Today’s real estate market holds win-win opportunities for both private equity and closely held property owners. As with any business arrangement, however, successful partnering requires that both types of entities understand the nuances of their agreement up front. Here’s what to keep in mind to ensure a mutually profitable outcome.
Potential Co-Investing Benefits
In the tight markets reflected by today’s escalating prices, family-owned entities often are not willing (or able) to purchase, manage, and develop real estate properties entirely on their own. In addition, as a result of the current lending environment, in which the minimum cash down requirements have been increasing, alternative investment and financing arrangements are becoming more attractive.
Flush with cash, private equity investors have found that real estate investment in the right markets can yield solid returns. Increased demand, particularly in major metropolitan areas, has raised overall real estate values, triggering stiff competition and bidding wars. Such market characteristics offer private equity multiple ways to participate. They can joint venture with experienced real estate developers and expand their portfolios to include marquee assets, which carry prestige as well as potentially handsome returns. Private equity firms can also choose to be a lender and/or equity partner to other real estate operators. Arrangements such as bridge and mezzanine loans often include quicker lending cycles and less restrictive covenants to secure plum deals.
Critical Areas to Navigate
Market forces are never entirely predictable, but these kinds of partnerships are more likely to succeed when both parties conduct thorough due diligence at the outset. Closely held property owners and private equity can begin by focusing on several critical areas.
Asset Management Decision-maker
Both parties should understand up front who makes the asset management decisions that determine what happens with typical revenue streams such as leasing commissions and development and management fees.
In practical terms, both parties should be fully aware of the private equity firm’s objectives. Closely held entities should define their own exit strategy—for example, whether they will exit any arrangement alongside everyone else or, if certain clauses are triggered, buy the other parties out.
Period of Ownership
All participants should also be clear on the length of the investment period. Many private equity funds must generate frequent payouts to attract new investors. With a continuing need to deploy cash, private equity typically holds assets for shorter periods, turns them over, and then invests in new assets. Closely held entities that tend to hold investments for the long term should be aware of private equity’s more accelerated exit strategies.
Required Return on Investment
Both parties further benefit from clearly understanding the required return on investment. As a starting point, a closely held company should analyze the private equity’s investment strategy. Is it long or short term? What returns have investors been promised? The asset types will determine the answers.
Investors who have historically sought steady cash flow from value-added investments, invest for longer periods in lower-risk properties. By contrast, private equity firms seeking high returns are more likely to invest in underperforming properties that can be quickly reorganized and resold.
Similarly, the investment objective will dictate the tenant arrangement. Retail, residential, hotel, and office leases all yield varying cash flows and expected returns. The investors’ preferred income stream will ultimately determine the leasing arrangement.
Companies should also assess whether they have the personnel to address any shifts in leasing and property management needs that result from these new tenants and rental terms.
Closely held companies partnering with private equity should also recognize that they will be taking on far greater administrative responsibilities, especially in the first year. These include quarterly, and even monthly, financial reporting, with strict deadlines akin to those faced by public companies.
These companies should avoid the mistake of assuming internal departments will be up to this task, especially if they already oversee multiple properties involved. An honest assessment of the company’s accounting and reporting systems and controls should be performed well beforehand when contemplating investing with a private equity partner.
Investors’ need for the appropriate reporting will be driven by their own audit and tax filing requirements on multiple underlying entities. Companies should therefore have high confidence in their ability to navigate these more onerous reporting requirements before proceeding with any deal.
Due Diligence is Key
As is true in most industries, successful real estate transactions hinge on both parties performing the appropriate due diligence up front.
Companies need to understand what the private equity partner requires. They should review the private equity firm’s previous deals, find out how they treated their partners, what restrictions they may have placed on them, and, most critically, if they lived up to their word.
For its part, private equity should thoroughly review the potential of the closely held company, including the types of returns typically generated, and the tenants they are able to attract. They should fully assess operations, personnel, and the organization’s capability to accommodate any new obligations the partnership will require.
Where questions arise—transfer tax issues, deferral of gain, for example—a trusted business adviser can guide both parties toward achieving their desired outcomes. By assessing all aspects of the union, including the potential benefits and pitfalls, both parties can ensure that any deal is a win-win for all.