Private Equity’s Playbook For Real Estate Market Selection

If you study the portfolios of some of the biggest real estate private equity firms in the world, you’ll see some very common patterns when it comes to the markets they choose to invest in.

And while every company’s strategy is a little bit different, there are a few best practices that are used almost universally by the most prominent capital allocators in this space.

So in this post, we’ll pull back the curtain on the private equity playbook for analyzing real estate markets (based on my own experience working with these firms for almost a decade), and the most important things that tend to factor into these decisions.

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The Core Investment Philosophy

When private equity firms are looking to place capital, the main goal of these investments is almost always to maximize the potential upside for investors while minimizing their potential downside.

This means that these companies look for markets where real estate values have a very high likelihood of rising and a very low likelihood of falling, based on a few different factors that are slow (or very unlikely) to change.

Factor #1: Supply Limitations

The first factor that these firms will often look at is the impact of geographic constraints that limit supply growth.

This could be a lack of available raw land to develop (due to existing buildings that have already been constructed), or water or other landmasses that prevent developers from building new product.

This is one of the biggest reasons why markets like New York and San Francisco are home to some of the most expensive real estate in the US, with both of these cities having extremely little available raw land that isn’t already accounted for, and both cities being surrounded by water almost entirely.

Markets like Boston, Miami, and Los Angeles would all fall into a similar category, with a body of water on at least one side of the city, and years of development that’s made raw land extremely difficult to come by.

When new properties can’t be built, this also tends to increase the value of existing real estate in a market, since this makes it significantly more likely that the supply of new housing, warehouses, shopping centers, and office buildings won’t be able to keep up with even small increases in demand.

And when demand outpaces supply, this drives up rents, drives down vacancy levels, and reduces the perceived risk of investing in a market, which directly increases prices that investors are willing to pay for commercial properties.

On the other side of the spectrum, this is also why cities like Atlanta, Phoenix, and Las Vegas tend to attract significantly less interest from institutional investors. These have historically been very cyclical real estate markets, with intense boom-and-bust cycles and a lot of available raw land that can easily be developed.

Factor #2: Political Constraints

On top of looking for markets with geographic constraints, private equity firms also tend to look for political constraints in a market that make building new product extremely difficult.

Cities like San Francisco and Los Angeles have notoriously restrictive zoning laws, a permitting process that can take years, and extremely strong community pushback when new developments are proposed.

And in cities like New York, pre-construction costs can creep into the hundreds of thousands of dollars even before a project breaks ground, which can make it really tough for developers to justify new construction.

Again, if developers can’t build new product, this makes existing real estate in the market a lot more valuable, and this can often protect investors from major downward swings in rental rates, occupancy levels, and property values.

This is another reason why institutions are often hesitant to invest in markets like Houston, Atlanta, or Orlando, which are known to have significantly fewer regulations than the cities we just talked about, since this makes the development process a lot quicker and less expensive overall.

Factor #3: High Replacement Costs

The next major factor that private equity firms will consider when analyzing a market is the price per square foot (or the price per unit) to develop new product, in relation to other competing properties that are currently operational.

This is what real estate investors refer to as replacement cost, which is the cost to build a new, similar property in the same location as an existing site. The replacement cost of a property factors in land costs, labor and material costs, and any other notable features or amenities that would need to be recreated.

Private equity firms tend to look for markets where existing properties are selling for prices that are significantly below replacement cost, which means the cost to build is a lot higher than the cost to buy. When this is the case, the rents that developers would have to charge to justify a new project are also significantly higher than current rents for existing properties, which helps reduce risk for property owners when development activity spikes.

This is also why many real estate investment firms will shy away from cities where developers are known to be able to build new product quickly and inexpensively, since the cheaper it is to build newer, nicer buildings, the more competitive these are likely to be with existing properties in the market.

If tenants can rent a unit at a brand new building for just slightly more (or even the same price) as it would cost to rent a similar space in an older building (with a lot more wear and tear), they’re almost always going to choose that newer, nicer unit. And when this happens at scale, this puts downward pressure on rents and upward pressure on vacancy rates for existing property owners.

Factor #4: Job Growth

The last three factors we talked about have been exclusively related to the risk of supply growth in a market. However, demand for commercial real estate is also extremely important to the investment thesis of a real estate private equity firm, and this is where job growth comes into play.

At the same time that cities like New York and San Francisco have some of the most difficult permitting processes throughout the entire country, these are also some of the most densely concentrated employment hubs in the US, with top talent in the tech and finance fields moving to these cities daily.

In San Francisco, the hype of AI advancements has led to a huge amount of growth in this market, with many of these companies offering extremely high salaries and profit-sharing plans for employees.

Miami is also a great example of this, with a lot of companies relocating to this area from higher-tax states, resulting in real estate prices rising in this market across virtually every product type.

And again, this is in contrast to a lot of cities in the South or the Sunbelt with significantly smaller job markets and long-term prospects for job growth, which can make these metros a lot less appealing to institutional capital.

How These Factors Work Together

What makes private equity’s market selection criteria so powerful is how these factors work together to maximize investor upside and limit investor downside.

The combination of very low supply growth risk (as a result of raw land constraints and a difficult and costly development process) alongside a very high likelihood of continued job growth tends to stack the odds in an investor’s favor. And even though market conditions can fluctuate over time, when it comes to sustainable, long-term rent and value growth, this is the formula that private equity firms tend to rely on.

How To Learn More About Real Estate Investment Analysis

If you want to learn more about the investment analysis process used by real estate private equity firms and how these companies build and use real estate financial models to value commercial properties, 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.