In the latest Bayfield Training Webinar, Sonia Martin-Gutierrez and Robert Leigh present: An Introduction to Real Estate Private Equity.

Real estate private equity valuation metrics are often found to be a confusing topic. Capital structure, and valuation models such as multiples, Discounted cash flows, and other performance metrics are key to building a strong understanding of private equity. This webinar introduces the basic structure of private equity and valuation methods needed to understand the performance of real estate private equity funds.

What is private equity?

Private Equity Real Estate (REPE) is a term that refers to firms that raise funds to acquire, develop, operate, enhance, and sell real estate to produce returns for their investors.

As Robert explains, there are two main players involved when structuring a real estate private equity fund. First, you have the investors, who are commonly called limited partners (LPs). LPs invest their capital into a fund. Second, you have the general partner (GP), who will manage the fund. Robert clarifies that REPE funds are illiquid investments where the lock-in period is an average of between 5 to 7 years.

REPE funds are generally structured as closed-end funds. Specifically, closed-end funds have a predetermined life set by the GP at the fund’s inception. These funds are usually value-add and capital gains focused, where asset sales drive the expected return rather than the income stream.

GPs are the ones acquiring and managing real estate assets. For this service, the GPs are paid performance and management fees. Generally, GPs are paid a 2% management fee and 20% performance fee. The management fee is often expressed as a percentage of the assets under management (AUM) on an annual basis. For example, if the AUM were £100 million, the GP would collect £2 million pounds in management fees. This can be expressed as a percentage of either “committed” or “invested” capital. In the former situation, the fee is calculated on the amount committed by investors from the partnership’s founding, regardless of when the capital is called. If the asset management charge is determined on invested capital, the fee is only calculated on the capital withdrawn.

Typically, the performance fee (“carry”) is expressed as a percentage of profits. Typically, a predetermined hurdle rate must be met before sharing can begin. Thus, a typical transaction might be represented as “20% carry over an 8% hurdle.” This means that the partnership must earn a minimum of 8% before the GP receives any performance fees, which would be 20% of the profits.

REPE funds operate through an investment mandate. The mandate establishes rules and guidelines for the investment of money. These rules then guide an investment manager’s decisions. For example, it will specify the type of risk and return the fund is looking to achieve.

The final thing to note about REPE is that there are two sides to it; specifically, there are the acquisition and asset management sides. The acquisitions team seeks out and analyzes potential acquisitions, negotiates them, arranges financing, and convinces the firm’s decision-makers to invest in real estate. Once the property has been purchased, it will be sent to the asset management team. The asset management team is responsible for carrying out the business plan established after the REPE firm acquires a property. Members of the teamwork to improve the property’s operations and financial performance and resolve any issues that arise. The pay is higher in acquisitions due to the perception that closing deals are more complex than managing properties.

Risk and return

REPE generally focuses on high return investments. Fund strategies differ; they include core, core-plus, value-add, and opportunistic fund strategies.

For example, the least risky type of investment is a core investment. They provide consistent returns and are typically comprised of the most recent properties in the best locations.
A typical core investment has a low leverage ratio (40–50%), a stable and predictable income stream, high-end finishes, and no significant structural or operational issues. Additionally, core investments are typically located in prime locations with nearly full occupancy, leased to tenants on long-term leases. Examples of core investments include multifamily assets, high-rise office buildings, or high-end retail shopping centres.

At the other end of the risk scale lies opportunistic investments. Opportunistic is the riskiest of all REPE fund strategies. Opportunistic properties frequently require extensive rehabilitation to reach their full potential. Often, these assets are acquired completely vacant or are greenfield projects. These types of projects provide the highest returns if the business plan is successful and carry the greatest risk. Sponsors of these projects frequently use a high degree of leverage and often face less favourable debt terms and higher interest rates than sponsors of more stabilized properties. Greenfield developments, acquiring an empty building, repositioning a building from one use to another are all examples of opportunistic investments.

REPE investors include university endowments, pension funds, sovereign wealth funds, or high net-worth individuals. Regarding GPs, the top 3, in terms of fundraising, include Blackstone, Brookfield Asset Management, and Starwood Capital Group.

Valuation metrics

There are several valuation metrics used in REPE, including the internal rate of return (IRR), distributed to paid-in capital (DPI), total value to paid-in capital (TVPI), and cash-on-cash return (CCR).

Calculating the IRR on a real estate investment is one of the most widely accepted methods of determining its profitability. The IRR is a financial metric that informs investors of the average annual return they have realized or can anticipate from a real estate investment over time, expressed as a percentage. For example, if the IRR for a project is 12%, you can expect an average annual return of 12%. There are two forms of the IRR: Gross and Net IRR. GPs will often quote the gross IRR in their marketing materials. Gross IRR is calculated before management fees, fund expenses, and carried interest are subtracted. After deducting the management fee, fund expenses, and carried interest, the return that the LPs receive from the fund is referred to as the Net IRR.

The IRR often follows something called the J curve. The curve begins with a zero IRR in year zero. It then declines into negative territory before reversing and trending upward in the fund’s later years, resembling the letter “J.”

The DPI and TVPI are money multiples. For example, if the money multiplier was two, for every $1, you invest, you get $2 back. They are both paid-in capital metrics. The capital contributed by LPs to the fund is known as paid-in-capital. Distributions are the amount of cash and stock that the fund has returned to (distributed) to its LPs. Distributions are typically low in the early stages of a fund’s life, gradually increasing as investments are exited. Total value is the sum of the distributions and the residual (remaining) value of the fund at a given point in time.

Thus, the DPI is the ratio of money the fund has distributed to the LPs relative to contributions. The TVPI is slightly different; it captures both the distributions given back to the limited partners and contains the residual value in the fund. Thus, the TVPI is a good measure for looking at how well the fund is doing today. The DPI is generally used at the end of the fund’s life because that’s when most of the distributions are going to be given out to the LPs.

The final metric that is useful is the CCR, which is a useful measure to evaluate the performance of individual investments in a fund. The CCR is the annual pre-tax cash flow divided by the total cash invested. For example, if you had an apartment building, renting it at $10,000 per year and you invested $100,000 the CCR will be 10%.

Trends in REPE

To conclude, Robert described the current trends in REPE. As Robert explains, there has been a reduction in activity in 2020, largely due to COVID-19. Some of the leading REPE players have not been raising as much capital because of the uncertainty brought about by COVID-19. For example, uncertainty regarding whether inflation and interest rates will rise and the resulting effect on rates of return.

Robert explains that a recent PwC report has outlined four primary concerns for REPE: international political stability, environmental issues, national political stability, and housing affordability. International political stability is important because regulation can significantly affect the total return on private equity funds. Moreover, ESG considerations are becoming ever more critical. Investors want to know that the properties they are investing in are environmentally friendly. According to Robert, environmentally friendly buildings generally sell at a premium and are less likely to become obsolete in the future. Thus, your investment becomes more likely to maintain its value over time. In addition, housing affordability ties in with national political stability, with governments under more pressure to provide more affordable housing.

Finally, Robert discussed the six trends emerging moving forward. The first trend emerging is significant growth in the warehousing sector. This is being driven by the enormous demand in online and e-commerce platforms. The second trend emerging is a significant reduction in private equity investment in retail. Third, office demand is expected to rebound. This is because investors expect there to be a mix of working from home and working in the office. Fourth, ESG will continue to grow in importance. Fifth, there is expected to be a higher capital allocation to Asia (25% compared to 15% in 2015). Finally, over the COVID-19 pandemic, residential investments have proven resilient, partly because of tax cuts in the UK (e.g. stamp duty cuts).