Real estate has long been viewed as an attractive asset class and an important component of a well-rounded investment portfolio. Indeed, while still technically viewed as an alternative investment, real estate is such a popular investment category that it is often listed alongside stocks and bonds when discussing a well-diversified portfolio composition, not to mention its anecdotal reputation as being responsible for minting more millionaires than any other industry. However, there can often be confusion as to how to gain exposure to real assets. While direct ownership of rental property is a good option for some investors, this strategy comes with time-intensive and often headache-inducing operational demands.
Most investors are therefore left with a choice between public real estate investment trusts (REITs) and private funds in order to gain real estate exposure. REITs are generally publicly traded investments and offer a total return profile similar to that of equities, so they are a good option for investors who value liquidity as a primary consideration. However, for accredited investors who desire consistent cash flow, a higher return profile, and are comfortable with a longer time horizon, private equity funds are an attractive vehicle for real estate investing.
Once an investor has settled on private equity real estate as their avenue of choice, they are faced with an abundance of potential options. Indeed, choosing a private equity real estate fund manager can feel like a daunting task, yet it is a crucially important decision. Choose the right fund manager, and you can enjoy all the benefits of owning real assets, such as current cash flow, asset appreciation, downside protection, and tax loss harvesting. Choose the wrong manager, and you could end up with an investment that underperforms relative to its peers, or worse, goes to zero.
What factors should an investor consider when evaluating a private equity real estate fund manager? Let’s take a look at four key determinants of fund sponsor performance.
Investment Thesis
You should have an investment thesis that essentially says why you think this is potentially a good idea. - Reid Hoffman
I’m not a businessman, I’m a business, man. - Jay-Z
Every fund manager worth her salt has an investment thesis, and this is the first item a would-be investor should examine when considering an investment. There are a multitude of ways to invest in real estate, and fund theses run the gamut across real estate asset classes, geographies, the use of leverage, and many other factors. One fund manager may plan to invest in real estate by foreclosing on distressed debt in developing countries – another may plan to buy single family homes in Kansas City. An investor should match her risk tolerance, time horizon, and personal investment convictions with the investment thesis of the fund manager she is considering.
Would-be investors should consider questions such as the following: Does the story the fund manager is telling make sense? Are you comfortable with the riskiness of her business plan? Does her time horizon match yours?
For example, if you’re looking for safe, predictable cash flow, make sure that this goal aligns with the strategy of the fund manager. If you want to generate current returns with strong downside protection, and you’re considering a fund manager who plans to make stabilized acquisitions at valuations below replacement costs in areas with strong inherent downside protection and high barriers to entry, your risk/return profile is well correlated with that of her investment thesis. If the fund manager plans to develop a chain of hotels in Indonesia, you should probably look elsewhere.
Track Record
If your fund isn’t in the top quartile, you’re doing the math wrong. - A funny quote I heard once
It’s one thing to *say* you’re going to generate a 50% IRR by foreclosing on industrial property in Guatemala. Actually doing it is another thing entirely. As such, evaluating a fund manager’s track record is critically important in making an informed investment decision. Has the manager ever accomplished what he said he’s planning to accomplish? Does he have a demonstrated history of executing on the business plan for which he is raising capital? Are the necessary relationships - such as deal flow, debt origination, and quality vendors - firmly established? While past performance may not indicate future results, I would much rather put my hard-earned cash to work with a fund manager who has a demonstrated history of profitably investing in real estate than with a fund manager who’s watched every season of “Flip This House” and thinks he’d be really good at telling contractors which walls should be covered in shiplap.
Bench Strength
Teamwork makes the dream work, but a vision becomes a nightmare when the leader has a big dream and a bad team. - John C. Maxwell
Leaders don’t execute in a vacuum, and while the fund manager is responsible for casting vision, it’s her team that will ultimately do the work required to generate strong outcomes. When considering a private equity real estate investment, then, investors should consider several questions regarding the bench strength of the fund. How many senior level executives are employed at the firm? How long have they been working together? Do their respective backgrounds correlate to success in their respective roles? Are there enough employees to effectively execute on the fund manager’s investment thesis? Do the general partners have key actor insurance policies in case something prevents them from working? Are management and operations conducted in-house, or are they subcontracted out to third parties? All of these factors should be kept in mind when evaluating the strength of the fund manager’s team.
Fund Structure & Alignment of Incentives
Show me the incentive and I will show you the outcome. - Charlie Munger
Finally, investors should consider the economic structure of the fund into which they are considering investing. While many people assume that fund terms are largely standardized, there are wide variations in terms, and even the terms that are standard exist on a wide spectrum. The best fund structures ensure that fund managers are only successful when their investors are successful. The worst fund structures allow managers to rake in cash hand over fist regardless of the performance of their investment vehicles.
For example, in a traditional “two and twenty” fee structure, the general partner gets twenty percent of profits over the fund’s stated hurdle rate, and a 2% yearly asset management fee. While an investor may salivate at the prospect of keeping 80% of the profits over the hurdle, one should keep in mind that 2% can be an enormous amount of yearly revenue. A single general partner managing a $100m fund – an entirely plausible scenario – makes two million dollars a year before making his investors a dime.
While two and twenty is the historical industry standard for many alternative asset classes, a different fee structure that better aligns sponsor incentives with those of their limited partners may include a heavier general partner carried interest but a lower management fee (or in some cases, no management fee at all). By rewarding fund managers with greater profits if their investments perform well – and paying them less money through non-performance-based fees – this type of structure incentivizes managers to ensure the performance of the underlying real estate, and thus, the performance of limited partner investments.
Additionally, investors should make certain that fund managers have co-invested their own capital alongside their limited partners. By having their own money at risk, managers are further incentivized to generate strong returns and do everything they possibly can to prevent the loss of equity. A sponsor’s willingness to personally guarantee debt for real estate acquisitions is another factor that creates a strong alignment of incentives. Poor performance in this scenario could result not only in the loss of a manager’s invested capital, but in the loss of their personal assets.
Finally, investors should be cognizant of terms beyond just profit sharing. While beyond the scope of this article, things like whether the waterfall structure is American or European, whether it’s single tier or multi-tier, and the presence of a clawback provision all affect how and when investors are paid and the extent to which their incentives are aligned with those of the fund manager.
Concluding Thoughts
Private equity real estate is a compelling option for investors who are looking for exposure to real estate without the headaches of day to day operations. However, investors must do their due diligence on the funds into which they are considering investing. By evaluating a fund manager’s investment thesis, track record, team, and fund structure, an investor will be well positioned to make an informed investment decision and enjoy all the benefits that investment real estate has to offer.
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