, but there could also be frontage on side roads which allow for the commercial real estate property to be seen and accessed from multiple points of entry.
  • Signage and Landscaping:  To go along with multiple sides of frontage, highly visible properties have ample signage to alert potential visitors to its presence.  Ideally, the signage is placed in a location with high visibility so it can be easily seen.  It should also be unblocked by things like trees, utility poles, or other landscaping features.  
  • Traffic Counts:  Highly visible properties are best in locations where there are high traffic counts of both cars and pedestrians.  High visibility, combined with high traffic means ample opportunities for a passerby to stop in to purchase something from a tenant business.

A property can be highly visible, but it must also be easy to get in and out of.  Otherwise, it may discourage both tenants and visitors.  The technical term for this is “ingress and egress” and it should be carefully considered as part of the property level research.

Ingress / Egress 

Ingress/egress are the technical terms that are used to describe how easy it is to get into or out of a property.  Again, the specifics may vary by location, but properties with easy access tend to have the following attributes: 

  • Signalized Intersections:  If a property is located at an intersection that has traffic signals, the flow of traffic into and out of it is easier and more orderly.  If the entrance to the property has a dedicated turn lane with an “arrow” traffic signal, it is even better.
  • Multiple Entrances / Exits:  Properties with good ingress/egress have multiple points of entry and exit.  

Once cars are able to access the property they need a place to park and adequate parking is one of the most important property level features, regardless of property type.


One thing that all commercial properties have in common is the need to have a place for visitors to park.   Whether the property contains retail space, office space, private offices, medical offices, mixed-use space or a multifamily building, everyone who lives, works, or visits needs a place to park.  

Unlike the other intangible attributes, there is some quantitative component to measuring the adequacy of a property’s parking lot.  In general, parking is measured as a ratio of parking spaces per 1,000 square feet of leasable space in the property.    Exact requirements can vary widely by property type and zoning rules, but as a general rule of thumb, a commercial property should have 3 – 5 parking spaces per 1,000 square feet of  leasable space.  

If the property level characteristics are favorable for investment, the next evaluation step is for investors to identify the risk in the transaction and the strategy used to minimize it.

Identifying Risk 

All private equity commercial real estate investments have risk.  One of the keys to a successful investment is for managers and investors to identify the risk and develop a plan to mitigate it.  When evaluating an investment opportunity, potential investors should look for six risks.

Market Risk 

Commercial real estate prices are influenced by a variety of economic factors such as inflation, interest rates, and unemployment, however the effects are not felt equally in all markets.  

For this reason, it is important for investors to consider how broad economic trends could impact the market in which the investment is located.  For example, there has been a long term trend that has shifted manufacturing jobs from expensive markets in the United States to less expensive markets in countries like Mexico and China. As a result, markets that had a strong manufacturing base, like Ohio and Michigan – and their associated real estate assets – have been disproportionately impacted whereas states like Florida and Texas haven’t felt as much pain.  

Mitigation of Market Risk

The key to managing market risk is diversification across markets, managers, asset classes, and property types.  A broadly diversified portfolio limits the impact of declines in any one asset class.  For example, a well constructed portfolio might include investments in stocks, bonds, and real estate.  And within those asset classes, there is further diversification across different companies and markets.

Property Type Risk

The unique characteristics of each property type mean that they respond differently in times of economic distress.  For example, rising levels of unemployment may have a relatively minor impact on multifamily assets because housing is a primary need and renters tend to prioritize their payments.  However, it could have a disproportionate impact on retail assets as consumers tend to decrease discretionary spending in times of economic uncertainty.

Mitigation of Property Type Risk

Again, the key to managing property type risk is diversification and it can come in two forms.  First, an investor may choose to invest in different property types. Or, if an investor specializes in one specific property type, they can diversify their portfolio by investing in multiple markets.  

Liquidity Risk

Liquidity is defined as the ease with which an asset can be converted to cash.  With regard to a CRE asset, it is how quickly and/or easily it can be sold.  

Commercial properties are expensive and their transaction costs are high, which make them less liquid than other asset classes like stocks and bonds.  As such, investors should carefully consider the ease with which a property can be sold at the end of its holding period.  In many cases, liquidity is tied to demand in a given market.  For example, demand for a property in a high growth market like Charlotte, North Carolina is likely to provide more liquidity than one in a low growth market like West Monroe, Louisiana.

