How Private Equity Real Estate makes money?
What thought crosses your mind when you hear the word real estate? We’re sure it must be revolving around investment, especially for Indians. Real Estate has always been an integral part of Indian people and their investments in that domain. Private Equity Real Estate is a no different concept, it is just an addition to the real estate domain. To understand the Basics of Private Equity Real Estate clearly, you can refer to our article which has explained different real estate investment avenues to provide you with a better understanding.
Let us give you a brief overview of Private Equity Real Estate, so you don’t get all juggled up with the terms. When a firm combines funds from different kinds of investors such as Institutional Investors, private investors, and third parties, which is used to purchase public & private commercial real estate assets. The fund is mainly responsible for recognizing proficient sponsors for investment, & performing activities such as purchasing/acquisition, financing, refurbishing, standardization, asset management & disposing of the property.
Now the real question arises, how do these private equity real estate firms make money? These days the question mainly revolves around the way the real estate is financed, which in turn gives us an overview of how these funds make money from real estate assets. Let’s get started and make you walk through the different concepts of money-making in Private Equity Real Estate.
It’s important to know GP & LP as they play a major role in private equity real estate. A private equity firm is also known as General Partner (GP) and the investors that entrust their capital are called Limited Partners (LP). Institutional investors, pension funds & wealthy individuals are usually a part of Limited Partners.
Management fees are levied to support overhead costs such as employee salaries, portfolio monitoring, & other day to day expenses. LP’s traditionally charge an annual management fee - 2% of the committed capital, when investing with a private equity firm. The fee usually differs from large to small funds. Large funds charge a management fee of less than 2%, while small funds charge LP’s more than 2%.
Performance fees are also known as carried interest or The Carry, which typically is 20% of the returns generated by the fund. The fee is charged to compensate the GP for its performance. This fee is charged irrespective of the capital returns, unlike management fees. Although for a private equity firm to earn performance fees, they need to cross a hurdle rate. A hurdle can be defined as a prefixed rate of return, a fund must earn to be eligible for performance fees. The typical hurdle rate is roughly 8%.
Asset Management Fees:
Asset Management fees are used to compensate the investor for managing the business plan, budgeting, investor distribution, etc. As it is a very time-consuming process, which private equity firms perform on the behalf of its limited partners, LP’s are typically charged 1.5% per year of the committed equity.
Acquiring a property is a strenuous process. Thus, private equity firms charge their investors for finding commercial real estate property and closing the deal on their behalf. Commercial real estate investors typically underwrite 50-100 deals, before they close on one deal. LP’s are roughly charged 2% of the purchase price for smaller deals & 0.5% of the purchase price for bigger deals.
Distribution Waterfall Structure – Funds Distribution between LP & GP
A distribution waterfall is a method by which capital gained by the fund is distributed between Limited Partners & General Partners. This method generally incentivizes the General Partner and creates a structural pay system for capital investors or limited partners. Fee & waterfall structures create alignment of interest between private equity firm & capital investors.
The Waterfall Distribution Structure makes the capital flow from Limited Partners to General Partners, which in turn helps the GP’s to maximize the returns of the fund. The waterfall structure can be easily envisioned as a set of tubs placed below one another. Each tub refers to the allotment of profits. When the first tub is filled to the brim, the profit flows into the second tub and the same thing goes on.
There are generally four tiers in a waterfall distribution system which are:
Return of Capital – The investors receive all the initial capital contributions which include initial capital along with some expenses and fees.
Preferred Return – 100% of the distribution goes to the Limited Partner until their preferred return is received on the invested capital.
Catch-up – 100% of the distribution goes to the General Partner of the fund until they receive a certain percentage of profits.
Carried Interest – It includes distributing the leftover amount between the limited & general partners.
Clawback, this feature is included to protect the investors from paying excessive incentive fees than required. In case this happens, it is mandatory for the manager to return the excess fees.
Here’s a pictorial insight of waterfall distribution between Limited Partners & General Partners:
SOURCE: ARGUS TALIANCE WEBSITE
We have got an idea of how Private Equity Real Estate works in terms of money. These investments require a huge amount of upfront capital and it may take years for a person to receive the initial investment. It is advisable to invest in this fund, only if you’re a long-term player. You might not get your invested capital if you are here for short-term gains.
Investor should always set their financial goals clearly so they don’t invest in the wrong investment options & keep their head clear with all the nuisance going around in the market.