Raising equity capital is one of the most essential functions of a real estate investment and development firm. Many smaller and mid-sized real estate firms are structured with a main operating entity and various affiliate limited partnerships and limited liability companies that own the real estate assets and contain equity investments from various investor groups. An affiliate of the operating company is usually the general partner or managing member of these investment entities.
The operating entity is usually the face of the operation and family or entrepreneurially owned. Even though there is plenty of capital in today’s hot real estate market, raising equity capital for smaller and mid-sized companies is a very arduous task. It is usually done on a deal-by-deal basis in the affiliated flow-through entities that own the individual properties. For example, an established medium sized West Coast-based CRE investment firm may have twenty-five or more different affiliated partnerships and limited liability companies that own CRE assets valued at $300 million, with an aggregate of $200 million in debt and $100 million in equity . The general partner or managing member of these entities and the operating company have to manage over time, twenty-five separate mortgages, equity offerings, private placement memorandums, partnership agreements, subscription agreements, etc. If the average equity investment is $250,000, then there are 400 separate investors in the twenty-five deals.
The question many of these smaller and mid-sized real estate firms need to ponder as their business grows, is when does it make sense to start raising equity capital in a fund structure versus one deal at a time? A fund structure for equity capital is more efficient, less costly in terms of fees, documentation and legal costs and quicker to complete. Raising equity capital for twenty-five different projects one at a time may also lead to lost investment opportunities due to the inability of the general partner to raise the required equity capital quickly enough, to take advantage of good deals that require a quick close. If the general partner had a fund with a $100 million equity raise it could have placed all the properties in the fund within a one to two-year timeframe versus the six to ten years, it may take to accumulate twenty-five separate real estate deals .
Gravitating to a fund structure is also no easy task and as with any investment program, the first one is always the most difficult. However, the benefits far outweigh the costs for any experienced real estate investment firm. The primary concern with a fund structure is who will sell the equity in the fund. Most CRE private placement funds cater to accredited investors only that include high net worth individuals, pension plans, endowments, registered investment advisors and wealth managers. Accredited investors are investors who have a minimum annual income of $200,000 ($300,000 if a joint investment) or a net worth of at least $1 million excluding the investor’s primary residence. Most firms will need to hire an experienced securities firm, broker-dealer or other placement agent to market units in the fund and the fee for this service is typically 5%-7% of the fund equity raised. There are also many independent broker-dealers and real estate brokerage firms that act as placement agents for third-party funds.
The next critical issue is the unit size of the offering. Unit sizes depend on the type of investor in the fund. If predominantly individuals, then $100,000 per unit is common. If the fund targets more institutions, then $250,000 per unit or more is commonplace. The next critical issue is what is the investment strategy for the fund? For example, will the fund invest in one class of property like apartments or will it be diversified over the four primary CRE sectors of office, retail, apartments and industrial. Will the fund engage in development or invest in niche CRE sectors like self-storage, manufactured housing or senior living? In addition, will the fund’s investments be diversified geographically and by industry? This is critical and a way to reduce portfolio risk. For example, a fund that acquires office properties in No. California and Silicon Valley is not diversified by property type, geography and industry. The technology industry is the economic engine for these areas and any downturn in the industry will be devastating to the portfolio. The sponsor or general partner of the fund will also have to determine any fees or compensation from the fund, the investor’s preferred return and ownership interests.
Many private placements have an upfront fee to the sponsor of 1%-2% for organizing the private placement, finding the properties for acquisition and arranging the property financing. There is also an annual asset management fee of .5%-1.5% of the equity raised to manage the fund. The asset management fee is paid quarterly. The investors will typically receive an annual preferred return of 5%-10% on their capital and 70%-80% ownership of the fund. The sponsor or general partner will receive a carried interest of 20%-30% and will also be required to invest some cash equity of .5%-5% of the equity offering. The sponsor’s equity investment is required to align its interests more closely with the investors and to have some capital, albeit small, at risk. Raising capital in a fund structure for the growing medium sized CRE investment firm is a key step in the evolution of the firm into a more institutionally oriented investor.
Joseph J. Ori is Executive Managing Director of Paramount Capital Corporation.