Mitigation of Liquidity Risk

Managing liquidity risk requires detailed analysis of the supply/demand characteristics of the market in which the property is located.  It is important to begin with the end in mind by knowing what the exit strategy is before the asset is purchased and to plan for the amount of time that it will take to sell.  The most liquid markets have a high volume of CRE transactions, high demand, and moderate to limited supply.

Tenant / Credit Risk

Any commercial property that leases space to a tenant has credit risk, which is the risk that a tenant can’t or won’t pay their rent.   Because a property’s value is tied to the length of the in place leases and the certainty with which the tenants will pay their rent, it is critically important that investors understand the credit risk associated with a given property.  For example, a fully occupied property with national tenants on long term leases represents less credit risk than a fully occupied property with local tenants on short term leases.

Mitigation of Tenant/Credit Risk

Credit risk can be managed through careful analysis of a tenant’s financial condition prior to purchase.  In addition, a tenant’s business should be considered within the context of broader market trends. For example, grocery stores and service oriented businesses likely have a brighter future than product oriented retail businesses like clothing or stationary, which have been impacted by the rise of online shopping.

Replacement Risk 

Real estate is a physical asset, which means its condition degrades over time.  In doing so, it becomes vulnerable to replacement by newer, more energy efficient and technologically advanced properties.  This risk is particularly prevalent in high growth, high demand markets where there is always a newer property coming online.  If a property is or becomes physically obsolete, costly renovations could be required to maintain occupancy and retain property value.

Mitigation of Replacement Risk

Managing replacement risk requires careful thought about a property’s condition relative to the market. If it lags the market, renovation and/or replacement cost must be calculated to determine if it’s economically feasible to update the property to market standards.

Debt / Leverage Risk

A real estate investment’s risk profile is directly proportional to its leverage, or debt. The more debt a property has, the riskier the transaction is.  This is because there is less room for declines in income before it is insufficient to make the required loan payments.  For example, a nominal 10% decline in rental rates could cause a highly leveraged property to turn cash flow negative, whereas it could be a relative non-issue for a property that is conservatively leveraged.

Mitigation of Debt/Leverage Risk

Debt risk can be particularly tricky to manage because high amounts of leverage can also boost returns.  So, it is incumbent upon investors to find the right mix of debt and equity when financing a transaction.  Generally, the amount of debt on a property should not exceed 70% – 80% of its value.  

Risk cannot be eliminated completely.  Instead, potential investors should identify the types of risk involved in the transaction and understand the plan to minimize them.  Each individual investor has their own level of risk tolerance and should only invest in deals with which they are comfortable with the risk/return profile.

Measuring Returns 

Risk, returns, and return stability are closely correlated.  The lowest risk deals will likely also offer the lowest (but most stable) returns.  Conversely, deals with more risk can offer higher returns, but there could be a lot of variability.  For example, a low risk deal could offer stable returns of 5% – 6% annually.  Or, returns for a high risk deal could range from -10% to 25% in any given year.

There are a number of ways in which private equity commercial real estate returns can be measured and it is important for investors to be familiar with the metrics, how they are calculated, and what “good” looks like.  But, before returns can be calculated a “proforma” must be constructed.

What is a Proforma?

A proforma is a financial projection of the property’s income, operating expenses, and loan payments.

Income is based on the amount of rental revenue that is expected to be received from tenant rent payments and other ancillary sources like late fees and application fees.  When estimating income over a multi-year holding period, certain assumptions must be made about lease renewal rates, and the annual growth of lease payments.

Operating expenses represent the costs associated with running the property on a day to day basis.  These include things like property taxes, insurance, property management, legal fees, utilities, and repairs.  

Gross income less total operating expenses results in the calculation of a metric called Net Operating Income or NOI for short.  Net Operating Income minus debt service equals a second metric called Cash Available for Distribution.  These two inputs are key in calculating property return metrics, starting with the Capitalization Rate.

Capitalization Rate 

A property’s “cap rate” is a measure of its annual return assuming an all cash purchase.  The formula used to calculate it is:

Cap Rate = Net Operating Income / Purchase Price

For example, assume that a property has a purchase price of $1,000,000 and the proforma projects $100,000 in Year 1 Net Operating Income.  The resulting cap rate is 10%, which is the return that investors could expect if the property was purchased with cash.  The addition of debt should drive returns higher.

The idea of a “good” cap rate is relative and based on the property type, location, and perceived risk in the transaction.  A Class A property in a prime location will have a low cap rate due to its relative stability.  A Class C property in a poor location will have a higher cap rate because it is riskier.  As a general rule of thumb, the bulk of CRE properties trade for cap rates in the 4% – 10% range.

