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Private Equity Capital for Commercial Real Estate: Understanding and Navigating the Options
Objectives
Understand the real estate private equity universe Discuss investment strategies and vehicles used by private equity Become familiar with the capital raising process and timeline Understand the workings of a joint venture, including fees, waterfalls and major terms Learn how to define your value proposition for investors Gain insight into current investor appetite from active capital providers
Family offices Commingled dedicated real estate equity funds Hedge Funds Pension funds, endowments, foundations Sovereign wealth funds Life insurance companies, banks, corporate investors Listed and unlisted REITs
Investment Criteria
Real estate private equity investors will consider the following in making investment decisions:
Returns Structure Strategy (Acquisition, Development, Land Banking, Debt, Capital Allocation) Property Type Geography Hold Period
Core - Plus
Variation on core investing Primary markets Fewer credit tenants Some vacancy or releasing risk Cash flow with some potential for growth through increased cash flow Slightly higher leverage 50-60% Unleveraged IRRs ~ 8.5% 10%
Value-Added
Class A and B assets Recovering Primary markets or Secondary / tertiary markets Mid-high vacancy / releasing risk / obsolescence / rents below market/repositioning Balanced mix of cash flow and appreciation Moderate leverage 60-70% Unleveraged IRRs ~ 9.5% - 13%
Opportunistic
Class A, B, or C Assets Secondary/tertiary markets or new developing markets Land/Development/Redevelopment/Repositioning/ Turnaround potential New or innovative product types Dramatic increase in cash flow Growth-oriented investment Higher levels of leverage 70-80% Unleveraged IRRs ~ 10% - 13%
Investment Structure
Single Asset Joint Ventures
Entity/GP Investment
Commingled Funds
Joint ventures are individually negotiated and tailored transactions A joint venture may be formed to:
Widely used vehicle for sponsors who have a good reputation and track record Establishes terms on which a series of investments may be made with a single investor or small number of investors Terms vary widely and are individually tailored (e.g., discretion within a box vs. deal by deal approval) Can offer a more certain funding source for projects within specified parameters
Investments by one or more investors at the operating company (entity) or sponsor equity (GP) level Involves sale of a portion of all income streams generated by the entity or the GP Investments can take form of common or preferred equity and can vary with respect to governance Can provide permanent capital and a longer term/global solution for the sponsor
Group of investors pool their resources to create a larger investment Money is gathered from various sources that is managed together in one account Includes a wide variety of entities including insurance companies, group trusts, limited partnerships, LLCs and private or untraded REITs
Acquire a specific property, a portfolio of properties, Make entity Level Investment Recapitalize an existing partnership Develop or redevelop a property
In a disposition JV, sponsor contributes assets at agreed upon value while institutional investor contributes cash Profit sharing based on value of equity contributed by the parties to the joint venture Increasingly popular alternative source of equity capital for public and private real estate operating companies (REOCs)
10
Each joint venture is idiosyncratic; there are no pre-set terms and conditions Terms to be negotiated include:
Contributions Preferred returns and Claw-backs Promotes Governance, guarantees (if any), fees, and transaction costs and expenses Hold period Winding-up, Buy/Sell
11
Sponsor handles day-to-day operations; paid market rate fees (which increase return on investment)
E.g., asset management, property management, leasing, development, construction, acquisition, disposition or financing fees
Exit may include buy/sell provisions where properties are liquidated through acquisition by one JV partner or sale to a third party
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Entity / GP Investments
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Company benefits from long term strategic alignment of interest Requires a close relationship with the investor, with fit crucial
Important to vet strategy, governance, mechanisms for conflict resolution and potential exit
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Need to address key man provisions and management time commitments to legacy assets Investor will need to be comfortable with limited governance inherent within GP structure
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Investment Houses
Long standing relationships with high net worth clients who can help capitalize these funds These banks, serving as frequent intermediaries, have access to proprietary deal flow Skillful at corporate finance and complex structuring Examples: Morgan Stanley, Goldman Sachs, Credit Suisse, and UBS Volcker rule will limit participation by banks in the future
Funds are generally stand-alone funds which are a part of a family of funds The advantage of having multiple funds under the same umbrella is in fundraising and underwriting Brand recognition is a huge factor in the investing business Examples: Blackstone, Carlyle, Cerberus, Apollo, Angelo Gordon, and Oaktree
