What is real estate private equity?
Ever wonder about the difference between real estate private equity, real estate development, and real estate hedge funds? Read about the differences between the three, and how the businesses can overlap.
Acquiring a building with existing commercial tenants
What you should know when reviewing the quantitative and qualitative history of a tenant that will remain in-place once you acquire a commercial real estate asset.
Real estate private equity vs. development vs. real estate hedge funds
9/4/2016 by Stephanie McConnon
Real estate private equity is primarily the business of capital allocation. Private equity funds have capital that they need to invest by purchasing income-producing real estate assets directly. They may also participate in a variety of other investments, such as buying operating platforms, funding developments for developers, and buying real estate debt.
On the other hand, in real estate development, capital allocation is only the start of the process. Once funding is in place, developers are involved in the day-to-day project and construction management of a project, which includes everything from government relations, architectural and engineering design, to sales and lease-up of the asset.
Real estate hedge funds are also in the business of capital allocation; they invest in more liquid assets. Since real estate is illiquid, hedge funds typically purchase publically traded shares of stock in existing real estate companies. Typically, real estate hedge funds invest in REITs.
In practice, a private equity fund may engage in all of the above, to varying degrees. It is dependent on whether or not the fund typically uses an OP (operating partner) to engage in development and/or value-add and project management. Some real estate private equity funds will also purchase shares of stock in existing real estate companies.
What you need to know about commercial tenants who will become yours
8/28/2016 by Stephanie McConnon
Credit analysis is useful when considering the financial strength of tenants and other operating partners. When thoroughly underwriting an retail, office, or industrial property, an analyst may look at these measures to understand the caliber and quality of existing tenants, and therefore, what the future strategy and predicted rental income at the property may be.
The five C’s of credit analysis:
Capacity. This measures a company’s capacity to make debt service payments. In other words, can the tenant afford the rent every month? To find out, take a look at the company’s historical and projected cash flows. In their cash flow statement, look at the Earnings before Interest, Taxes, Depreciation, and Amortization (EBITDA). This figure determines how much money is available to pay their rent. We use the EBITDA figure because it does not subtract depreciation and amortization – as it should be looked at – because depreciation and amortization are non-cash expenses.
Once the EBITDA figure is identified, credit analysts typically divide that number by any proposed debt service obligations. This calculation is called the Debt Service Coverage Ratio (DSCR). Typically, banks consider a 1.2x DSCR as a good benchmark. This means that the tenant can afford to pay their mortgage payment 1.2 times with their monthly income after expenses.
Collateral. Collateral serves as a back-up should the tenant be unable to pay their rent. A dollar value needs to be placed on the tenant’s collateral, but thankfully this is usually done by third parties. Collateral can be anything from inventory, equipment, other real estate, and accounts receiveable.
Capital. When analyzing a tenant, one should make sure that the tenant stands to lose something if the business fails. Chances of failing are much less in instances where the company has a lot of money on the line; they are incentivized to do everything in their power to keep the business alive and well. How do you measure the capital that a company has invested? Look at its debt-to-equity ratio, and expect a number less than 3x.
Conditions. This simply means that the landlord should be aware of the economics of the industry that the tenant is. How do macroeconomic conditions affect their business? Are there specific trends that are positive or concerning?
Character. A tenant’s character may be judged by the landlord. For example, a landlord may not be interested in having Hobby Lobby as a tenant given their involvement with controversial religious and/or contraceptive practices for their employees. Understanding a tenant’s character and public reputation is important in predicting whether or not they will have a PR disaster that may take them out of business and affect their ability to pay rent.
While other metrics may be used, these are the general items looked at by analysts who want to understand the quality of commercial tenants in a potential acquisition.
Excel model coming soon!
Open end vs. Closed end funds
8/21/2016 by Stephanie McConnon
Open end funds are generally focused on assets that can be freely transferred and are traded on an established trading platform or market. These funds are designed to allow for regular re-calibration of the portfolio to meet the contribution and redemption needs of investors. These funds typically have no specific finite term.
Upon committing to invest, investors typically put in their capital at that time, with no future capital calls required.
For example, many hedge funds are open end funds. They allow investors to join or leave and redeem their capital at regular intervals. This is not possible in closed end funds.
Closed end funds are generally focused on assets that cannot be freely transferred for a ceratin period of time. These assets cannot be marked to market and are generally held on the books until a realization event, such as a refinance or sale of the asset, occurs. These funds typically have a 10-12 year term with 1-2 year optional extensions.
Closed end funds have capital calls when they need capital from investors. As such, investors may or may not contribute money to the fund directly at the time of commitment. The commitment time period lasts between 3 and 5 years. Aftwards, the GP will invest during the investment period, which lasts for several years, and varies from fund to fund. In addition, some funds allow for the recycling of capital during the extension period.
When capital is called from investors, they are contractually obligated to provide the pre-agreed upon capital amount to the fund. However, investors can pay late, which often results in an interest penalty. In addition, if the investor defaults on the capital call, the GP can terminate the investor’s right to fund future deals. The GP will likely also buy out the investor in any prior investments that they participated in. This happens at a fraction of what the investor contributed to the deal.