For individuals considering a real estate investment, there are a variety of structures through which they can deploy capital. For example, a property can be purchased directly in the name of an individual or through a Limited Liability Corporation. But, for individuals seeking the benefits of real estate ownership without the time commitment needed to manage it, there is a third option, a private equity real estate partnership.
In this article we’ll define what is a private equity real estate partnership, explain who can invest in private equity real estate, and explain the pros and cons of such a partnership.
What is a Private Equity Real Estate Partnership?
A private equity real estate partnership is a specialized type of investment structure that invests in the non-publicly traded securities of a company that owns real estate. To further define private equity real estate partnerships, it is helpful to break the term into two parts.
- First, a “private equity” firm is a specialized type of investment manager that provides financial backing or invests in the non-publicly traded securities of startups or operating companies. These investments can span all industries, including real estate.
- Second, a “real estate partnership” is a legal investment structure that combines the liability protection of a corporation and the tax benefits of a partnership.
In many cases, the private equity commercial real estate firm will find a property and create a limited liability corporation through which to purchase it. To fund the acquisition, they will contribute a portion of their own funds, usually 10% – 20% of the purchase price, and sell securities to investors to raise the rest.
To facilitate this transaction structure, private equity commercial real estate firms rely on an exemption that allows them to sell the company’s securities to investors without having to register the offering with the Securities and Exchange Commission (SEC). However, this same exemption limits who can purchase the securities.
Who Can Invest in a Private Equity Real Estate Offering?
SEC exemption rules limit private equity real estate investors to those who are deemed to be either “accredited” or “sophisticated.”
Under SEC Regulation D, an accredited investor must meet one of two requirements:
- Net Worth: Individual net worth, or joint net worth with an individual’s spouse in excess of $1,000,000.
- Income: Individual income in excess of $200,000 in each of the two most recent years or joint income with an individual’s spouse in excess of $300,000 in each of those years with the reasonable expectation of reaching the same income level in the current year
If an investor does not qualify as accredited, they may still be able to invest in a private securities offering if they can prove that they are “sophisticated.”
Under SEC Regulation D, a sophisticated investor is one who “has sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment.”
In both cases, the intent of the rules is to limit investors to those who have the financial capacity and/or the knowledge necessary to understand the risks and benefits of investing in non-publicly traded securities.
Benefits of Investing in a Private Equity Commercial Real Estate Partnership
For investors seeking to earn passive income through real estate, a private equity commercial real estate firm can offer the benefits of real estate ownership without the hassle of managing it. A private equity commercial real estate partnership comes with a number of benefits:
1. Leverage
By partnering with a private equity commercial real estate firm, an accredited investor can leverage the firm’s network, tools, technology, and expertise, all of which are used in service of finding the most profitable investment opportunities.
2. Quality
Because a private equity commercial real estate firm pools investor funds to facilitate the purchase of an asset, it gives each individual fractional ownership of an institutional quality asset that likely could not afford on their own.
3. Income
By definition, the real estate assets owned in a “commercial” real estate partnership are rented to other businesses to generate income for investors. By virtue of their investment, individuals are entitled to a portion of the income and profits produced by the underlying asset, resulting in a steady stream of dividend income.
4. Diversification
Real estate price movements tend to have a low level of correlation with publicly traded securities. As such, private real estate provides a layer of diversification for the traditional stock/bond portfolio.
5. Incentive Alignment
In most cases, the return structure in a private equity commercial real estate partnership is designed to align the financial incentives of the manager with those of the investor. Usually, this takes the form of a “preferred return” for investors, which means that the manager’s access to property income is limited until the investors have received a certain return on their money.
6. Time
By investing with a private equity commercial real estate firm, investors outsource the task of property identification, acquisition, and management to a third party (the private equity commercial real estate firm), freeing up their time to pursue other interests.
How Private Equity Partnerships Protect Wealth
Private equity real estate partnerships protect wealth in three ways:
1. Portfolio Diversification
Private real estate price movements tend to have a low level of correlation with those of publicly traded assets like REITs or Equities2 which means that they may not fall as far or as fast when the next down leg of the economic cycle occurs. They also tend to be less volatile than those of publicly traded assets by appreciating slowly over time rather than going up one day and down the next.
1 National Bureau of Economic Research
2 Based on comparison of the NCREIF National Property index to equity indices such as the Russell 2000
2. They Own Physical Assets
Private equity real estate partnerships own physical real estate that produces revenue in the form of monthly rental payments or unit sales. These cash flows are the driving force behind lower price volatility and help to stabilize values in downturns while continuing to provide income to investors.
3. They’re Tax Efficient
Private real estate partnerships tend to be more tax efficient than their publicly traded counterparts. Through strategies like depreciation and cost segregation, individual investors benefit from paper losses that can be used to offset taxable income, reducing their tax bill and freeing capital to be reinvested into other profitable projects.
While these benefits are impressive, there are a few drawbacks to consider.
Drawbacks to Private Equity Real Estate Partnerships
While the benefits are impressive, a private equity commercial real estate investment is not risk free. Like other assets, real estate is vulnerable to changes in economic conditions and returns can suffer as a result. In addition, the investment may be illiquid during the 5-10 years that it takes to implement the property’s business plan and fees charged by the manager may erode overall returns.
Like any investment, there are two sides to the private equity real estate partnership story. Creating and protecting wealth through real estate assets is a time tested and effective strategy, but there are nuances to consider when working with a private equity firm:
1. There Are Fees
Using real estate expertise and vast networks of brokers, sellers, and investors, private equity firms identify, select, purchase, and manage assets on behalf of their clients. To fund these activities, private equity firms charge fees. They typically include a small management fee and participation in the profits once certain return milestones are reached. Fees vary by asset manager and may affect an investor’s overall return.
2. Performance Varies
Each private equity firm has their own investment ideas and viewpoints. One may prefer the Industrial asset class while another may prefer Multifamily, but time will tell who performs best over the long term. When selecting an asset manager, it’s important to work with firms who have an established track record of delivering consistent returns to their investors and an investment thesis suitable for your risk tolerance and time horizon.
3. Fund vs. Deal
Some private equity firms offer the opportunity to invest in a fund, which will pool investor capital and deploy it into a diverse basket of properties. Others solicit investments for a specific property or deal. One isn’t necessarily better than the other, but it speaks to the importance of understanding a firm’s investment strategy and structure before committing to invest.
4. Regulatory Requirements
In most cases, private equity investments are only available to investors who are either “accredited” or “sophisticated.” An accredited investor must demonstrate compliance with certain income and net worth hurdles while a sophisticated investor must possess the knowledge
required to sufficiently evaluate the risk of an investment opportunity.
Private equity real estate partnerships can be complex so it’s important to understand the nuances of each opportunity before committing funds to it.
Even with the known risks, private equity commercial real estate partnerships can be a suitable option for accredited and/or sophisticated investors looking for access to institutional-quality commercial real estate assets.
Ready to Learn 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.
To learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
