The Real Estate Private Equity Business Model Explained

Private equity is a really attractive place to be for young real estate professionals, but if you haven’t been in this business before, it can feel kind of like a black box as far as what’s going on behind the scenes.

Real estate private equity firms control a lot of the capital in this industry, and if you want to work in commercial real estate, you’re likely going to be working for or with a company that raises equity to fund their deals.

So in this post, we’ll pull back the curtain on how the real estate private equity business model actually works, and how this ecosystem comes together to help companies (and individuals) acquire and develop commercial properties.

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What Is Real Estate Private Equity?

Real estate private equity essentially refers to any company that invests in real estate and raises third-party equity capital to fund their transactions.

A very small number of real estate firms use only in-house capital to fund their deals, but in the vast majority of cases, real estate investment and development firms will raise money from investors to acquire or develop commercial assets.

And among real estate private equity firms, there are two separate categories that these companies will fall into: the general partner (or GP), and the limited partner (or LP).

General Partners (GPs)

Commercial real estate investment and development firms that are on the front lines of doing deals (sourcing investment opportunities, buying properties, and managing the business plans of their investments) are referred to as the general partner (GP) on a deal or fund. This is the active partner on the deal, that’s responsible for doing most or all of the legwork.

Limited Partners (LPs)

GPs will often raise equity from bigger private equity firms that act as the limited partner (or LP) on a deal, and serve as the main equity contributors. While these firms contribute most of the capital required, they typically don’t contribute to any of the day-to-day responsibilities associated with managing an investment.

LPs will also typically raise their capital from outside sources, effectively creating a third layer of funding in these investments. These firms often look to capital sources like pension funds, sovereign wealth funds, or university endowments for capital, and then deploy that capital on behalf of these institutions.

Putting It All Together

Putting all of this together, an example of this might look like a small investment firm buying a $50 million industrial property in San Francisco, California acting as the GP. This firm would typically reach out to a major private equity firm to fund the deal in the LP position, and provide the majority of the equity required to close on the transaction. From there, that major private equity firm will often fund the deal with capital that was previously raised from other capital sources, like pension funds or endowments.

Partnership Fees

Once we have an idea of the players in this part of the industry, we also need to understand how these deals work from a financial perspective, because this is really where incentives start to come into play.

To start, there are typically fees a GP will charge an LP in exchange for finding and managing a deal, usually in the form of:

1. Acquisition fees – These typically fall somewhere between about 1-2% of the purchase price of a property.
2. Construction management fees – These usually come in at anywhere from about ~4%-8% of total construction costs.
3. Asset management fees – These usually come in at ~1%-2% of the effective gross revenue generated by a property.
4. Disposition fees – These usually come in at ~1%-2% of the sale price of the deal.

Because these are paid out as percentages, a lot of real estate firms will look to buy the biggest deals they can to maximize fees generated on each transaction. For example, on a $100 million deal with a 1% acquisition fee, that acquisition fee alone would be $1 million. If this property also generated $10 million per year in revenue with an asset management fee of 1%, this would produce an additional $100,000 per year in recurring fee income.

Promoted Interest

Where these numbers really get big is on the back end of a deal, where the GP is often able to participate in a percentage of the profits over and above their initial equity investment. This is referred to in the industry as promoted interest.

How Promoted Interest Works

Promoted interest is generated when the LP on a deal exceeds what’s referred to as a preferred return, which is usually related to a target IRR or equity multiple. When the preferred return is exceeded, the GP will then be allocated a larger portion of all cash flows generated above that preferred return figure. In these scenarios, promoted interest will be earned by the GP, regardless of how much capital they initially invested in the deal.

The Double Promote

From there, the cash flows generated by the LP are then often subject to similar promoted interest structures agreed to by their capital partners when they initially raised these funds, which creates what’s often referred to as a “double promote” structure. In these cases, there are two layers of promoted interest that two different parties earn, and this is one of the biggest incentives for real estate private equity firms to invest in real estate.

Why Don’t Pension Funds Invest Directly?

You might be wondering why these pension funds or sovereign wealth funds don’t make these investments themselves, and in the vast majority of cases, this is because these organizations don’t have the internal teams necessary to run this entire process.

In many cases, real estate allocations for these groups will only be between ~5%-15% of their total portfolio value, so this sector doesn’t tend to be a huge focal point for these organizations. Instead, they’ll choose to outsource this to professional real estate investors to place capital for them, who then either invest that capital directly in real estate or invest alongside an active general partner.

This ultimately means that in a lot of cases, real estate private equity is investing on behalf of teachers, firefighters, police officers, and other government workers who are relying on a pension to fund their retirement. This need to provide income to long-term employees is ultimately what sets these real estate investments in motion on such a large scale, and what drives many of the return targets that are set on these deals.

Now, there are different levels to this, and there are many companies out there that choose to remain small and raise capital only from friends and family, so “real estate private equity” doesn’t necessarily mean a company is big by default. But regardless of the size of the firms involved, this industry is driven by an investor’s need for income and capital growth, and the fees and promoted interest earned by the companies that make these investments.

How To Break Into Real Estate Private Equity

If you want to make sure you have the skills you’ll need to land interviews at real estate private equity firms and pass an Excel modeling exam that might be given to you during the interview process, make sure to check out our all-in-one membership training platform, Break Into CRE Academy.

A membership to the Academy will give you instant access to over 120 hours of video training on real estate financial modeling and analysis, you’ll get access to hundreds of practice Excel interview exam questions, sample acquisition case studies, and you’ll also get access to the Break Into CRE Analyst Certification Exam, which covers topics like real estate pro forma and development modeling, commercial real estate lease modeling, equity waterfall modeling, and many other real estate financial analysis concepts that will help you prove to employers that you have what it takes to tackle the responsibilities of an analyst or associate at a top real estate firm.