I'm becoming more and more interested in real-estate. I know how to value a real-estate portfolio, but I want to know the main problems and risks associated in real-estate private equity. I do realize that I could google this and find answers, but I want insight information from guys that work in real-estate private equity.
Thank you!
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Your question could be taken a number of different ways...you'll need to clarify to get a meaningful response. Are you asking what are the major problems an LP has to consider when investing in an RE PE fund (fund structure, incentive alignment, etc.)? What are the key challenges and risks of being a PE professional (fundraising/firm survival, deal sourcing, compensation structure)? Or what are the real estate problems and situations that PE funds try to solve (over-leveraged capital stacks, capital starved properties, market mis-pricing)?
Related question(s):
How is corporate real estate taxed?
How does this impact a REIT structure (i.e., where tax liability is passed through) vs. a generic corporation which owns a lot of real estate?
How does a REPE buyout of an REIT compare along these lines, to a standard LBO where the income tax deduction would play a big role.
thanks to whoever can answer these.
RE-IB-NY: can you answer the original question taken in this manner:
what are the real estate problems and situations that PE funds try to solve (over-leveraged capital stacks, capital starved properties, market mis-pricing)?
Are there more than those three core value creation opportunities? How do the funds extract value in each situation?
There are a couple of ways that RE PE funds (often called value-add or opportunity funds) seek to achieve an outsized IRR (high teens and up). One is to simply move buy assets with weak/no institutional demand (tertiary markets, low-quality product, etc.) that prices to a high yield and, with leverage, may generate a sufficient cash-on-cash yield.
Another way to achieve it, and the subject of the question, is to target assets that--but for some flaw--would attract institutional "core" buyers. The next question, then, is what sort of solvable flaws (so let's leave aside pure market mispricing) might deter core buyers.
Core buyers are looking for simple cash-flowing investments that don't require a lot of "work." To many of them, real estate is an alternative to fixed-income...they want a quasi-bond that spits off predictable payments but has some upside potential. Executing expensive renovations, major lease-up, repositioning, etc., are not attractive components of the business plan. So assets that are vacant / under-leased, have significant deferred maintenance, have major tenants with maturing leases up for renewal, or need to be repositioned to appeal to changing tenant demand all represent opportunities to value-add buyers.
These are typical "operational" elements of distress. Often, the operational distress stems from financial distress. Perhaps a private owner is having unrelated financial difficulties and can't make reinvestments in the asset. More often in this cycle, values have declined below the value of the debt, so the owner has no incentive to put new money in. Opportunistic buyers can attempt to structure a takeover of the asset through the debt (or some other restructuring), thereby curing the financial distress, and then attempt to solve the operational problems.
I'm sure there are almost infinite variations on the theme of "solving real estate problems" but hopefully that's a nice summary of what value-add buyers in general attempt to accomplish.
Thanks for the great explanation. You've been a lot of help quite a few questions lately, I definitely owe you a beer next time I'm in NY. Sounds like a lot of fun to be working on deals like this, can't wait to start and finish my mba...
As a follow up to this, if the value add opportunity comes from operational issues such as needing renovations, repositioning, ect, do the funds typically try to solve these issues in house or do they partner with developers to handle those details? Then, if funds do typically work with developers, how does that partnership begin? Do the funds first target properties, create a plan, and then find a developer to take it on? Or do the funds simply review and select proposals that are set to them by developers/brokers?
Broadly speaking from a risk perspective, there are two major risks associated with RE private equity investing:
Lack of liquidity - you are essentially taking the most illiquid investing strategy (private equity) and utilizing that strategy to invest in the most illiquid type of asset (real estate).
The expecation of high yields (3-7 Yr IRR in the mid to high teens) - very difficult nowadays to extract unusually high yields from even value-add investments. Part of this expectation is driven by the liquidity risk of REPE and also because LPs expect high yields in general from their private equity investment allocations.
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