commercial re private equity understand and navigating the options workshop primer
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Private Equity Capital for Commercial Real Estate: Understanding and Navigating the Options
Primer on Private Equity
# NAIOP 2010. Do not distribute or reproduce without permission.Real Estate Capital MarketsObjectivesUnderstand the real estate private equity universeDiscuss investment strategies and vehicles used by private equity Become familiar with the capital raising process and timelineUnderstand the workings of a joint venture, including fees, waterfalls and major termsLearn how to define your value proposition for investorsGain insight into current investor appetite from active capital providers
#2Real Estate Capital MarketsReal Estate Private Equity Investors
#3 NAIOP 2010. Do not distribute or reproduce without permission.Real Estate Capital MarketsReal Estate Private Equity Investor UniverseOwner / developer personal resourcesFriends & familyHNW investors
Family officesCommingled dedicated real estate equity fundsHedge FundsPension funds, endowments, foundationsSovereign wealth fundsLife insurance companies, banks, corporate investorsListed and unlisted REITs
Traditional SourcesInstitutional Sources#4Real Estate Capital MarketsInvestment Criteria Real estate private equity investors will consider the following in making investment decisions:ReturnsStructureStrategy (Acquisition, Development, Land Banking, Debt, Capital Allocation)Property Type GeographyHold PeriodOne size does not fit allCertain investors constrained by very specific investment mandates dictated by their investor base Investor cost of capital will determine strategy
#5Real Estate Capital MarketsInvestment Return Characteristics Class A assets or premier multi-tenant buildingsPrimary marketsHigh occupancy/credit tenants/long-term leasesStable cash flow investmentModest leverage 20 investorsSeveral months to a year or moreFastMonths#34Sample Investor UniverseFund ManagersPension Fund AdvisorsOtherUnlisted REITsInternationalFamily Office / Private WealthInvestor#355Description of Typical FeesDescription of Services Investment banking services:Screen and qualify potential investors Create and distribute marketing materials Contacting investors and solicit proposalsAnalyze investor proposal(s)Negotiate the transactionFees Retainer feeSuccess fee based on sliding scaleReimbursement of out-of-pocket expenses Other Engagement Terms TerminationTailLock-upIndemnification#36Accessing Private Equity CapitalConsiderations, Process and Timeline
Understanding The Investors Financial Drivers/ Investment Framework
ULI January 11th, 2011# NAIOP 2010. Do not distribute or reproduce without permission.Real Estate Capital MarketsType of FundTypical CharacteristicsPREA Unlevered IRRsCoreWell-diversified, low risk/return strategyTraditional asset classes (i.e. office, retail, industrial, multi-family) in established locationsWell occupied and well maintained assets with stable cash flowsGenerally little or no debt is employed (i.e. up to 30% levered)Income stream represents significant part of expected total return7.5 8.5%Core-PlusModerate risk/return strategyCore-type assets, some of which may require some form of value-add enhancementAssets located in either primary or secondary locationsModerate amount of leverage employed (i.e. up to 55% levered)8.5 10%Value-AddModerate to high risk/return strategyOpportunity to add value through operating, re-leasing, and/or redevelopmentLeverage employed is higher (i.e. up to 70% levered)Value appreciation comprises significant part of expected total return9.5 13%Return Requirements by Investment Strategy#Chart obtained from RealPac: Real Property Associate of Canada
Go over the various investment strategies. Equity funds pick a strategy or two to follow and also determine the return target that they expect to achieve.38 NAIOP 2010. Do not distribute or reproduce without permission.Real Estate Capital MarketsType of FundTypical CharacteristicsPREA Unlevered IRRsOpportunisticHigh risk/return strategyRe-positioning of poorly managed, obsolete, and/or vacant assetsAcquisitions of entire companies with portfolios of assets and operating platforms in-placeNew-build development or conversion projectsInternational focus pursing opportunities in established and emerging marketsLeverage employed is higher (i.e. over 70% levered)10 13%Mezzanine/ DebtOriginate loans at terms which are more aggressive than traditional lendersMay contain profit-sharing in addition to higher interest rates and fees chargedAcquire distressed loans from lenders at discount prices (i.e. below par value)Participate in higher-yielding tranches of mortgages (i.e. non-rated CMBS; first-loss positions)Generally not adverse to owning the assets in the event such loans default.Return Requirements by Investment Strategy#39 NAIOP 2010. Do not distribute or reproduce without permission.Real Estate Capital MarketsReturns and Leverage