Internal Rate of Return

A property’s Internal Rate of Return or IRR is the rate of return on each dollar invested for each period of time that it is invested in.  It is often the main metric advertised by fund managers and transaction sponsors.  The formula used to calculate IRR is complex, but it is made easier by using the “IRR” function in a spreadsheet program and the annual cash flows available for distribution.    

Potential investors should be aware that IRR can skew higher if the cash flows are front end loaded in the holding period and that it doesn’t do a very good job of measuring an investment’s absolute return.  The general target for a “good” IRR is a minimum of ~15% annually, but this metric should not be the only one relied upon to make an investment decision.

Equity Multiple 

The Equity Multiple is a metric used to measure an investment’s return relative to its initial equity contribution.  The formula used to calculate it is:

Equity Multiple = Total Cash Received / Total Cash Invested

For example, if an investment returns $250,000 on a $100,000 investment, the resulting equity multiple is 2.5x.  Looked at from an investor standpoint, an Equity Multiple of 2.5x means that an investor could expect $2.50 for every $1 they invested.  A “good” equity multiple varies by individual investor requirements, but a general target of 2.0x or higher is preferred.  However, investors should be aware that this metric is not time bound.  An Equity Multiple of 3.0x may sound fantastic, but if it takes 15 years to achieve it, it may not be as impressive.

Cash on Cash Return 

Cash on cash return is a measure of the cash earned on the initial investment each year.  The formula used to calculate it is:

Cash on Cash Return = Cash Received in any 1 year / Total Cash Invested

For example, if an opportunity required an initial investment of $100,000 and the cash distribution in year 1 was $8,000, the cash on cash return is 8%.  Cash on Cash return is helpful because it provides an indication of what an investor could earn in any one year.  But, it ignores the impact of taxes and the initial investment does not always represent the true acquisition cost.  It may not include things like broker commissions and loan fees, which can be material.  A “good” cash on cash return target is 6% – 8% annually.

Investor Best Practices 

Every investor has different return requirements.  What may be acceptable for one investor may not be acceptable for another.  When evaluating the returns advertised by private equity deal sponsors, investors should ask themselves the following questions:

  • Are the advertised returns commensurate with the level of risk in the investment?
  • Are the return calculations clearly described in the offering documents?
  • Are proforma assumptions for rent growth, expense growth, and occupancy reasonable and supported by market data?
  • Are the advertised returns consistent with the sponsor’s historical track record?
  • Are the advertised returns reasonable given the property type and market?
  • Has the sponsor accounted for potentially adverse economic conditions at some point during the holding period?  Or, does the proforma only assume positive economic growth?

Answers to the above questions should provide potential investors with valuable information about whether or not the advertised returns are truly achievable and whether they are acceptable given individual risk/return preferences. 

If the returns are acceptable, the next step in the investment evaluation process is to review the deal structure.

Evaluating Deal Structure 

The key to a favorable deal structure is when the financial incentives of both the private equity sponsor and the investors are aligned.  When one does well, the other should do well.

Returns for most private equity commercial real estate deals follow a “waterfall” distribution, which means that property income is split based upon a predefined structure that incentivizes the private equity firm for performance.  In order to understand how waterfalls work and their role in an equitable deal structure, it is first important to identify the components of the “capital stack.”

What is the Capital Stack?

The “Capital Stack” is the collection of capital used to finance the purchase of the property.  For the purpose of this document, the Capital Stack can be divided into two components:  Debt and Equity.

  • Debt:  Debt represents the loan used to purchase the property and it sits at the top of the capital stack.  In return for their money, the lender’s claim is secured by a first position lien on the property.  This means that they are first in line to receive any money produced by it (for loan payments) and have the ability to initiate foreclosure proceedings if the borrower does not meet their obligations.  Depending on the transaction, debt can account for 60% – 75% of the purchase price.  Because the debt holder has a primary claim on the property’s cash flow, it is considered to be the least risky position in the Capital Stack.
  • Equity:  Equity is the money that makes up the difference between the property’s purchase price and the amount of debt that can be obtained.  For example, if a property has a purchase price of $1,000,000 and debt of $750,000, the amount of equity needed to close the transaction is $250,000.  Equity holders sit behind the debt holder(s)in the capital stack so their position carries more risk.  This point is particularly important in the event of a bankruptcy or liquidation scenario because equity holders are only entitled to whatever money is leftover after debt holders have been paid.

