Most people invest in real estate by purchasing their home. Private real estate is a popular option for more adventurous investors. These structures, similar to PE and VC funds, can provide tailored investments into management teams that are undertaking complex projects.
In an environment where it is becoming increasingly difficult to earn returns of high quality on the stock and bond market, a great many are turning towards alternative investments. Alternative investments promise to increase portfolio yields and provide investors with unique, untapped investment opportunities in less efficient markets.
Private real estate is one of the best alternatives to traditional investments. This article will discuss the advantages and challenges of private real estate investments and provide some tips on how to evaluate these investments.
But before we jump in, a quick programming note. This article will not cover two of the most popular ways to invest in real estate, namely real estate investment trusts and direct ownership. This article will concentrate on investments that are less time-consuming and involve less effort than direct ownership but are smaller and more focused than a typical REIT. This is investing in a real estate private equity fund managed by a third-party professional investment manager.
Preqin reports that private equity real estate fundraising has been consistent in recent years. The range of funds raised per quarter is between $20-40 billion. Different investment themes can be scaled according to risk profiles. From “core” investments (safe, trophy-type properties) to “opportunistic,” which involves highly leveraged investments with little or no cash flow, there are many options. In terms of the amount of capital raised and funds closed, opportunistic investment funds are currently the most popular.
Private Real Estate Fund Offerings
Many private real estate investors find that the best way to invest is in assets managed and acquired by a professional investment manager. It can take the form of a specific fund or hybrid structure, which combines purchases and future acquisitions. These real estate funds are structured as follows:
Investors benefit from the expertise of the sponsor. The sponsor’s full-time focus tends to be real estate investment, and they often have established operations that professionals run.
Costs of investing are usually known upfront and outlined in the contract as manager fees, carried interests, and other benefits.
Investors can invest in different asset types and sizes. A small investor can even achieve effective diversification. They can also invest in structured products such as senior loans, mezzanine, preferred equity, and LP equity. These require specialized knowledge and relationships and are difficult to invest in a one-off.
Investors may be able to have a meaningful impact on fund decisions, including those relating to asset acquisition, management, finance, and disposition.
The day-to-day management of the property is a responsibility that falls to the sponsor and not the investor. This is particularly important for a manager who has other duties than managing real estate.
While the benefits listed above are great, there are other factors to consider before investing in private real estate. While most managers are willing to provide investors with a lot of information about their investment opportunity (and they’re required to by law in some cases), it is up to the investor to review that information and use it as a basis to decide whether to invest or not.
Investing in Private Real Estate Offerings Effectively
There are several types of real estate funds, each with different strategies, goals, and structures. To be successful, a private investor needs to become adept at assessing and understanding the details of each offer. This section will give you some ideas on how to evaluate new investment opportunities and where this type of investment could fit into your portfolio.
The Investment Itself
Warren Buffett once said: When a management team with a good reputation tackles a company with a bad reputation, the business’s reputation remains intact. This is also true for the real estate market, so the first question that should be asked when evaluating a new investment opportunity is to determine what the investment is and why it makes sense to invest. Real estate is one of many asset classes that investors can choose from. It is full of niche businesses and strategies, each with a unique purpose and a guaranteed return. Real estate offers a wide range of investment opportunities, from low-leverage loans on urban trophy properties that have a similar profile to high-credit bond investments to highly speculative projects with returns that are more comparable to VC funds or small-cap equity investments. Everything in between.
It is impossible to cover all the options available on the market, but it’s important to remember that there are so many. It is also useful to consider how to formulate a series of questions to uncover the “what” behind a potential investment. What is its place in the spectrum?
Start with the ROC
A good place to start is by asking the sponsor for their assumptions and pro forma financial forecasts about the investment or fund. Sponsors of high quality will have prepared pro forma financials for review. They will also be able to answer questions in detail about their strategy, their assumptions, and their results and explain the workings of the structure that they are creating. This may seem obvious, but many investors invest without knowing this information. They do so because they want to be exposed to a particular manager or asset class and don’t have a thorough understanding of the business.
You can then develop a series of questions based on the financials. It is impossible to discuss all the ways to evaluate pro forma financials and assess business models in this article. One of the most useful ones in real estate is Return on Cost.
ROC is what you get if you divide the property’s net operating income (stabilized income) by the total cost (including all fees), including all costs associated with buying, upgrading, developing, leasing, financing, etc. Here is the formula.