An Investor’s Guide to Commercial Real Estate Deal Structures
Because commercial real estate assets are so expensive, they are rarely purchased by just one or two people. For example, the types of properties that we typically purchase are usually in the $20MM – $30MM range, which is out of reach for all but the most well funded individual real estate investors. Instead, most properties are purchased using a real estate deal structure that allows many individual investors to pool their money together to make a purchase.
In this article, we are going to discuss the most common commercial real estate deal structures. For each, we will describe what it is, how it works, and the benefits and risks of utilizing it. By the end, readers will be able to recognize the differences between the most common deal structures and utilize this information as part of their pre-investment due diligence process.
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What is a Deal Structure?
The term “deal structure” refers to the legal parameters of a commercial real estate deal. More specifically, in a deal that involves multiple individual investors or real estate firms, it refers to the roles, responsibilities, and rights of every party in the transaction.
In most cases, the planned deal structure addresses key issues like: who is responsible for managing the property, who is entitled to the cash flow produced and how much are they entitled to, who is responsible for the loan balance, how profits are split, and who is liable for the financial performance of the asset.
Needless to say, the deal structure is a critically important deal element for real estate investors to understand because it has a major impact on whatever return they ultimately receive.
Types of Commercial Real Estate Investment Deal Structures
Every deal is unique, but most commonly fall into one of three structures.
In any type of business a joint venture is a structure where two or more parties come together to pool their resources for the purpose of completing a specific task. In a commercial real estate (CRE) deal, that task is to purchase and manage a commercial property.
A joint venture is typically governed by a “Joint Venture Agreement” that outlines the roles and responsibilities of each party in the transaction. Most notably it covers things like:
- How much capital each party will contribute
- Who has decision making authority for major property management issues
- How the cash flow and profits produced by the property will be split
- How additional capital needs will be addressed
- How disagreements will be handled
Once both parties read and sign the Joint Venture Agreement, it is binding for the duration of the deal holding period.
Joint Venture Benefits
Clearly, the benefit of a joint venture is that pooled resources can be used to purchase larger properties, which can be helpful for investors trying to scale their portfolios. In addition, it can spread management responsibility around so it lowers the burden on any one individual.
Joint Venture Risks
But, the downside is that the Joint Venture agreement has to be crystal clear on roles and responsibilities, otherwise there can be disagreements that can lead to a wide variety of negative events like lawsuits or misappropriation of funds.
Investors who are considering a Joint Venture should take great care to perform due diligence on their joint venture partner(s) and to work with professional attorneys to prepare the joint venture agreement.
A syndication is a structure that allows individual investors to purchase a fractional share of an institutional grade property and earn passive income in the process. There are two groups of investors in a syndication.
The first is the deal leader, usually referred to as the General Partner or GP, and their responsibility is to find suitable properties, analyze them, arrange the financing, complete all of the necessary due diligence, and to manage the property once closed (including leasing). In short, they do all of the leg work of finding, financing, and managing investment opportunities for individual commercial real estate investors. For this work, they typically charge some amount of fees and take a share of the profit.
The other group is the individual investors, usually referred to as Limited Partners or LPs. Their job is very simple – they provide investment capital, but otherwise have no say in the day to day management of the property. They also get a share of the profit, but usually have to split it with the General Partner on a predetermined schedule that depends on the performance of the property. Depending on the size of the deal, a syndication could have dozens or even hundreds of Limited Partners.
From an investment strategy perspective, the major benefit of a syndication is that it provides investors with a fractional share of large commercial real estate properties and totally passive income. In addition, investors may get a preferred return on their investment (meaning they get paid before the General Partner) and they may get the tax benefits from the pass through legal structure (LLC) of the deal and the depreciation taken on the income statement.
The downside of a syndication is the lack of control for individual investors. In addition, the fees charged by the General Partner may cut into profits and the General Partner’s performance may lead to inconsistent returns – which highlights the need to only work with those that have a long term track record of stability.
Delaware Statutory Trust
A Delaware Statutory Trust is a specific type of trust formed under Delaware law and for the purpose of conducting business. It is very similar to a syndication in the sense that there is a two tiered GP/LP structure and investors get fractional ownership of the property. However, there is one key difference. Shares in a Delaware Statutory Trust can be used as a “Replacement Property” in a 1031 Exchange, which can allow investors to defer taxes on the profitable sale of an investment property.
Delaware Statutory Trusts are offered for all major asset classes – multifamily apartment buildings, office buildings, retail, and industrial, but are not usually offered for residential real estate or single family homes. In addition, they usually have relatively low minimum investment requirements, which can allow individuals to add some diversification to their investment portfolio.
Delaware Statutory Trust Benefits
As a type of real estate transaction, the major benefit of a Delaware Statutory Trust investment is the tax deferral opportunity and the passive income. In addition, there are some ancillary tax benefits for heirs who can inherit shares from the deceased at a stepped up cost basis.
