How do REPE firms build Alpha in Core funds?

How do Private equity funds build alpha or any sort of outsized returns vs the market in the 'core' segment of real estate? I understand from working in the sector that LPs are looking for cash/cash vs IRR for 'core' strategy investments so: how do they return 6-8% annually while buying at a significantly lower cap rate?

Is the alpha built in by the ability to borrow at a lower rate then reits or other PERE firms?
is it in the financial engineering of debt during the acquisition?
do they build NOI margin y/y that outpaces inflation?

Comments (8)

Mar 4, 2013

Leverage and some try to build NOI through strategies that are riskier or more creative then competitors.

Mar 5, 2013

Exactly what Mogulin said - Ex. annual rent increases, rolling existing leases to higher rental rates, etc.

Mar 5, 2013

Buying "best in class" assets that will appreciate due to higher barriers to entry, sub-market performance, macro events, demographic trends, employment concentrations, cyclical trends, etc. None of this will likely happen but you have to write something in the brief.

Mar 5, 2013

None of this will likely happen

This is how I wanted to respond to the OP. Core funds, alpha? Really?

Mar 5, 2013

@PF_CRE nice haha

Ok well thanks guys

So what type of firms are receiving mandates then? One that have proven track records, or just brand name funds? There seem to be a limited number of variables to differentiate a GP

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Mar 6, 2013

There are two different questions here. I'll answer them separately. The first is straightforward: how do you hit a 6-8% cash on cash return when you're buying at a 4-5% cap rate?

The answer is a mix of debt and NOI growth. It's actually pretty easy to turn a 4% cap rate into a 6-7% cash on cash return. Borrowing rates right now are around 3% or better for core product, and you can get 65% LTV pretty easily. So on a $100 property with $4 of NOI (4% cap rate) you will be paying $1.95/yr in interest and taking home $2.05 to the $35 of equity you put in. That's a 5.9% cash on cash return. Factor in a couple years of rent growth and your cash-on-cash can grow quite a bit (operating and financial leverage should amplify the rental rate growth too).

The second question, and your headline question, is a little trickier. Alpha generation requires earning an unusual high return for a given level of risk, or a lower level of risk for a given return. Generally, I think most private equity real estate investors are looking at that second half of the equation. They'll underwrite the probable returns in a deal, and see whether it checks the box of meeting the minimum return needs for their fund and limited partners. The next question is the level of risk to hit those returns. One form of alpha generation involves, at any given time, identifying the specific opportunities that are undervalued by the market that may offer outsized gains. The other is exercising discipline when putting out capital...stopping when markets overheat, and being aggressive when markets pull back.

Best Response
Mar 6, 2013

Also, by the way, everyone cares about IRR. IRR is generated in two ways, one is through cash flow from operations (hence the cash on cash yield), and the other is value appreciation realized upon sale. It is true that core investors tend to care principally about cash flow from ownership/operations, and hence focus on cash on cash return, whereas value-add and opportunistic investors are focused more on value appreciation and realizing big profits over short holding periods. However, no core investor is going to intentionally buy a deal for cash-on-cash return that they expect to generate a low IRR by virtue of the value of the building going down. They just care more about earning their IRR through the cash on cash return rather than through a near-term realization.

One counterpoint to this is that there are a lot of investors (think private REITs) that are so focused on cash yield to pay an outsized dividend (because their unsophisticated investors are sold a story about how safe this massive dividend is) that they buy cheap properties that spit off a ton of cash but are arguably very junk properties in the long-run. This is more a problem of mismatched incentives and bad stewardship of capital than true core investor preference, though.

    • 2
Mar 7, 2013