Leverage Ratio (LR):at the time of purchase = Acquisition Price/Equitythereafter = Value/Equity
re required return on levered equityrp required return on property without leveragerd return on debt (cost of mortgage debt)(rp rd) risk premium without leverageLR leverage ratiore = rd + LR*(rp rd)
#Levered Returns Table
LTVRequired Return Unlevered Assumes 5% cost of debt #41Median IRRs
#42Venture Cash Flow Sharing Arrangements
#43Joint VenturesTwo types of partners that combine expertise with capital
Cash flow sharing arrangement made between these two partnersDeveloper/ Operator/SponsorInvestor#44Joint Ventures: Cash Flow SharingSharing Cash Flow Operating Cash FlowsTypically pari passu or at predetermined percentagesSharing Cash Flow Property Sale/RefinanceRepay any debtReturn of initial investment (return of invested capital remaining)Remainder Distributed (return on capital) Split of Cash Flow (often a waterfall arrangement)Predetermined portions/percentagesPreferred returns and return hurdlesHard HurdleSoft HurdleIRR lookback (clawback) or catch-up with soft hurdle#Pari Passu: a phrase that literally means "equal footstep" or "equal footing" Proportionally, without preference.This term is also often used for cash distributions to be paid in accordance with the amount of capital contributed
45Example JV Waterfall DistributionFirst, to repay capital contributions made by each partner (typically 90%/10%) pari passuSecond, to pay each partner a 9% cumulative annual return on capital Remaining proceeds split 50% to Institutional Investor and 50% to Developer/Sponsor Target IRR 18% to Capital Investor
#46 NAIOP 2010. Do not distribute or reproduce without permission.Real Estate Capital MarketsHard vs. Soft HurdlesThe difference between a hard hurdle and a soft hurdle is like the difference between a deductible and a threshold. Source: Real Estate JV Promote Calculations: Catching up with Soft Hurdles, by Stevens Carey #47Hard HurdlesA hard hurdle functions like a deductible: Operator would not receive any promote unless and until capital investor were to receive IRR hurdle and then operator would received a predetermined percentage of the incremental cash flow. In effect the profit distributions required to achieve the hurdle would be deducted from all profit distributions in determining the portion that is shared by Operator.
Source: Real Estate JV Promote Calculations: Catching up with Soft Hurdles, by Stevens Carey #48Soft HurdlesThe soft hurdle is a threshold that must be reached as a condition to operators retention of any promote: If the profit distribution is sufficient to achieve the IRR hurdle, thenThe threshold would be reached Operator would get a predetermined percentage of all profit distributions Catch up if preferred returns are met firstIn that sense, the soft hurdle would go awayIf the profit distributions are not sufficient to achieve the IRR hurdle, thenThe threshold would not be met Operator would not get a predetermined percentage of all profit distributions Operator must forfeit distributions (lookback or clawback if preferred returns are not met first) to the extent necessary to meet the thresholdSource: Real Estate JV Promote Calculations: Catching up with Soft Hurdles, by Stevens Carey #A hard hurdle always reduces the amount of profit distributions that may be shared by Operator (if there are profit distributions to share), whereas a soft hurdle is contingent and may not result in any reduction at all.
49Uncertainty of Soft HurdlesA hard hurdle always reduces the amount of profit distributions that may be shared by Operator (if there are profit distributions to share), whereas a soft hurdle is contingent and may not result in any reduction at all. Source: Real Estate JV Promote Calculations: Catching up with Soft Hurdles, by Stevens Carey #50Look back vs. Catch-upLook-back for Investor: one approach is to give Operator 50% of the profit distributions from the outset with a so-called Look-back:The parties look back at the end of the deal and to the extent Investor hasnt achieved a 9% IRR, Operator must turn over to Investor its promote distributions (in this case, all of Operators distributions) Catch-up for Operator: another approach is to give Investor 100% of the profit distributions until Investor achieve IRR hurdle, and then give Operator its share with a so-called Catch-up:After Investor achieves a 9% IRR, Operator gets 100% of all subsequent profit distributions until profit distributions are in 50/50 ratio
Source: Real Estate JV Promote Calculations: Catching up with Soft Hurdles, by Stevens Carey #51Return Multiples#52Net MultipleThe net multiple return is used by investors to determine how much they have received in cash relative to how much they paid inIt does not take into consideration the timing of capital call-ups and distributionsIt does provide a good indication of fund performanceCalculated as a Ratio: Total Cash Inflows/Total Cash OutflowsSource: 2010 Preqin Private Equity Real Estate Review #53Net Multiple (cont.)
