Private Equity Real Estate Deal Considerations

More than ever, individual accredited investors are looking to real estate to balance their portfolio or diversify their investment portfolio.  As accredited investors begin to analyze where and what to invest in, it is important for investors to consider every facet of an investment before choosing to make an investment.  Most knowledge in real estate investing comes through experience, which is tough to replicate.  In this real estate investing educational series, we are going to explore how deals are commonly structured and analyze some of the pitfalls that real estate investors encounter when making real estate investments. 

First, let’s discuss how private real estate deals are typically structured and then lay out some considerations and hot topics that investors should look at before making an investment.  At a high level, real estate investing is made through limited liability companies or LLCs.  LLCs are the most common form of commercial real estate ownership on syndicated private equity real estate investments in the U.S. so it is most likely that accredited investors will be indirectly investing in a real estate transaction through an LLC.  It’s very typical in an organizational structure for there to be at least two entities with direct and indirect ownership in a real estate investment.  Usually, there is a property owner LLC that holds legal title to the property.  Most lenders require a special purpose entity or SPE to hold title to the land.  The reason for this can get complicated, however, it’s setup up this way so that it’s bankruptcy remote.  This is done so that if the sponsor of the real estate investment goes bankrupt, the real estate asset is isolated from the bankruptcy proceedings of the corporate entities.  In addition to the property owner LLC, there is usually a holding company LLC which is where the accredited investors usually invest.  The holding company LLC is typically the sole member of the property owner LLC; in other words, the property owner LLC is the direct investor in the property and the holding company owner LLC is the direct investor in the property owner LLC.  This additional layer provides protections to the accredited investors and is typically a necessary and desirable structuring mechanism.  An organizational chart will layout how ownership is held and will describe which entity the accredited investors are investing in.

While it is important to understand the overall structure of the investment, the organizational chart becomes easier to understand after reviewing a few deals.  The time spent on the organizational chart becomes relatively small compared to the due diligence and analysis needed on the accompanying documents.  In a private equity real estate deal, there are several documents that are provided to accredited investors as part of the investment offering.  These documents include the Investor Marketing Presentation (investment book, deal book, marketing deck are all synonymous with Investor Marketing Presentation), the Private Placement Memorandum, or PPM, the Operating Agreement for the holding company LLC and property owner LLC, the Subscription Agreement, and any pro forma/deal underwriting data that typically comes in a Microsoft Excel file.  Please keep in mind that there may be other important due diligence materials that directly apply to the underlying deal that are not included in this list.  It is important to ask the real estate sponsor certain follow up questions while reviewing a particular deal which we will touch on in the conclusion of this educational piece.  The five preceding documents are the cornerstone of any properly structured private equity real estate deal and should be reviewed carefully.  Here are some things to consider for each of them:

• Investor Marketing Presentation & Pro Forma: The investor marketing presentation is usually the first document that potential investors look at to understand the investment opportunity and gather facts and understand the business plan for a certain real estate investment. It’s a good idea for every investor to start here in order to formulate their initial level of interest on a particular investment.  Most investors are searching for investments that match their investment objective; whether it be fixed income, growth, stability, or high growth. It’s important to try to categorize where the investment sits along the risk spectrum while analyzing the investor marketing presentation.  Some investors spend too much time looking at a real estate investment that does not fit their investment objective so it’s important to do a high level analysis first before spending time on other documents. This is like the speed dating phase where investors should interview the investment compared to their investment objective.  If the stars are not aligning, it’s best to stop reviewing and move on to a better match.  All investor marketing presentations present the best virtues of a particular investment so it’s important to retain some skepticism and not let any bias cloud the objective analysis of a particular deal.  There are always risk factors beneath the surface that need to be understood.  At Pierside Capital, we start our analysis by asking these questions:
  • Are they paying a fair price for this investment?Do the rent and sales comps match their assumptions in the pro forma?Does the business plan seem feasible? What are the odds that the sponsor can execute on the business plan?Do I like the location of this real estate investment?What are the local economic drivers in the area?  Are they temporarily inflated or are there long-term benefits to the underlying economic drivers?Is the investment over-leveraged?  In other words, is there too much debt on the property?  Remember that higher levels of debt = higher riskWhat other risk factors are specific to this investment?  For example, if it is a real estate development deal, do they have the necessary municipal approvals to do whatever the business plan calls for?  If not, what is the likelihood that it gets done?Are the people putting this deal together also investing their own capital into the deal?Are the forward looking assumptions that the sponsor is using reasonable? 
  • If this investment fails for whatever reason, am I okay losing my entire investment?