People who head these funds have worked in real estate most of their lives Skilled at raising money Comparative advantage is typically at the property level Examples: Starwood, Lonestar, Westbrook, AEW, Lubert Adler, Walton Street, Colony Capital
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Fund Timeline Most private equity is invested via partnership of a limited duration
Commitments by investors in multiple closings Cash Flows from investors Cash Flows to investors
1 Year Marketing
10 Years
Draw down/Investments Divestments
3 Years
Extension
Follow-on fund
Marketing
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Investment Strategy
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Closed-ended Funds
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Fundraising Statistics
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Fund Size
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Accessing Private Equity Capital Accessing Private Equity Capital Considerations, Process and Timeline
Considerations, Process and Timeline
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Pre-Marketing
Outline objectives Identify major transaction issues Due diligence and underwriting Develop returns analysis Explore structural / financing alternatives Formulate key investment terms
Prepare Teaser Finalize investor list Continue due diligence and prepare other marketing materials/ presentations Begin assembling electronic data room and / or supporting information Develop financial model
Contact / screen potential investors Complete and distribute Teaser Incorporate feedback and refine marketing materials / presentation (and potentially term sheet) as necessary Evaluate cultural fit
Negotiate and execute CAs Finalize and distribute Marketing Materials, financial model and open data room Respond to investor requests/ questions Begin drafting Definitive Agreement Receive proposals
Tier potential investors based on transaction criteria Distribute draft Definitive Agreement Facilitate due diligence process / respond to investor questions Conduct management presentations / site visits (if applicable)
Finalize due diligence Negotiate proposals Negotiate and sign Definitive Agreement Closing / funds transfer
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Management biographies Organizational chart of asset-level management or any employees necessary to manage properties Transaction sourcing strategy Investment committee policies and procedures, if available Industry information / forecasts completed internally or by third parties, including any sub-market studies for each asset Strategy for investing in primary markets / market selection criteria Arial submarket photos, with contributed properties and land for development identified Detail of replacement costs for each submarket (i.e., land, bldg., site, interest, commissions, TIs, design, etc.) Property detail for contributed assets, including address, size, age, physical details, etc. Current rent rolls Property level historical financial information for the past three years Abstracts of all leases Development pipeline and related contracts / documentation Property inspection / asset summary reports
Market Analysis
Property-Level Information
Copies of appraisals, environmental and engineering studies completed within last 2 years
Land surveys and site plans for all properties Copies of title reports Debt schedule, including amount, rate, terms, etc. Supporting debt documentation Copy of standard tenant lease Significant tax information that may adversely impact the company or third parties
Financing Information
Other Documents
Disclosure of any prior or pending litigation related to business dealings generally and portfolio specifically
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Third party lease abstracts, documents and tenant data Review previously provided portfolio financial model Any third party reports on properties Appraisals, environmental, structural, etc. Supporting material used in current offering memorandum provided Any document(s) previously gathered for data room Property photos All property-level Argus data
Teaser Offering memorandum Confidentiality agreements and process documents Contribution agreement LLC agreement
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Equity Investment
Sale of Property
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Construction Period
Distribute Fees (as a % of Total Project Cost) A = 3.00% B = 3.65%
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Return of Equity
Lease-Up Period
Management Fee: $9,000 (in 2011)
24 35
Stabilization Period
Stabilized Management Fee 3% of Gross Effective Rent
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Business Strategy
Quality sponsor
Acquisition v. development
Determine investment strategy (core, core-plus, etc.) Narrow the focus of the transaction, as needed Consider industry trends & fundamentals
Depth of bench
Ability to navigate current market environment Strong relationships
Footprint (major MSAs?) Mix of (re) development / stabilized assets Size and age of portfolio
Upside from new projects brought online? Access to off-marketed deals? Anticipated returns
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Investment Highlights
Premium quality asset portfolio Strong industry fundamentals
Positioning
Simplified management structure
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Motivation
Limited construction financing 3 generations 1031. Recycle capital (not REIT eligible) Need capital for construction or continue to layoff Local sharpshooter A quality MF Friends & family 50%+ asset level returns Development JV