To illustrate how these components are used in a typical private equity commercial real estate transaction, an example is helpful.  Suppose that a private equity firm discovers a retail shopping center that has all of the hallmarks of a good investment and they place it under contract for $5,000,000.  They are able to get a loan for 75% of the purchase price or $3,750,000 and must raise the difference ($1,250,000) in equity.

Of the required equity, the private equity firm may contribute 20% of the total ($250,000) and raise the remaining 80% from individual investors ($1,000,000).

Once the property is purchased, the income generated by rental payments is first used to pay for the property’s operating expenses and second for its loan payments.  Any money left after the loan payments have been made is eligible to be distributed to equity holders and this is where the waterfall structure comes into play.   

How Equity Waterfalls Work

The equity waterfall distribution starts with the pot of money that is left after a property’s operating expenses and loan payment have been paid.  The split of this money between the private equity firm (the General Partner or GP) and the investors (the Limited Partners or LPs) depends on how the waterfall is structured.  There are three key components of a waterfall that govern how the money is divided:

  • Preferred Return:  In order to incentivize potential investors, the General Partner may offer to pay a preferred return.  This means that all equity investors (including the GP if they invested their own money) will get 100% of the property’s cash flow until they have achieved a certain return target.  For example, the first “tier” in a waterfall may be that the investors get 100% of property cash until they have received an IRR of 8%.
  • Additional Hurdles:  Above the Preferred Return, there may be additional rate “hurdles” that govern how the remaining cash is divided.  These hurdles are designed to incentivize the General Partner to deliver as high a return as possible.  As the return gets higher, the GPs share of the cash flow becomes greater.  This “bonus” paid to the GP is known as a “promote.”
  • Hurdle Measurement:  Because the return hurdles are critical points at which the cash flow split changes, it is important to identify how they are measured.  In most cases, they are measured using the Internal Rate of Return, but in others the Equity Multiple or some other metric could be used.

To illustrate how these features work, a typical waterfall structure is described in the table below:


Description     Promote     Return Hurdle    GP Share     LP Share  


    Preferred Return   






GP Promote #1





3 GP Promote #2 20% 40%



In this waterfall, there are three steps.  In the first step, the Limited Partners get 100% of the commercial real estate property’s cash flow until they have achieved an 8% return on their investment.  If the GP is able to deliver a return higher than 8%, but less than 12%, they get a 10% promote.  Given that their original contribution was 20% of the total equity, this entitles them to 30% of the cash flow while the Limited Partners get the remaining 70%.  In the third step, if the GP is able to deliver a return greater than 12%, they get another 10% promote, which entitles them to 40% of the cash flow, while the LPs get the remaining 60%.

The incentive alignment in this structure should be clear.  The GP’s (the private equity firm) chance to earn the most money comes when they meet the highest return tier in the waterfall.  If this happens, the LPs also benefit because they earn a high return.  

It is important to note that waterfall structures can vary widely from one investment opportunity to another.  The key points that investors need to understand are:

  • The incentive alignment between the GP and LPs.  Do they both benefit from strong performance?
  • What metric is used to calculate the return hurdles?
  • Does the structure offer a preferred return?
  • How does the cash flow split change at each hurdle?

The answers to these questions – as well as the complete details of the waterfall structure – should be provided in the investment’s offering materials.  They should be read carefully and understood thoroughly before committing capital to investment.  If there are any questions, they should be asked of the transaction sponsor.  For new investors, it may also be helpful to seek advice from a third party like a real estate attorney or CPA.

If the waterfall structure is acceptable, the last major component of a deal that needs to be evaluated is the fees.

Evaluating Fees of a Private Equity Real Estate Firm 

A private equity commercial real estate firm puts a significant amount of time and resources into every real estate transaction.  It requires a dedicated staff of underwriters, asset managers, commercial property managers, and support staff to coordinate transaction logistics and investor reporting.  It is an administratively intense and costly effort.  To recoup some of the costs associated with these activities, it is common for there to be private equity real estate fees associated with each investment.

Fees should offset administrative costs.  They should not be a profit center for the firm.  To that end, investors should look for one or more of the following fees in an investment’s offering documents.  The amount can vary, depending on the firm, but generally acceptable ranges are provided for each fee.

Acquisition Fee

In an individually syndicated deal, the sponsor may charge a fee for their effort in putting together the capital needed to close a deal.  The acquisition fee can range from 1% to 2% of the asset value.