These are just a few questions that we go through during our analysis and many more often come up through our iterative process.  If it’s a local investment that we can drive to we typically take time to walk the site with a representative of the sponsor group to better understand the neighborhood and business plan.  We often learn things about the property that we didn’t know or couldn’t discover by simply reading an investor presentation.  For newer investors, it makes sense to first invest in markets or asset types that they are familiar with.  For example, let’s say that you own an investment property in Scottsdale, Arizona.  A single family residence that you rent out to a family.  You manage it yourself so you have some knowledge around how they operate.  There is a mortgage payment involved, you sort of know how the rental market moves, you do some routine maintenance every year.  These operations can be extrapolated to multifamily investments.  They operate in a similar way so you have a knowledge base to benchmark certain assumptions.  We find that many investors run into problems when they invest in asset types they don’t know or understand and have no basis to ask the right questions.  They end up making an investment they have not properly handicapped and are surprised when the outcomes don’t match what was pitched because they did not ask the right questions or set their expectations too high. Remember, higher targeted returns usually means higher degree of risk.

• Private Placement Memorandum:  In most cases, real estate sponsors hire an attorney to prepare the Private Placement Memorandum, or PPM, which is also known as a risk disclosure document.  It is best practice for real estate sponsors to create this document and distribute to potential investors once an investor indicates some level of interest in making an investment.  These documents are considered confidential and should be treated as such.  The purpose of the PPM is to outline the deal in writing for an investor. The document is meant to further educate the accredited investors on the key risk factors that the investors encounter on a particular deal.  It should also outline the business plan, introduce the key decision makers within the real estate sponsor group, and highlight conflicts of interest between the real estate sponsor and the accredited investors.  It is very common for this document to be in excess of two hundred pages.  These documents are crafted by securities law attorneys so the language is dense and should be reviewed thoroughly before making an investment.  While some of the material can be boilerplate legal language, all of the business plan, sponsor info, and conflicts of interest section are customized for the specific transaction at hand.  At Pierside Capital, we ask these following questions when reviewing PPMs:
  • Does the business plan outlined in the PPM match with the Investor Marketing Presentation?Do the noted risk factors seem to be difficult to overcome or likely to occur thus negatively impacting this investment?Who are the key decision makers and are they capable of knowing what to do if things don’t turn out as planned?What is the biggest risk we face?What is the most likely risk to occur and is this risk mitigated?Do the sponsors have adequate levels of investment in the deal?Are the fees too high?Is the sponsor receiving proper compensation (once the investment is realized)?
  • Are there certain conflicts of interest that seem out of place?

We cannot state that any one section of the PPM is more important than the other.  Every investor will need to review the document in its entirety before making an investment decision, however, certain investors choose to focus on different elements before arriving at a decision to invest.  Some investors have hot button issues that they focus on or certain deal points that will lead the investor to say “no” to a certain investment.  Often, investors focus in on the fee structure, which is a very important consideration.  A real estate sponsor is in the business of acquiring, operating, and disposing of real estate investments so they need to earn fees in order to stay in business.  The question usually boils down to a comfort level for a certain investor.  Some investors may be okay with higher management fees or a profit participation that is skewed toward the sponsor especially if the sponsor has had a lot of success in a particular investment strategy.  For example, companies that are large with long track records typically have fees that are more in their favor.  They have the experience and they have the ability to demand higher fees because the demand for their product is higher.  One major pitfall to review is to make sure that the real estate sponsor is not making all of their fees in the early part of the investment life cycle.  It’s important to ensure that they continue to pay attention to the investment they are managing.  If they have no incentive to produce (due to no fees at the end of the investment cycle) they may have less desire to work hard to achieve those goals.  Keep in mind that real estate sponsors have a fiduciary duty to their investors so the mandate is that they act in an investors’ best interest, however, fees can be a big incentive to produce so it’s important to make sure that the investors interests are aligned with the real estate sponsor.