Markets
Investment
Offering
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Teaser Outline
Teaser Overview
3-5 page summary of joint venture investment Provided to interested, potential joint venture partners along with Confidentiality Agreement Enables potential joint venture partners to quickly determine preliminary interest
Teaser Outline
Transaction Overview Corporate Overview
Company History Track Record The Opportunity
Selected Investment Highlights Market Highlights Portfolio Overview Process & Timing Contacts
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Process Alternatives
Process Number of Buyers Confidentiality
Narrow
< 5 investors
Targeted
5 to 20 investors
Broad
> 20 investors
Moderate (risk of leak) Formal and elongated process Complete set of marketing materials prepared and distributed to potential buyers Preliminary term sheets with general transaction terms submitted in a first step
Structure / Process
Straight from Confidentiality Agreement to data room Small group of investors selected to proceed to a close Provides competitive tension to enhance value and optimize JV terms Months
Timing
Fast
3 4
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Unlisted REITs
Fund Managers
Investor
International
Other
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Description of Services
Retainer fee Success fee based on sliding scale Reimbursement of out-of-pocket expenses
Fees
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Understanding The Investors Financial Drivers/ Accessing Private Equity Capital Investment Framework Considerations, Process and Timeline
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Typical Characteristics
Well-diversified, low risk/return strategy Traditional asset classes (i.e. office, retail, industrial, multi-family) in established locations Well occupied and well maintained assets with stable cash flows Generally little or no debt is employed (i.e. up to 30% levered) Income stream represents significant part of expected total return
Moderate risk/return strategy Core-type assets, some of which may require some form of value-add enhancement Assets located in either primary or secondary locations Moderate amount of leverage employed (i.e. up to 55% levered) Moderate to high risk/return strategy Opportunity to add value through operating, re-leasing, and/or redevelopment Leverage employed is higher (i.e. up to 70% levered) Value appreciation comprises significant part of expected total return
Core-Plus
8.5 10%
Value-Add
9.5 13%
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Typical Characteristics
High risk/return strategy Re-positioning of poorly managed, obsolete, and/or vacant assets Acquisitions of entire companies with portfolios of assets and operating platforms in-place New-build development or conversion projects International focus pursing opportunities in established and emerging markets Leverage employed is higher (i.e. over 70% levered) Originate loans at terms which are more aggressive than traditional lenders May contain profit-sharing in addition to higher interest rates and fees charged Acquire 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.
Mezzanine/ Debt
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re = rd + LR*(rp rd)
re required return on levered equity rd return on debt (cost of mortgage debt)
LR leverage ratio rp required return on property without leverage
thereafter
= Value/Equity
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Median IRRs
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Joint Ventures
Two types of partners that combine expertise with capital
Developer/ Operator/Sponsor
Investor
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Source: Real Estate JV Promote Calculations: Catching up with Soft Hurdles, by Stevens Carey
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Hard Hurdles
A 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
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Soft Hurdles
The 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, then
The threshold would be reached Operator would get a predetermined percentage of all profit distributions Catch up if preferred returns are met first In that sense, the soft hurdle would go away
If the profit distributions are not sufficient to achieve the IRR hurdle, then
The 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 threshold
Source: Real Estate JV Promote Calculations: Catching up with Soft Hurdles, by Stevens Carey
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Source: Real Estate JV Promote Calculations: Catching up with Soft Hurdles, by Stevens Carey
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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
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Return Multiples
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Net Multiple
The net multiple return is used by investors to determine how much they have received in cash relative to how much they paid in
It does not take into consideration the timing of capital call-ups and distributions It does provide a good indication of fund performance
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8.0% 10.0% 12.0% 15.0% 17.5% 20.0% 25.0% 30.0% 35.0% 40.0%
3 1.24x 1.31x 1.37x 1.48x 1.58x 1.68x 1.89x 2.12x 2.37x 2.64x
5 1.40x 1.52x 1.65x 1.87x 2.07x 2.29x 2.80x 3.39x 4.09x 4.90x
7 1.56x 1.75x 1.96x 2.33x 2.70x 3.11x 4.12x 5.43x 7.09x 9.19x
10 1.80x 2.12x 2.50x 3.22x 3.98x 4.92x 7.45x 11.18x 16.54x 24.14x