#54Investment Horizon in YearsAssumes capital contribution made at time zero and also assumes 8% cash distributions per yearIRR Multiple Table
IRR #552. Sponsor receives a 30% promote until a 15% IRR hurdle3. Sponsor receives a 40% promote until a 20% IRR hurdle1. Cash flow split pari passu until an IRR of 10% is generated4. Sponsor receives a 50% promote thereafter
JV Waterfall ExamplesTypical JV Promote Structure: The Sponsor invests a small portion of the equity, with a Limited Partner (LP) providing the balance. The Sponsor is generally entitled to received performance incentives in the form of promotes (a greater portion of the cash flow) upon achieving certain return hurdles
#5652. Sponsor receives a 30% promote until a 15% IRR hurdle3. Sponsor receives a 40% promote until a 20% IRR and a 2.50x equity multiple1. Cash flow split pari passu until an IRR of 10% is generated4. Sponsor receives a 50% promote thereafter
JV Waterfall ExamplesJV Promote Structure with Minimum Equity Multiple Hurdle: The scenario below is similar to the previous structure, with an added return hurdle. The investment must generate a minimum equity multiple for the LP before the second promote can be paid out to the Sponsor
#5752. Sponsor gets a catch up (receives all cash flow) until a 12% IRR is reached3. All remaining cash flow is split 50%/50%1. JV Investor receives a 12% preferred return
JV Waterfall ExamplesPreferred Return: In the scenario below, the Sponsors return is subordinated to the LPs (the Sponsor does not receive any cash flow until the investment generates a set return for the LP). After this hurdle is achieved, the Sponsor may be entitled to a catch up payment sufficient to generate the return already received by the LP. Afterwards there may be additional promotes or a set cash flow split
#5852. All remaining cash flow is split 65%/35% in favor of the Sponsor1. Cash flow split pari passu until all invested capital is returned
JV Waterfall ExamplesCash Flow Split after Return of Capital: In this scenario, once the total invested capital has been returned to the Sponsor and the LP (on a pari passu basis), all of the profits are distributed based on a pre-determined split
JV Waterfall ExamplesEach scenario produces similar returns IRRs ranging from 20.03% to 20.74% for the Investor and 51.05% and 52.41% for the SponsorEquity Multiples ranging from 2.37x and 2.42x for the Investor and 7.38x and 7.87x for the SponsorProfit ranging from $18.45m to $19.19m for the Investor and $9.56m and $10.30m for the Sponsor
#605More on Commingled Funds#61Commingled Fund Customary TermsMinimum investment commitment in these funds is at least $1 millionA typical return target for these funds is a 20% IRR and a 2x equity multiple over the life of the investment However in light of the financial crisis, these returns have crept down significantlyFund sponsors hope to raise new funds seamlessly and are generally permitted to raise a new fund after 85% of the funds capital is invested The sponsor also invests its capital in the fundThe amount invested by the sponsor can range from 1-3% for first time fund managers, to 25-50% of total equity commitments#62Commingled Fund Customary TermsA return waterfall details how cash is split between the investors and the sponsorThese preferred returns range from 8 to 10% If the returns exceed the preferred return than these additional profits are split 80/20 With 80% of the profits going to the investorThe 20% of the profits given to the sponsor is called a carried interest or promoteIn addition to their promote, fund sponsors also receive an annual management fee
#63Commingled Fund Customary TermsManagement fees an annual payment made by the investors in the fund to the fund's manager to pay for the private equity firm's investment operations (typically .50% to 2% of the committed capital of the fund)Management Fees are fees paid to the funds manager based on a variety of measures which include: Total equity commitmentTotal equity invested to date Gross or Net asset value Percentage of incomeOr combinations thereof
#Go over the fees earned by the fund sponsor/manager. Note that any other services provided by the sponsor would also be specified, e.g., property management, brokerage, acquisition or disposition fees, etc. 64 NAIOP 2010. Do not distribute or reproduce without permission.Real Estate Capital MarketsCarried Interest or PromoteCarried interest - a share of the profits of the fund's investments (typically up to 20%), paid to the private equity funds management company as a performance incentive (also called a promote). The remaining 80% of the profits are paid to the fund's investorsHurdle Rate or preferred return a minimum rate of return (e.g. 8 - 10%) which must be achieved before the fund manager can receive any carried interest paymentsFees are calculated based on a set hurdle rate (IRR) and often include claw back provisions if funds hurdle rate is not achieved
#Carried interest, also known as promote, is how the investment sponsor shares in the profits of the fund.Clawback - A provision that ensures that a general partner does not receive more than its agreed percentage of carried interest over the life of the fund. So, for example, if a general partner receives 21 percent of the partnership's profits instead of the agreed 20 percent, limited partners can clawback the extra one percent.
65 NAIOP 2010. Do not distribute or reproduce without permission.Real Estate Capital Markets- Small Developer MF merchant builder run by family for 75 years
- Large Owner MF developer, owner, operatorComments
SizeTeam / Employees20 people 200 people Market concerned about depth of bench and possible conflicts
Assets5 stabilized multifamily developments Own 100 assets ( multifamily, office) Small size limits ability to contribute asset. Positive cash flowing
Pipeline3 shovel ready$500mm MF dev / acq, $500mm office dev / acq.Can development pipeline be completed with existing financing? Guarantees? Are targets available at sensible pricing?
MotivationFinancial StressLimited construction financingRecap existingNot all assets have same financial stress. Refinancing? CMBS / crossed?
Control3 generationsDiscretion within a boxFamily unlikely to cede control
Tax1031. Recycle capital (not REIT eligible)Need simplified structure. Low basis assetsDifferent tax issues for each investor (individuals vs. institutions)
GrowthNeed capital for construction or continue to layoffImmediate acquisition pipeline in current marketsWilling to split business lines?
MarketsFootprintLocal sharpshooterNational, coastal focusPositive fundamentals in markets?
SectorA quality MFA / B MF in SoutheastA MF CBD in NortheastMF demand is strong
InvestmentInvestorsFriends & familyFriends & family and 7 institutionsExisting institutional investors lend credibility but conflicts may exist
Returns50%+ asset level returnsHi teen / low 20% returns to investorsStability of returns and at what leverage?
OfferingStructureDevelopment JV Acquisition JV including possible GP investmentDifferent investors choose different entry points