Committed Capital Fee 

In some cases, an investor may make a financial commitment to a fund, but the entirety of the commitment may not be drawn down for some time.  In such cases, a management fee may be charged on the amount committed, no matter how much is actually drawn down.  The fee may range from 1% to 2% of the commitment amount.

Investment Management Fee

To pay for the operations and management of the investment, a fee of 1% to 2% of invested equity may be charged.  It should be noted that the investment management fee is not charged on top of the Committed Capital Fee, but instead of it once capital has been invested.

Setup & Organization Fee

The legal, accounting, travel, marketing, and administrative costs associated with starting a new investment fund can be significant.  To recoup these costs, it is common for an investment manager to charge a setup/organization fee between 1% and 1.5% of invested equity.

Administration Fee

It takes a team of real estate professionals across different domains of expertise to support and manage a fund’s investments.  The administrative fee is charged to provide the funding that pays for the expense of employing them.  This fee can range from 0.1% to 0.2% of invested equity.

Debt Placement Fee

When debt is used to finance a deal, an outside broker may be used to obtain it.  If this is the case, it is normal for a fee to be paid for their services.  On occasion, the manager may choose to layer an extra fee on top of the broker fee known as the debt placement fee.  Combined, the fee may range from 0% to 1.5%.

Refinancing Fee

For assets that need repairs and/or renovations, it is common to obtain a short term loan to fund these costs and to refinance the asset once stabilized.  Because it takes time and effort to line up a permanent loan, a sponsor may charge a fee for their efforts.  It is normal for the fee to range from .25% to 1%.

Wholesale Marketing Fee

To distribute their product to a wide audience, non-publicly traded REITS may charge a fee that is paid to a broker dealer for sales efforts on their behalf.  This fee can reach 3% of equity, but its existence depends on whether or not wholesalers are used as part of the marketing strategy.

Advisor/Syndication Fee

Certain companies, including private REITs, use a broker-dealer network to distribute their products through financial advisors.  In many cases, the financial advisors are paid an upfront advisory fee ranging from 4% – 7%.  In addition, some syndicators will charge an upfront fee, adding it to acquisition and/or transaction charges. On occasion, these fees are buried in the fine print of the “sources and uses.”

Selling Fees

When it comes time to sell a commercial real estate property, it is common for a manager to partner with a broker who has the capability and network to get the best price for the property.  For their services, the broker may charge from 1% – 3%, but some managers may try to add .25% to .75% on top of it.

When investors are evaluating the fee structure of a potential private equity commercial real estate investment, there are three important points to remember:

  1. There will be fees and they may impact the investment’s total return.
  2. The fees should be reasonable and in line with market standards.  
  3. Fees should be used to offset the cost required to administer the investment.  They should not be a profit center for the sponsor. 

Fees are detailed in the investment’s offering documents and should be carefully reviewed prior to making an investment decision.

Final Thoughts and Contact First National Realty Partners 

For Accredited Investors looking for exposure to commercial real estate assets, an investment partnership with a private equity firm can be a way to achieve this end.  But, each private equity firm is different.  They pursue a variety of investment strategies and offer a variety of investment structures.  For this reason, potential investors should invest time and effort to understand the offering prior to making an investment decision.  This due diligence should be centered around four components of each deal:

  1. The Sponsor:  Who is the transaction sponsor and do they have a successful track record?
  2. The Deal:  What type of commercial property is being offered for investment, where is it located, and does it fit with the investor’s individual preferences?
  3. The Deal Structure:  How much debt will be placed on the property?  How is the return waterfall structured?
  4. Fees:  What fees are charged by the sponsor and how do they affect potential returns?

First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We leverage our decades of expertise and our available liquidity to find world-class, multi-tenanted assets below intrinsic value. In doing so, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in. 

If you are an Accredited Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or for more information.

Sign Up

Get Access
to Our CRE Deal Flow

Get instant access to all of our current and past commercial real estate deals. 

A World-Class Operating Platform


Subscribe Now

Sign Up for Our Newsletters

Get the latest news on real estate

Get More From FNRP

Free CRE Book

How to Evaluate Private Equity CRE Investments

Free CRE Book

How to Complete a 1031 Exchange with a Private Equity Sponsor

Sign Up

Get Access
to Our CRE Deal Flow

Get instant access to all of our current and past commercial real estate deals. 

commercial real estate deals
Please enter your email address to access Deal Lobby Content.