How Real Estate Private Equity Firms Value Commercial Properties
Major private equity firms are some of the most sophisticated real estate investors in the industry, with access to in-depth market data, top-tier talent working on deals, and complex proprietary financial models to make cash flow projections and analyze properties.
But after working at these types of firms myself for almost 10 years, I’ve seen firsthand that, when it comes to valuing commercial real estate, there’s a pretty standard process that’s used across the board (that’s not quite as complex as you might think).
And in this article, we’ll talk through how real estate private equity firms come up with offer prices on commercial properties in the market, the core drivers of pricing that these investors are focused on most, and how you can use these same strategies to improve your real estate investment decisions when building your own portfolio.
If video is more your thing, you can watch the video version of this article here:
Real Estate Private Equity Defined
To step back and start with the fundamentals here, by “real estate private equity firm”, I’m referring to a company that raises third-party capital from passive, limited equity partners. These limited partners can be companies, families, or even individuals that want exposure to real estate, but don’t have the time, resources, or potentially even the knowledge necessary to make these investments themselves.
And when these companies raise money from limited partners, these LPs will generally be looking for a minimum target return on their investments, usually with a focus on the annualized, time-weighted return.
And to measure this annualized, time-weighted return, the IRR (internal rate of return) is almost always the main benchmark used by real estate LPs, since this factors in both cash flow from a property’s operations and cash flow from the ultimate property sale, while also taking into account when each of these cash flows is projected to occur.
But even if an investor knows they want to focus on the IRR, they still need to choose a minimum IRR target, and this is where what are referred to as capital risk buckets start to come into play.
Capital Risk Buckets
Capital risk buckets are essentially used to help an investor determine what their target IRR should be, based on the business plan and the risk associated with an investment. And in commercial real estate, these break down into four main categories, which are core, core plus, value-add, and opportunistic.
To start off with the lowest-risk category, we have the core bucket, which tends to include newly built properties with strong credit tenants located in major gateway markets, often financed with very conservative levels of debt (or no debt at all).
To use an example, this could be an office building in Manhattan, built one year ago, and currently 100% occupied by Google on a 20-year lease. In this case, there’s a very low risk of default by the tenant, very little or no renovation needs at the property, and a very high probability of the property owner being able to re-lease the space to another quality tenant at the end of the lease term.
On core deals, investors will usually expect levered IRRs of anywhere from about 7% on the low end to about 9% on the high end, and investors are usually looking for these deals to be held long-term over a ~7-10 year period.
Essentially, core deals are generally “trophy case” assets that involve very little risk and are usually sold for a premium, but are also extremely likely to perform well (and consistently) over time.
From here, if investors are willing to take on a slightly higher level of risk in exchange for a slightly higher target IRR, this brings us up to the core-plus bucket.
This usually includes acquisitions of relatively new properties with only a small handful of capital needs or operational adjustments, usually located in secondary markets. An example of a core-plus deal could be a 5-year old apartment complex located in Seattle, just outside of the city center, with some cosmetic upgrades that could be made to the property that would allow an investor to moderately raise rents (without much risk).
Investors will usually expect a levered IRR of somewhere between about 9% on the low end and about 12% on the high end on core-plus deals, and again, investors will generally be looking for a relatively long-term hold horizon on these deals of somewhere between about 7-10 years.
Ultimately, core-plus deals are usually relatively new, relatively well-located, require only very small changes to add a small amount of value, and these are just one step up from core deals from an overall risk perspective.
For investors that are comfortable taking on even more risk than this in exchange for even higher projected returns, we’ll move into the next capital risk bucket, which is the value-add bucket.
Value-add deals tend to require a significant amount of renovation and/or re-leasing to increase rents at a property, with investors often using high levels of leverage to manufacture higher returns.
An example of a value-add deal could be a retail shopping center built 25 years ago, currently sitting at 80% occupancy in a growing submarket in Miami, with a significant number of below-market leases at the property that could be re-leased at current market rates.
For value-add deals, because of the risk and the speculation that comes along with construction, re-leasing, high levels of leverage, and/or betting on the continued growth of an emerging market, investors are usually looking for an IRR of somewhere between about 13% on the low end and about 16% on the high end on these deals, with a relatively shorter expected hold period of about 3-5 years. Value-add deals tend to be your typical renovation and re-leasing plays, but these things also come with risks associated with things like cost overruns that could put a project over budget, a weakening economy that doesn’t allow an investor to raise rents as planned, or rising interest rates that could cause significant cash flow issues on the deal.
For investors that are looking to maximize projected returns and willing to take on a significant amount of risk to get there, we have our final capital risk bucket, the opportunistic bucket.
This tends to include acquisitions requiring a complete repositioning of a property, the ground-up development of an entirely new structure, and/or the use of very high amounts of debt in order to boost returns.
An example of this could involve an investor buying a 50-year old, 50% occupied office building in San Francisco with the plan to convert the building into for-rent apartments, meaning that the investor will need to take on the process of obtaining necessary government approvals, completing a significant renovation, and managing a speculative lease-up once the renovation is complete.
On opportunistic deals, investors are usually looking for an IRR of anywhere from about 16% on the low end to 20% or more on the high end, with these types of investments involving business plans with the highest levels of risk.
Ultimately, opportunistic deals are a real estate investor’s attempt to “hit home runs”, while also accepting the fact that things could go a lot differently than planned (in a negative direction).
How To Learn More About Property Valuation & Analysis
These ranges can shift up or down slightly over time based on the “risk-free” rate of return in the market, but regardless of the exact percentage values within each range, these categories are generally the main drivers used by investors to determine target IRR values, which ultimately drive pricing and valuations in the market.
And if you want to learn more about capital risk buckets, target return metric valuations, and how to use all of this information within a real estate financial model, 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 also 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.
As always, thanks so much for reading, and make sure to check out the Break Into CRE YouTube channel for more content that can help you take the next step in your real estate career.