What is Real Estate Investing Anyway? 
So real estate investing is any investment, whether it's time or money invested into real estate or some type of real estate. And I'm going to go through a few types, different types of real estate investing so that you understand better. 
Rentals
So, the first one, the most popular one is where you buy a property, you rent it out and you collect rents from that property. You pay your expenses. There are several expenses associated with buy-and-hold rental properties. Over time, you should get to the point where you're going to get more, collect more rents, and have fewer expenses. Other key components will contribute to making money in real estate and that’s appreciation. Meaning the property will go up in value. And then there is the principal paydown, meaning you're going to be paying down your mortgage over time.

Okay? So that's the most common way to get involved in real estate investing that most people start with.
Fix and Flips
Another big one is fix and flips. And you see this all the time. There are a lot of TV shows out there where you see people go out and buy a property. You would invest in a property and then you fix it up because it needs to be fixed up. And then you sell it over time. The challenge with fix and flips is you never know what you're buying, even after inspections. You never know what kind of work you're going to end up doing. You never really know the cost. Sure. There's, a certain amount of risk that you can reduce by having experience, but there's still sort of the unknown with fix and flip. And the other challenge with fix and flips is there are so many people out there doing it. So it's harder to find the properties that fit the model of a good fix and flip. 
Money Partner
The other way you can get involved in fix and flips is you not really doing the work, but you could be a money partner. So, somebody else is doing the fix and flip, but they need the money. They need the down payment. They need to call a private mortgage. You would be that person to be able to invest with them in a joint venture type of arrangement for that real estate investing.
Private Mortgages
Speaking of mortgages, another way to invest is you could become a very passive investor in real estate by investing in mortgages. Yes, you can become a bank, just like the banks lend out mortgages. There are a lot of companies and there are a lot of people out there that specialize in what's called private mortgages. And what that means is somebody looking for a mortgage who can't necessarily qualify for a standard mortgage but is looking to buy a house or is looking to invest in a property as an investor, but they can't get a mortgage because for whatever reason they can’t qualify for a traditional mortgage. They have too many mortgages. They don't have good credit. They have seasonal work, meaning, they only work in the winter, or they only work in the summer. So, banks don't like that. It's a high risk. Anything, where they are not an employee where they're an independent contractor, is another challenge. So, you, as an investor could evaluate the person that's looking to get a mortgage and determine you want to give that person a mortgage. 
Now, the nice thing about these mortgages is usually that there's enough equity in there, meaning there's enough spread between what the property's worth and what you're willing to lend so that your risk is greatly reduced. And you also can charge a much higher return than banks are charging. Like right now, mortgage rates are 3% or 4%. But you could charge 7, 8, 9, 10%. I had one loan on one deal. I was working on, I was paying 14%, but I didn't care because I had the investment
Wholesaling
A couple of other types of real estate investing but I don't know if you'd call them real estate investing, because they are more about putting in the time.

You're not actually taking money out of anybody's pocket and putting it into a property. And that’s wholesaling. 
Wholesaling is more of a job, I think than real estate investing. And what wholesaling is, it's going out, finding people who are motivated sellers, meaning people that are looking to sell their home, but can't really sell it because it needs work or whatever. You will go and talk to that seller and arrange for a very good price from that seller because they are very motivated. And then you would put it under contract and then you would go and find somebody else, another investor who is interested in doing a fix and flip. And that other investor would come in, purchase a property through you as a wholesaler. Again, you're buying it from the original seller, selling it to this fix and flipper who's going to fix it up and sell it to the retail market.

Rent to Own
Okay. So that's wholesaling and then another real estate investment strategy is rent to own. And I'm not going to that right now, but rent to own is basically getting a property, putting it under contract, and then finding a tenant-buyer who's going to lease it from you with the option to buy it.
Okay. So those are several ways in which you can get involved in real estate investing. And there are a few more, the other big one, the other really big one is private equity investing with real estate.

