How do Commercial Real Estate Funds Generate Returns for Investors?

This week Real Estate 360 takes a deep dive into the ways real estate equity funds generate returns. These funds are an alternative investment option that allows individual investors to purchase shares representing a passive, fractional stake in the ownership of real estate projects managed by investment professionals.

Private real estate funds are not listed for trading on a public stock exchange, as opposed to public real estate investment trusts. The value of the shares in a private real estate fund do not fluctuate based on trading activity, as can occur with publicly traded securities. Private real estate funds’ shares are also illiquid and not easily sold to convert to cash; these funds may be suitable for those with longer-term investment horizons.

Passive investment in real estate funds requires a fund manager to act as a fiduciary in actively selecting and managing the fund’s assets on behalf of the fund’s investors. This gives investors access to professionally managed real estate without the commitment of personally collecting the rents and repairing a leaky roof. Investing in a real estate fund makes the asset class more accessible to a larger number of investors who may not possess resources, experience, or capital to acquire and manage real estate themselves.

So how do commercial real estate funds aim to generate returns to investors? Fund managers use investor capital to purchase properties at or below their intrinsic value or replacement cost and generate returns by operating the property efficiently to produce cash flow, investing in improvements to increase the value of the property, or commonly, a combination of both.

These objectives may translate to realized returns for real estate investors through two components:

1. Operating Distributions – distributions to investors from operating cash flow generated by the fund’s real estate investments. This is tied to the ability of the fund manager to keep properties well-occupied, maintain or increase rental rates, and reduce costs to generate cash flow in excess of any debt service.
2. Capital Appreciation – the return on invested capital resulting from the growth in value of the fund’s investments relative to the amount of capital used to purchase and improve the real estate. Appreciation returns may be “unrealized” (in the gain or loss position) throughout the term of the investment or fund; the position becomes “realized” (i.e. paid) to investors upon the sale of an investment or the full liquidation of the fund at the end of its term.

These two components of returns can be significantly interrelated. For example, a general approach to valuing real estate is based on its projected income stream. Cash flow growth contributes to capital appreciation. Similarly, activities focused on capital appreciation, such as making physical improvements or rebranding, can also support leasing objectives and reduce operating costs, which contributes to cash flow growth.

The investment objectives of different funds may place more emphasis on one return component over the other. A fund specializing in stabilized properties, often called core properties, with in-place cash flow may intend to generate the majority of its returns to shareholders from operating distributions; whereas a fund specializing in ground-up development, often called opportunistic properties, may have no free cash flow for years during construction and will generally place more emphasis on capital appreciation. Value-add funds fall somewhere in the middle of this spectrum, focusing on both capital appreciation and operating distributions.

The type of fund and its respective emphases on operating distributions and capital appreciation may also [influence] the return metrics used to evaluate the fund’s performance targets and results.

• Equity Multiple: the measure of total dollars generated on an investment relative to the amount that was invested. For example, an investment would break-even at a 1.0x multiple (i.e. returned 100% of invested capital), whereas a 2.0x or 3.0x multiple would mean the investment’s earnings doubled or tripled what was invested (i.e. returned 200% or 300% of invested capital). The equity multiple calculation is a nominal measure of total profit and does not consider the time value of money.
• Internal Rate of Return (IRR): the annualized rate of return generated on an investment over its hold period. An IRR differs from an equity multiple calculation as it is time-weighted, accounting for the time value of money. Maybe you’ve heard the old adage, “a dollar today is better than a dollar tomorrow.” To illustrate this concept, imagine investing $10,000 each in two different investments. Both return $20,000, but one does so over 5 years and the other over 10 years. Although both achieve $10,000 profit and 2.0x multiple, the 5-year investment would have a higher annualized Internal Rate of Return because the return was achieved faster. Both equity multiple returns and IRRs are inclusive of all cash flows from the start to end of the investment, including the initial equity invested, any operating distributions or additional equity investments during the hold period, and capital event distributions, sometimes referred to as “non-operating distributions,” such as proceeds from sale, liquidation or refinance.
• Distribution Yield (also referred to as a Cash-on-Cash Return): the cash flow received in the form of annual operating distributions as a percent of the amount that was invested. The distribution yield only accounts for operating distributions issued during the investment term from ordinary operations (i.e. dividends), and does not account for capital event distributions. For example, an investment of $100,000 that earns $5,000 in distributions per year would produce a 5% annual distribution yield. The distribution yield can vary from year to year, and often does in the case of equity investments such as real estate funds.

Return metrics are applied to typical fund strategies, which is where these two concepts begin to come together:

An opportunistic or development fund which purchases unimproved land to develop and promptly sell after completion typically favors an IRR target, and likely an equity multiple as well. It is uncommon for such a fund to reference a distribution yield since the intent is to sell the asset post-completion rather than operate the property for an extended term. Opportunistic-type funds, such as development funds, generally target the upper range of IRRs seen in the market because they aim to significantly improve the property and achieve an outsized return on invested capital based on the sale of the improved property over a short investment period. Of course, higher returns are associated with higher risk, as typified by development funds. Fund managers of development funds look to shorten asset hold periods not only to increase IRR, but to limit risk of changing market conditions before selling the property.

Conversely, a core fund which purchases well-occupied assets with the objective of operating the properties to generate steady cash flows may emphasize a distribution yield, because it intends to produce the majority of its returns from continued operational cash flow over a longer investment period, rather than from capital appreciation on sale. Stable asset strategies fall on the lower range of the risk-return spectrum.

A value-add fund sits somewhere in between opportunistic and core on the risk-return spectrum. Value-add funds are likely to favor both IRR and equity multiple targets on a medium-term investment horizon and may also target an “as stabilized” distribution yield. The objective of value-add funds is both capital appreciation and operating distributions, so the business plan usually consists of improving the quality of the property in the earlier years of ownership to support leasing initiatives and stabilized operations in the following years. Since the years pre-stabilization often have low or zero operating distributions, a distribution yield may instead be quoted “as stabilized.”

When evaluating an investment opportunity, there are many considerations, especially when deciding how to allocate capital within your portfolio. Understanding how potential returns correlated with an investment strategy might influence planning to obtain financial goals.