Commercial real estate deals typically require multiple financing sources. Within the broad debt and equity categories, commercial deals include a variety of sub-categories, as well. Known as the “capital stack,” these different financing sources allow capital-intensive deals to get off the ground. Recognizing this, savvy investors understand the importance of finding different financing sources, with private equity one of the more common. As such, we’ll use this article to answer the question, what is real estate private equity?
Specifically, we’ll cover the following topics:
- Equity in Commercial Real Estate
- What is Real Estate Private Equity?
- Advantages to Equity Financing
- Final Thoughts
Equity in Commercial Real Estate
From an accounting perspective, equity refers to ownership. That is, how much does someone own in a given asset? Say, for example, you buy a single-family home. If you purchase the property for $400,000 using an 80% loan-to-value (LTV) mortgage, you would need a 20% – or $80,000 – down payment. As a result, you would have $80,000 in equity – or ownership – in the property immediately following the purchase (assuming the value remained constant). The bank would have a lien on the remaining $320,000 due to the outstanding mortgage.
But, in this example, you would also have 100% of the equity in the property. That is, once you pay off the mortgage, you will own 100% of the home. If the value increased to $500,000, you would have $500,000 in equity. Conversely, if the value decreased to $300,000, you would only have $300,000 in equity. In this respect, equity and contributed capital are related – but not identical – concepts. At the outset of a deal, an investor’s contributed capital often equals equity in dollar terms. But, as you pay down a loan and a property’s value changes, your dollar equity will change, but (barring a change to the deal structure) your percentage equity will remain constant.
This leads into a key distinction in commercial real estate: equity versus debt financing. When you raise capital for a deal by selling an ownership stake, you use equity financing. Alternatively, you can borrow money from a lender – similar to the above example – with debt financing. Most commercial real estate deals use a combination of both financing sources. And, when people discuss finding equity for commercial real estate deals, they mean raising capital by selling ownership interests in a given deal.
In the next section, we’ll discuss private equity, a key source of equity financing in commercial real estate.
What is Real Estate Private Equity?
Private Equity Overview
Private equity firms raise investment capital from institutional and accredited investors via deal- or industry-focused funds. Accordingly, private equity typically includes sums of money far greater than what any individual investor could/would contribute to a deal.
With a certain threshold of capital raised, these funds would traditionally buy and actively manage privately-held companies before selling them – ideally at a significant return. Private equity funds typically add value to these companies through a combination of operational improvements, cost savings, and scalability.
Private Equity in Commercial Real Estate
Recently, capital from private equity funds has begun to flow into real estate holdings – not just purchasing companies. As such, large enough development deals can potentially attract investments from real-estate-focused private equity funds. Or, more realistically, a portfolio of development deals could attract private equity investments.
Real estate private equity funds pool investors’ money with active managers. These managers then screen potential real estate deals and, if they meet the firm’s criteria, invest in those deals. Often, a sponsor finds a quality deal, identifies financing requirements, and pitches a real estate-focused private equity firm with an offering memorandum. If the deal’s numbers and traits align with the private equity firm’s objectives, it will join as an equity investor. However, due to private equity’s active management approach, these investments generally come with a more active role than a standard, limited partner investor.
Frequently, real estate private equity funds will focus on a specific property type and geographic area. For example, a certain fund may invest in cold storage facilities in the southwest or multifamily properties in New England. This approach allows a fund’s management to gain specialized expertise to drive returns.
Advantages to Equity Financing
Having explained private equity in commercial real estate, equity financing offers two tremendous advantages: ability to scale and risk mitigation.
Advantage #1: Ability to Scale
Rather than the above example of a $400,000 single-family home, say you want to purchase a stabilized apartment building for $20,000,000. Assuming you can secure the same 80% LTV debt financing, you would need $4,000,000 in cash for the down payment (ignoring closing costs). In terms of scale, coming up with $4,000,000 will likely pose far more of a challenge than finding $80,000.
Recognizing this reality, many CRE professionals find other investors to help raise enough cash to make a deal happen (e.g. a private equity fund). In this example, you know that your maximum debt financing is $16,000,000, meaning you need $4,000,000 in equity financing to close the deal. Let’s assume you have $1,000,000 of your own cash, so you need to find someone willing to invest another $3,000,000.
With this structure, you would need an additional $3,000,000 in contributed capital from an investor. This would translate to $3,000,000 in initial equity and a 75% equity percentage. In other words, for $3,000,000, an investor would purchase a 75% ownership interest in this apartment building. In doing so, this equity investor would enable you to close on the deal, with you keeping a 25% interest for your $1,000,000 in contributed capital.
Advantage #2: Risk Mitigation
Including equity investors like private equity funds in real estate deals also helps to mitigate risk. With debt, you must make your loan payments every month, regardless of a property’s performance. As such, too much debt in a deal can significantly increase the risk profile of that deal.
On the other hand, equity financing provides downside protection. Say that, in a given quarter, your property’s vacancy skyrockets, crushing your quarterly net operating income. Regardless of this poor performance, you still need to service your outstanding debt. But, you do not need to provide returns to equity investors (NOTE: exceptions to this rule exist with certain types of preferred equity).
In many CRE deals, equity investors collect a pro rata share of a property’s free cash flow – usually on a quarterly basis. If you have $100,000 in cash to distribute, a 50% equity investor would receive $50,000. If you have no money to distribute, that same 50% equity investor wouldn’t receive any distributions. In this fashion, equity investors take some upside from a deal, but they also provide significant downside protection.
Final Thoughts
A variety of financing sources exist in the commercial real estate world. For larger deals, real estate private equity may make sense. These firms generally focus on specific property types and regions, so many investors look to align their projects with the investment objectives of a specific private equity firm.
If you’d like to discuss different real estate investing options for your unique situation, we’d love to chat! Drop us a note, and we’ll set up a meeting to talk about available passive real estate investment opportunities.