• Operating Agreement: The operating agreement for the holding company LLC is typically the most operative document.  The purpose of the operating agreement is to outline the rights and duties of the management and the members of the company.  Remember, the holding company LLC is the indirect owner of the property.  Upon making an investment in an LLC, each investor becomes a member of the LLC.  The members of the company usually have certain rights in choosing who manages the affairs of the company.  The operating agreement will also layout the fees to the manager which the members, by signing the Subsription Agreement, expressly approve.  In the case of any ambiguity between all of the documents, the operating agreement will control.  So, it’s important to review the operating agreement for how the business is managed.  The PPM is supposed to summarize the operating agreement but may not fully describe all of the terms of the operating agreement so this document needs to be reviewed carefully.  Depending on the complexity of the transaction, the operating agreement can be equally as complicated as the PPM.  Here are some things we consider at Pierside Capital:
  • Can the Manager be removed without cause and what is the threshold for removal?Do the fees seem reasonable based on the level of work performed?Are there any special provisions of the agreement that seem onerous?Is there a finite term of the entity and agreement?How many members are required to consummate an amendment to the operating agreement?Do amendments need lender approval?Do the terms of the waterfall match what is stated in the Investor Marketing Presentation and PPM?  Discrepancies should be investigated and clarifiedIf a capital call is needed, are they voluntary or mandatory?
  • In the case of a capital call, do non-contributing members face dilution?  How is dilution calculated i.e. based off what valuation

As previously stated, operating agreements can be complex and are always tailored to the specific transaction at hand.  Keep in mind that the real estate sponsors have paid an attorney to draft the operating agreement per their instructions and cost so there is no one representing the potential investors when the operating agreement was drafted.  Depending on the deal and sponsor, sometimes investors can ask that their investment be conditioned on a modification to the operating agreement.  These modifications can be difficult to get for the average accredited investor.  We see side letter agreements between investors and sponsors on occasion.  The most common modification that accredited investors ask for is a fee break in their favor.  The larger the investment you are bringing to the table, the more leverage an investor has in the negotiation so the larger investors could end up with slightly better deals vs. the average accredited investor.  It’s okay to ask if there are any side letter agreements with any other investors.  It’s also okay to ask for a modification but you may not get it.  As we say at Pierside Capital, the answer is always “no” if you don’t ask.

• Subscription Agreement: The subscription agreement is the document an investor signs to subscribe to a particular investment.  This agreement is ubiquitous in the private equity real estate investment world.  So, if you choose to make an investment in real estate private equity, the odds are that you will be signing a subscription agreement before you send in your investment.  Subscription Agreements are fairly standardized but can contain special provisions that you want to thoroughly review.  When an investor subscribes to an investment, they are then bound by the Operating Agreement and both parties (the sponsor and new member) make certain representations.  In exchange for the capital investment, members receive membership units in the investment vehicle.  Often times, there are certain restrictions on transfer or sale of the membership interests.  These restrictions can be governed by securities laws and by the Subscription Agreement or Operating Agreement.  It’s important to note that private real estate equity transactions are illiquid investments and there is not an established market for the exchange of membership interests into cash.

While there are several pitfalls that private equity real estate investors face, with experience comes knowledge and the more deals that investors review before making a decision, the better off they will likely become.  The industry terms and jargon can be confusing and somewhat overwhelming initially but they start to become like a second language after some practice and light reading of the corresponding presentations, PPMs, and Operating Agreements.  Through our experience in the private real estate equity world, we have gained this knowledge through many hours of review and investing practice.  Feel free to reach out to us through the Contact Us page if you have any questions on any of the topics contained in this educational piece.

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