When looking to deploy their funds into commercial real estate, many investors face a familiar conundrum. For most investors, the price of a commercial asset is beyond what their individual resources can accommodate, but the risk/return profile of the investment is superior to many alternatives. Fortunately, there are ways for individual real estate investors to pool their money in partnership with an experienced sponsor to purchase a commercial property and realize all of the cash flow benefits afforded by it.
One of those ways is known as a private equity commercial real estate partnership, and we believe it is the best way for individual investors to gain exposure to commercial real estate assets.
In this article, we’ll explain what private equity real estate partnerships are, who can invest in them, their benefits and risks, as well as elements of a successful 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. In many cases, the private equity 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 total equity needed, and sell securities to investors to raise the rest.
To understand 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.
To facilitate this transaction structure, private equity firms / private equity funds 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 Partnership investors to those who are deemed to be either “accredited” or “sophisticated.”
Under SEC Regulation D, an accredited investor is a high net worth individual whose financial resources 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 Private Equity Real Estate Partnerships.
Benefits of Private Equity Real Estate Partnerships
For those that meet the SEC’s requirements for accreditation or sophistication, there are a number of benefits to investing in private equity real estate partnerships. Among them are:
1. Access to More Opportunities
By pooling funds with others, investors can gain access to a variety of commercial property deals and property types that they could not acquire on their own due to capital constraints.
2. Diversification
Since an individual does not need to commit 100% of the equity in a given transaction, they are able to invest smaller chunks over multiple deals which provides diversification for their real estate investment portfolio. This type of diversification can be obtained through investing in different asset classes (retail, industrial, multifamily), locations, and with different sponsors.
3. Risk Dispersion
The risk in any given commercial real estate asset is dispersed over multiple equity partners, which reduces the risk on any one of them. For example, if a property needs additional capital, an individual investor would have to provide all of it in a direct ownership scenario. In a partnership, the capital need is spread out over all of the partners, which decreases the amount that each individual needs to contribute.
4. Leverage
Because a Private Equity Commercial Real Estate Partnership is always led by an experienced sponsor, each individual investor is able to leverage their access to deals, knowledge, expertise, and industry relationships. In many cases, this allows an individual investor to gain access to a deal they would not have been able to purchase on their own.
5. Passive Involvement
In a Private Equity Commercial Real Estate Partnership, individual investors play a passive role. The transaction sponsor is responsible for the identification and financing of a property and the management of it once the purchase is complete. This allows the individual investor to realize all of the benefits of ownership without any of the hassles of management.
Despite the substantial benefits, Private Equity Real Estate Partnerships are not a good fit for all investors.
Risks of Private Equity Commercial 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.
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.
Elements of Successful Commercial Real Estate Partnerships
Although each partnership is unique, there are a number of elements that tend to be correlated with success for private equity commercial real estate partnerships, including:
1. A Good Deal
First and foremost, one of the strongest predictors of a successful transaction is a good deal. This means investing in an attractive asset in a good location at a favorable price. These are the key attributes that will drive return metrics like IRR.
2. Clear Business Plan
The transaction sponsor’s investment strategy and plan for the asset needs to be clear and simple to understand. Key elements include, the length of the holding period, cost of planned renovations, and target rental increases.
3. Experience
An experienced sponsor has a strong track record of successfully executing their business plan and delivering strong returns as evidenced by previous transactions.
4. Experienced Property Management
Due to their size and complexity, a commercial property needs a full time property manager. If the sponsor plans to use an outside vendor, it is important to understand their level of experience with the asset class and location. Their stewardship of the property can have a major impact on the success of the investment. In our own case, we prefer to bring the management function in house, which allows us to add our expertise and reduce operating costs.
5. Alignment of Interests
By definition, a Private Equity Commercial Real Estate Partnership involves two groups of investors, the sponsor and the investor(s) and it is important that the property’s income and profits be split between the two groups in a manner that aligns the interests of both parties. One hallmark of this is when the sponsor pays a “preferred return” to the investors, which gives them a first claim on the property’s income until it has met a certain threshold.
Individual investors considering an investment in a private equity commercial real estate partnership should complete their own due diligence on the transaction sponsor/general partner with regard to each one of the above elements.
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.
To learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
