How Private Equity Real Estate Companies Make Money
Private equity real estate companies are companies that invest in real estate on behalf of equity investors, usually pooling together capital from multiple investors to buy large commercial properties like multifamily apartments, office buildings, retail shopping centers, and industrial warehouses.
And these companies are compensated to both find opportunities to invest in on behalf of their partners, as well as compensated additional amounts if those real estate investments perform well, ideally creating a “win-win” scenario for all investors involved.
But the exact mechanics of how a private equity real estate firm makes money tends to be a topic that isn’t talked about all too often outside of the real estate industry itself.
So if you’re new to the real estate investment industry and wondering how companies make money by investing in real estate on behalf of their partners, or you’re just curious about how the process works, this article is for you.
If video is more your thing, you can watch the video version of this article here.
Private Equity Real Estate Firm Compensation
Private equity is one of the most lucrative industries out there, and it’s no surprise. When you’re responsible for managing millions (or even billions) of dollars on behalf of investors, and you’re able to leverage other sources of capital like debt, private equity firms can control huge assets with a very small portion of their own capital necessary.
And like private equity firms that invest in operating companies, private equity real estate firms are no different, with debt and partnership equity making up a significant portion of the capital required to acquire and manage large commercial real estate assets.
But even with significant assets under management, it’s still unclear to most people exactly how private equity real estate companies make money, and how this differs from the traditional private equity model used to acquire non-real estate related operating companies.
So in this article, let’s walk through five of the most common ways private equity real estate firms make money, and how this can often be a “win-win” for the company and its investors on a real estate deal.
First on this list, and prevalent in most private equity real estate partnership structures, are acquisition fees.
When a company acquires a property on behalf of investors, there is a lot of work and cost that goes into that process.
For most private equity real estate firms, the company will underwrite about 100 deals for every one deal they put under contract.
And this takes hours of employee time, as well as thousands of dollars in travel costs involved with touring properties and markets on deals that ultimately are lost in a bidding war.
An acquisition fee is intended to compensate the private equity real estate firm for doing the up-front work of sourcing a new deal, and spending the time, effort, and resources to close on the transaction.
As far as the amount of the acquisition fee itself on a real estate deal, this generally falls somewhere between 1.0% and 2.0% of the purchase price, with larger properties (>$15MM) generally falling on the lower end of that spectrum, and smaller properties (<$15MM) generally falling on the higher end of the spectrum.
Asset Management Fees
Next on the list, and almost equally as prevalent as acquisition fees in real estate partnership structures, are asset management fees.
Managing the business plan execution, overseeing the leasing process, manage property management teams, and take care of the budgeting and financial planning at a property takes a lot of work. This is also one of the most important parts of making sure a real estate investment is profitable, so the stakes are high for the private equity firm to pay close attention to the operations of the deal and take steps to drive the performance of the asset.
Asset management fees are generally structured in one of two ways on real estate deals – either as a percentage of effective gross revenue (EGR) generated at the property, or as a percentage of equity invested in the deal.
For partnership structures with asset management fees calculated as a percentage of effective gross revenue, this is generally going to be between about 1.0% and 2.0% of the EGR the property generates on a monthly basis.
And for partnership structures with asset management fees calculated as a percentage of equity invested, this will generally be between about 0.5% and 1.5% of the equity invested in the project.
Construction Management Fees
Third on this list, and much more prevalent on ground-up development deals or projects with a heavy renovation component, are construction management fees.
These fees are charged in order to compensate the private equity real estate firm for managing the construction on the deal, whether that’s the construction of a brand new building or the renovation of common areas and unit interiors on an apartment project.
Construction management can be one of the most time-consuming processes on a value-add or opportunistic real estate deal, and with so much value often being created in this process, it’s critical for a private equity real estate firm to spend a significant amount of energy and attention on making sure all construction is on time and under budget.
This fee is generally calculated as a percentage of the overall construction costs on the deal, usually somewhere between 4.0% and 8.0% of total costs.
Fourth on this list, and in my experience, less common to see than the first three fees on this list, are disposition fees.
Managing the sale of a property is a significantly time-consuming process, with the process of cleaning up operations to prepare for sale, interviewing brokerage firms to list the property, working with buyers during due diligence, and working with title and escrow firms to close on the asset commonly taking six months or more from start to finish.
And to compensate the private equity real estate firm for this work, the disposition fee will generally be structured as a percentage of the sale price of the property, usually 1.0% of 2.0% based on the size of the asset.
Fifth on this list, and commonly the largest form of compensation for a private equity firm, is promoted interest.
Unlike the first four points on this list, promoted interest isn’t a fee itself, but rather a change in distribution splits after certain return thresholds are hit on the deal.
For deals that perform well, promoted interest often will be significantly higher than these other forms of compensation on this list, and is calculated as a percentage of the cash flows over and above certain return hurdles.
Promoted interest calculations can get a little bit tricky, so for a more in-depth look at the math behind how this works, you may want to read through this article.
But for the purposes of this article, just know that promoted interest allows the private equity real estate firm to receive an outsized portion of the profits in proportion to their equity invested in the deal up-front, assuming the deal meets and exceeds investor expectations.
Private Equity Real Estate Firms & Alignment of Incentives
At the beginning of this article, I mentioned that these five ways that private equity real estate firms make money all serve to create a “win-win” scenario for the firm and their investors, and here’s why that’s the case.
As a Limited Partner or passive investor, you’re investing with a private equity real estate firm because you probably don’t have the time, the interest, the balance sheet, or the expertise to buy a large commercial real estate property on your own.
So to help with that, private equity real estate firms will invest on your behalf, giving you access to real estate deals that you otherwise would not have had access to if left up to your own devices.
Acquisition fees give private equity real estate firms an incentive to identify and close on profitable real estate investment opportunities.
Asset management fees give private equity real estate firms an incentive to make sure the property continues to perform well, and net operating income (and subsequently, property value) increases over time.
Construction management fees make sure the private equity real estate firm is attentive to the renovation or development project, and that the project is completed on time and under budget.
Disposition fees make sure the private equity real estate firm is incentivized to maximize sale price for the investor group as a whole.
And finally, the promoted interest makes sure the long-term interests of the private equity real estate firm and their investor base is aligned, making sure the company only wins if investor return expectations are exceeded, creating a true “win-win” scenario for all parties involved.
Want To Break Into Private Equity Real Estate?
There is a significant amount of money to be made in private equity real estate, and one of the best ways to learn the business is to work for another firm and learn how the best in the industry find (and execute on) profitable real estate deals.
And if you’re looking to land your first job in private equity real estate, the most important skill set to make that happen is to master real estate financial modeling in Excel. And with that, if you need to brush up on your abilities to prepare for an Excel interview exam or the application process in general at private equity real estate firms, make sure to check out Break Into CRE Academy. A membership to the Academy will give you instant access to our entire library of courses on real estate financial modeling and analysis, waterfall modeling to calculate promoted interest, and one-on-one, email-based career coaching to help you navigate your own unique scenario to break into the business.
I hope this helped pull back the veil of private equity real estate, how these firms make money, and how you can get in on the action, too.