Institutional Equity for Private Real Estate Companies
(Printed in The California Real Estate Journal)
Privately owned real estate development and investment companies have historically been built one deal at a time utilizing private equity from friends, family and high net worth individuals. This is commonly referred to as the “stop and go” business. As real estate has become more institutionalized, access to institutional equity has become more common. Many real estate operators are unaware of ways to access institutional equity, what attracts institutional partners, and the benefits of forming a long-term relationship to fund current and future projects.
To qualify for institutional equity, a real estate operating company should have an excellent reputation in its field, a focused investment strategy, a proven tract record, and be led by a team of experienced professionals. The company must also demonstrate an excellent future flow of investment or development projects. A company that displays these traits is a good candidate for an institutional partner. Having such a partner allows the operator access to tremendous amounts of capital, entrepreneurial partners who react quickly, and cachet in the marketplace. These are tremendous benefits when competing for real estate opportunities.
The source of most institutional equity is pension funds, foundations, and endowments that have invested in funds operated by real estate investment professionals. In most cases,
these fund managers have discretion over the dollars with which they have been entrusted. The managers usually invest their own capital along side the institution to create an alignment of interest.
These funds exist to form joint ventures with local real estate partners. In addition to contributing capital to the partnership, the fund managers bring capital markets knowledge, debt relationships, and perhaps deal flow. An institutional partner levels the playing field against the large institutional buyers and public companies when negotiating for acquisition and development opportunities.
Typically, the equity partner has no desire to become involved in the operation of the company on a day to day basis. However, they will likely require shared control over important decisions such as large leases, development budgets, financing, and sales. Once a letter of intent is negotiated, due-diligence on the first investment and execution of a joint venture agreement will be completed.
The financial structure associated with these types of partnerships varies greatly. However, a typical investment might provide for leverage of 75% with the equity partner providing 90% of the equity and the operating partner investing 10%. All equity will receive a pari passu return to an agreed upon level, after which the operating partner receives a disproportionate share of the returns, referred to as "promotes". Promotes are negotiated so the operator,
based on leveraged internal rates of returns (IRR’s) at the time of refinancing or sale, could earn an additional 25-40% above their pari passu equity return. The operator is generally able to earn market rate fees for its services such as development and property management fees.
Individual funds may prefer specific product type and geographic markets. Some funds will assume more risk, such as development risk, while others prefer investment with partners who only acquire existing properties. At any given time almost all asset classes are acceptable. The funds typically have an investment life of three to seven years. However, some funds prefer a capital event, such as a refinancing or sale, to occur at or shortly after stabilization. Understanding and agreeing upon possible exit strategies is very important and mutually acceptable buy-sell provisions are also always a part of the joint venture agreement.
Forming a joint venture with an institutional equity partner is an exciting way for private real estate companies to fix the terms of their equity on a going forward basis. Such a partnership frees the real estate executive from the tedious and time consuming task of continually raising equity. These partnerships also provide broader participation of profits for key professionals, create stronger positions with lenders and, most importantly, allow the company to quickly and profitably grow its business.