What comes to mind when you think of institutional investment in real estate? Speculative investment, student housing, or U+2? Well you might have to think again.
In the next 5 years we’ll see a new type of institutional investor entering the picture: Private Equity firms.
In this post we’ll explore how private equity firms are becoming a major player in the residential commercial real estate market
how those architects who want to attract institutional investors should start adapting their strategies today. So let’s begin…
What is Private Equity?
First a short introduction to what private equity is, what kinds there are and how they differ.
If you want to dig deeper into the topic there are some great sources out there that give a more in-depth explanation (1,2).
This post will provide a high level overview though.
So first off: What is private equity? Well, think of it as the money you use to buy your house or your car:
All private funds come from investors and in return for their money investors receive an ownership share called equity (3).
Now, before you ask: Yes, private equity is different from a bank loan.
Instead of a bank giving you money, private equity invests in real estate projects and companies that they expect will generate cash flow and profit.
This means that their money is tied up for a long time until the investment shows results.
And what makes it even more different?
Whereas banks lend you your house or car as soon as possible
(sometimes even at a lower rate than when you actually get them),
private equity investors expect to wait years before they get their money out of the investment (3).
That’s why they are called ‘patient investors’.
Let’s just say that the life of private equity can be compared with the life of a restaurant:
while it might take years before you get your money back,
the investment will probably produce a profit over those 10-15 years.
So who are these private equity investors and how many of them are there? In the U.S. alone there are around 100,000 private equity firms
which have raised $1.9 trillion in funds since 1980 (5).
Now larger funds such as Blackstone ($115 billion) still dominate the market but we’re seeing more and more smaller firms enter and establish their own influence on this market. And this trend is expected to continue.
What will these private equity firms invest in?
If we compare the investment strategies of private equity with those of real estate developers then the similarities are striking.
Almost every institutional real estate investor looks for the same return on investment goals and values:
a 20% internal rate of return (IRR) and a company that can generate cash flow.
In fact, many investors are even willing to accept a lower IRR as long as they can get higher cash flow.
And how do they know if a project will generate cash flow? Well, most private equity investors use their own proprietary valuation models to assess projects before investing (3).
And, just like real estate developers have their networks of contacts to find out which properties are up for auction,
private equity firms have their own networks to find out which companies and projects are in need of money (6).
So where do these investors look for opportunities?
Well, it’s no surprise that some private equity firms look for real estate investment opportunities in the same cities as traditional institutional investors.
For example 70% of real estate deals with a value of between $50 million to $200 million happen in metropolitan areas (7).
This is why we see so many high-level executives coming from these finance centers such as New York, Los Angeles or London.
But while most private equity firms follow the same strategy as their institutional investors, they are still trying to differentiate themselves.
In fact, the average size of their deals is around $60 million (8). https://fabulousstory.com/
Why are Private Equity Firms Investing in Real Estate?
There are two main reasons why private equity firms start investing in real estate: The first reason is simple: because it allows them to diversify risk and profit (4).
The second reason, and probably more important, is that they can lock in a long term investment with the least amount of risk (6).
How? Well, real estate provides predictable returns: Unlike the stock market
they don’t have to worry about their investment crashing and burning if an emerging economic crisis suddenly occurs.
In fact, according to a report by JLL real estate prices are expected to rise over the next 10 years in most major world cities (9).
So we can see why private equity firms might be attracted to this industry.