Assumes capital contribution made at time zero and also assumes 8% cash distributions per year
IRR
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JV Waterfall Examples
Typical 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
Cash Flow Waterfall Period Annual Net Cash Flow Year 0 (15,000,000) Year 1 600,000 Year 2 700,000 Year 3 800,000 Year 4 900,000 Year 5 40,750,000
1. Cash flow split pari passu until an IRR of 10% is generated 2. Sponsor receives a 30% promote until a 15% IRR hurdle 3. Sponsor receives a 40% promote until a 20% IRR hurdle 4. Sponsor receives a 50% promote thereafter
1. All cash flow split pari passu until each Member has reached a 10.0% IRR JV Investor (13,500,000) 540,000 JV Sponsor (1,500,000) 60,000
630,000 70,000
720,000 80,000
810,000 90,000
18,197,242 2,021,916
2. JV Sponsor receives a 30.0% promoted interest until the JV Investor receives a 15.0% IRR JV Investor JV Sponsor JV Sponsor 1st Promote- 30.0% 3. JV Sponsor receives a 40.0% promoted interest until the JV Investor receives a 20.0% IRR JV Investor JV Sponsor JV Sponsor 2nd Promote- 40.0% 4. JV Sponsor receives a 50.0% promoted interest on all remaining cash flow JV Investor JV Sponsor JV Sponsor 3rd Promote- 50.0% Total Distributions JV Investor IRR: 20.6% JV Sponsor IRR: 51.5% (1,500,000) 60,000 70,000
(13,500,000)
540,000
630,000
720,000
810,000
29,825,824
80,000
90,000
10,924,176
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JV Waterfall Examples
JV 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
Cash Flow Waterfall Period Annual Net Cash Flow Year 0 (15,000,000) Year 1 600,000 Year 2 700,000 Year 3 800,000 Year 4 900,000 Year 5 40,750,000
1. Cash flow split pari passu until an IRR of 10% is generated 2. Sponsor receives a 30% promote until a 15% IRR hurdle 3. Sponsor receives a 40% promote until a 20% IRR and a 2.50x equity multiple 4. Sponsor receives a 50% promote thereafter
1. All cash flow split pari passu until each Member has reached a 10.0% IRR JV Investor (13,500,000) 540,000 JV Sponsor (1,500,000) 60,000
630,000 70,000
720,000 80,000
810,000 90,000
18,197,242 2,021,916
2. JV Sponsor receives a 30.0% promoted interest until the JV Investor receives a 15.0% IRR JV Investor JV Sponsor JV Sponsor 1st Promote- 30.0% -
3. JV Sponsor receives a 40.0% promoted interest until the JV Investor receives a 20.0% IRR and a minimum 2.50x equity multiple JV Investor 6,867,663 JV Sponsor 763,074 JV Sponsor 2nd Promote- 40.0% / 2.50x equity multiple 5,087,158 4. JV Sponsor receives a 50.0% promoted interest on all remaining cash flow JV Investor JV Sponsor JV Sponsor 3rd Promote- 50.0% Total Distributions JV Investor IRR: 20.7% JV Sponsor IRR: 51.0% (1,500,000) 60,000 70,000 80,000 90,000 10,762,938
(13,500,000)
540,000
630,000
720,000
810,000
29,987,062
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JV Waterfall Examples
Preferred 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
Cash Flow Waterfall Period Annual Net Cash Flow Year 0 (15,000,000) Year 1 600,000 Year 2 700,000 Year 3 800,000 Year 4 900,000 Year 5 40,750,000
1. JV Investor receives a 12% preferred return 2. Sponsor gets a catch up (receives all cash flow) until a 12% IRR is reached 3. All remaining cash flow is split 50%/50%
1. JV Investor receives all cash flow until a 12.0% IRR JV Investor (13,500,000) JV Sponsor (1,500,000) 2. JV Sponsor receives all cash flow until a 12.0% IRR JV Investor JV Sponsor 3. All remaining cash flow is split 50.0% / 50.0% JV Investor JV Sponsor Total Distributions JV Investor IRR: 20.0% JV Sponsor IRR: 51.1% (1,500,000)
600,000 -
700,000 -
800,000 -
900,000 -
19,792,141 -
2,642,214
9,157,822 9,157,822
(13,500,000)
600,000
700,000
800,000
900,000
28,949,963
11,800,037
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JV Waterfall Examples
Cash 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 predetermined split
Cash Flow Waterfall Period Annual Net Cash Flow Year 0 (15,000,000) Year 1 600,000 Year 2 700,000 Year 3 800,000 Year 4 900,000 Year 5 40,750,000
1. Cash flow split pari passu until all invested capital is returned 2. All remaining cash flow is split 65%/35% in favor of the Sponsor
1. All cash flow split pari passu until invested capital is returned JV Investor (13,500,000) 540,000 JV Sponsor (1,500,000) 60,000 2. All remaining cash flow is split 65.0%/35.0% in favor of the JV Sponsor JV Investor JV Sponsor Total Distributions JV Investor IRR: 20.4% JV Sponsor IRR: 52.4% (1,500,000) 60,000
630,000 70,000
720,000 80,000
810,000 90,000
10,800,000 1,200,000
18,687,500 10,062,500
(13,500,000)
540,000
630,000
720,000
810,000
29,487,500
70,000
80,000
90,000
11,262,500
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JV Waterfall Examples
Each scenario produces similar returns
IRRs ranging from 20.03% to 20.74% for the Investor and 51.05% and 52.41% for the Sponsor Equity Multiples ranging from 2.37x and 2.42x for the Investor and 7.38x and 7.87x for the Sponsor Profit ranging from $18.45m to $19.19m for the Investor and $9.56m and $10.30m for the Sponsor
Return Summary JV Promote Structure JV Investor Returns Net Profit Levered IRR Equity Multiple Profit % Split JV Sponsor Returns Net Profit Levered IRR Equity Multiple Profit % Split JV Promote Structure with Preferred Return with Catch Profit Split After Return of min. Equity Multiple up to Sponsor Capital
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In addition to their promote, fund sponsors also receive an annual management fee
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