Delaware Statutory Trust Risks
The major downside is that these investments are only available to Accredited Investors who meet certain income and/or net worth requirements. In addition, the equity investment in them tends to be illiquid with a holding period requirement of five to ten years.
Of these three structures, there is no “right” option. Instead, there are options that are the best fit for each individual investor’s unique circumstances and investment objectives.
How Are Private Equity Real Estate Deals Structured?
Private equity real estate deals are typically structured as a syndication and there are two options.
The first is a “fund” level syndication where investors contribute capital to a general pool of resources that will be used to buy properties at a later date. In other words, investors are placing their trust in the fund manager to find profitable assets that offer a compelling rate of return, but they won’t know what properties will be purchased at the time of investment.
The other type of syndication is a “deal” level syndication where investors contribute capital to a specific deal/property and know exactly what it is at the time of investment.
There are benefits and risks to each type so investors should study each structure carefully to determine which one is the best fit for their needs.
Fees on Private Equity Real Estate Deals
Because a private equity deal is a syndication, the private equity firm acts as the General Partner in the deal – which means they do all of the leg work of finding and managing the investment. In return for their effort, General Partners get paid in two ways – fees and a share of the profit.
With regard to fees, there are a number of fees that investors should be aware of in a private equity deal. For example, it would be common for a firm to charge an origination fee, asset management fee, and disposition fee. In any deal, these fees should not be profit centers for the private equity firm, instead, they should be enough to cover the costs incurred and should be competitive with other participants in the space.
With regard to the profit split, each deal has a unique structure, but it typically follows something called a “waterfall” distribution model. While the term may sound complicated, it just means that the cash flow/profit split changes at certain predetermined thresholds in the deal. For example, if the property returns up to 8%, the split may be 10% to the General Partner and 90% to the Limited Partners. But, if the return exceeds 8%, the split changes to 20% for the General Partner and 80% for the Limited Partners. This structure is purposely designed to incentivize the General Partner to maximize the return produced by the property, which benefits the Limited Partners as well.
Finding Commercial Real Estate Deals
Finding any commercial real estate deal is fairly easy, but finding one that is going to produce a profitable return is much more difficult and requires adherence to strict underwriting criteria, detailed knowledge of the local real estate market, and established relationships with lenders to finance the purchase.
For individual investors looking for deals on their own account, it is a best practice to scour internet search sites like Loopnet, drive the local market, network with other investors, and forge relationships with brokers. This is a lot of work and requires near constant attention and persistence. For this reason, time starved investors may prefer to work with a private equity firm.
Finding a deal with a private equity firm may also require a little bit of upfront due diligence, but not nearly as much as the previous option. The search for a private equity deal is much more focused on the firm and their track record of success, not necessarily the risks and benefits of the property at the time of investment because this is not always known.
Private equity deals are typically found through existing relationships, internet searches, or through consultation with a financial advisor.
Investing Through Private Equity Real Estate
Because of the time savings and expertise that a private equity firm brings to the table, many investors – especially those with hectic daily schedules – find that a private equity investment is a compelling option. In a typical deal, investors can expect the following:
- Private equity deals are only available to accredited investors so individuals should expect to be able to demonstrate compliance with accreditation requirements
- Private equity deals may come in a “fund” or “deal” structure and investors should decide which one is the better fit for their own needs
- Private equity deals require holding periods of five to ten years, during which time investor funds are unavailable
- Investors will typically split the cash flow and profits from the property with a “waterfall” distribution
- In addition, the private equity firm is likely to charge fees for their stewardship of the investment
- Finally, returns can vary widely by deal, but investors can generally expect IRR in the range of 12%-15% and cash on cash returns in the range of 6%+.
If these characteristics are appealing, investors should begin the process of researching private equity forms that offer the types of deals they are interested in.
Summary of Commercial Real Estate Deal Structures
Because commercial properties are so expensive, they are rarely purchased by a single individual. Instead, they are purchased by groups of individuals who come together to pool their resources to complete a purchase.
To coordinate the logistics of a multi-investor deal, there are three common structures – Joint Ventures, Syndications, and Delaware Statutory Trusts.
There are risks and benefits to each of these deal structures so investors should study them carefully and choose the one that is the best fit for their needs.
Private equity deals are usually offered in a syndicated structure where the private equity firm acts as the General Partner in charge of finding, financing, and managing the property while investors provide capital but have an otherwise passive role.
For investors without the time or expertise to manage a commercial real estate property, a private equity investment may be a good alternative because the firm does all of the heavy listing for investors.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, 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 Real Estate Investor and want to learn more about our investment opportunities, contact us at (800) 605-4966 or email@example.com for more information.