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:
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.
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.
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