I have had a few people reach out to me that they are interested in knowing about the private equity business model in real estate and, more specifically, how PE firms make money, so, I'll expand on it today.
Private Equity firms are universal to businesses. A common business model is to find undervalued businesses, maximize their value, and sell them for a high upside.
Most private equity firms raise money from wealthy people to buy these businesses, and the investors benefit by getting a portion of this upside usually. These capital investors are mainly called limited partners.
It's not unexpected that private equity firms(or general partners) can control huge assets with very little of their capital invested when they're in charge of managing hundreds of millions or billions of dollars of assets on behalf of equity investors and can still leverage other sources of capital like debt.
In the real estate industry, private equity firms are no exception.
Because real estate investing is capital intensive, most investors end up raising capital to increase their AUM(assets under management)
However, how do these real estate private equity firms make money from their real estate investments?
There are many fees that the PE firms can consider charging, but there are five main ways real estate investment firms or general partners make money by investing cash on behalf of equity investors or limited partners.
Let's take a look at each of these, one by one.
Acquisition fees are one type of fee paid to the firm for going out and finding a commercial real estate property and completing the transaction.
Finding an acquisition opportunity on behalf of an equity investor is a time-consuming and expensive process. Before closing on a single transaction, commercial real estate investors typically underwrite(analyze the property) and review 50, 75, or 100 contracts.
Nonetheless, they are only rewarded for that one acquisition, so you can see how that fee is merited.
This can range from around 2% of the purchase price for smaller properties to around 5%, or 50 basis points, for larger properties valued at more than $50, $75, or $100 million.
For one of my recent deals, I charged only 1% in acquisition fees just because there was not enough meat on the bone.
The second fee type is asset management fees, which compensate the firm for conducting business strategies, budgeting, investor distributions, and anything else under that agreement's asset management level. The private equity firm will go through a lengthy procedure on behalf of its limited partner equity investors. As a result, it is reasonable to reimburse the investor for his or her efforts.
This is typically paid out as a percentage of either the equity included in the agreement, the overall effective gross revenue of that contract, or even the net or gross asset value of the deal if the property is going to be reassessed every year.
The most common asset management fee is 2% of the total initial capital raised.
It’s important to note that it is not the same as property management fees, which is paid out to a professional property management company for day-to-day oversight of the property.
Construction management fees are the third type, and they are paid for managing the construction process throughout a commercial real estate transaction.
When the investor produces value through the investment, this is typically where the value add comes in. This will be a time-consuming procedure as well. The private equity firm, once again, will manage everything for its limited partner investors and will be compensated for its efforts. This normally amounts to 4 to 8 percent of the deal's total capital costs.
Furthermore, the fourth type is disposition fees, which are payments made to the private equity firm to manage the property's sale.
Even if you have a broker who will help you with the sale, you should go through the broker's opinion of the value process, pick a good broker to market the property, gather all of your due diligence materials to present to that potential buyer, and finally choose a buyer and go through the transition process.
Due to a lot of work involved, a private equity firm typically receives a disposal fee, which is normally one to two percent of the total sale price.
Finally, and perhaps the most important way the PE firms get paid is through a carry.
The carry is performance compensation that the partners of a private equity fund receive if they exceed a specific threshold return. This compensation is meant to align the private equity partners with their capital providers, as the majority of their compensation comes from the carry.
In the agreement with a private equity firm that promised a certain rate of return to its investors, is when the waterfall structures come into play like I talked about in the last newsletter.
If they beat that rate of return, the private equity firms get a portion of the profits and this is how PE firms majorly make money.
There is usually a win-win situation for both the private equity firm's general partner and the limited partner capital investors who invest alongside when it comes to these fee arrangements.
Private equity firms must be rewarded for doing all the legwork upfront to discover real estate acquisitions on behalf of their investors in order to earn acquisition fees.
Asset management costs, construction management fees, and disposal fees are all the same. You want to know that your interests are aligned as a limited partner in a private equity firm.
By creating these fees, the real estate private equity business assures it is fulfilling its responsibilities in each primary area of buying, maintaining, remodeling, and eventually selling a deal.
This is typically a preferred structure between a real estate private equity firm and investors since it establishes an alignment of interest on the entire profits of the purchase.
As a result, by keeping the majority of the compensation on the back end, the private equity firm ensures that its main focus is on achieving the highest rate of return possible for the project, resulting in excellent returns for both limited partner capital investors and the real estate private equity firm.
That is it for the five of the most typical ways real estate private equity businesses make money, all of which are profitable for both the private equity firm and the capital investors.