What is Real Estate Investing.

One of the things I want to talk about today is investing in single-family homes and how making a lot of money in single-family homes is probably one of the biggest lies out there in the real estate investing community.

A lot of gurus are talking about going out and buying single-family homes and making money through investments in single-family homes … and over time you'll become rich. The challenge with single-family homes is a lot of things. 

Qualifying for single-family homes

First, you can't qualify for a lot of single-family homes. 

After you purchase 1, 2, 3, 4 homes you're going to have trouble being able to purchase anymore because you're going to end up not being approved by banks. Now, there are ways around that where you can go out and start getting private mortgages. Or you're going to bring in partners to buy these single-family homes. But that's going to take time and it’s going to take a lot more effort to get these mortgages. 

Monthly Income

And the other big problem with single-family homes is trying to make a monthly income. 
I see a lot of people who lost their job and went to these so-called gurus and these gurus were telling them what to do and what to invest in. They told them to go out and purchase properties and replace their income using single-family homes. 

The challenge with that is if you buy a home and you put a mortgage on it, your expense for that house is going to be quite high. You're going to have your mortgage; you're going to have your taxes; you're going to have your insurance and you're going to have maintenance. And so, to be able to cash flow is not going to be that easy because to get a high enough rent is going to be quite difficult. 

But still, these gurus or these people are coaching other people on how to make money in real estate investing. And they tell them to shoot for $100 or $200 or $300 a door per month. Well, if you're doing that and you're making an income of let's say even $3,000 per month dollars, you would need 10 homes just to make that $3,000 a month if that's what your income was prior to looking for real estate as a replacement for your income. 

Re-renting Single-Family Home

The other big challenge with single-family homes is the costs associated with re-renting them.

So you have a tenant, and that tenant is paying rent on a regular basis. You don't see any problem with them, but when it comes time to leave, they give their notice, and everything still seems fine. But when you go in there you realize you've got all this expense to clean up and to paint. Maybe they ruined some things; maybe they had a dog or a cat; maybe they ruined the carpet. So now your expense to re-rent this place is much higher than what you originally anticipated. 

So now you've got all these extra costs, and if you're only making a cash flow of $200 a month, and you end up spending $2,000 to prepare that home for another tenant, there goes your profit for the year. 

So that's the big problem with single-family homes is the re-renting expense. 

Appreciation with Single-Family Homes

A lot of people are talking about how you really make money with single-family homes is through appreciation. I agree with that, but appreciation isn't going to replace your income. 
Appreciation and principal paydown are about making money with single-family homes or with any rental or with any real estate investment over time. 

Now the way you do that is you buy a single-family home every year. Let's say for the next 10 years, and you hold them for another 10 years. So, over a period of 10 to 20 years, your property has appreciated, which doesn't always happen depending on the community you're in. And as long as you've been breaking even, or covering your costs, and you're able to allow your property to gain in value and the principal is paid down over that period of time.

So after the 10, 15, 20 years, or whatever the timeframe is, you sell off half your portfolio. So, let's say you've had 20 properties. Then you sell off 10 of them and you use the money from that sale to pay down the other 10. So now you're able to realize a not too bad profit or not too bad income from those properties, because now the mortgages on those properties are free and clear, or hopefully as close to free and clear as you can get them. Free and clear means there is no mortgage on the property or no loan against the property.

Now you're going to be earning a much better income because of not having as many expenses. 
So, for example, you don't, you may not have any mortgage expenses anymore, and hopefully your maintenance will be less because you've been keeping up with your maintenance. And the other nice thing is your rents will hopefully be much higher. 

Property Management

There's another big challenge with owning single-family homes is property management. Property management can be a pain. I hate property management. I hate tenants. There are lots of issues with property management. You must be able to take calls at any time during the day for example. That’s what’s called toilets, tenants, and trash as the expression goes.

So, you've got to manage your tenants and you've got to replace your tenants when they move out. You've got to be at their beck and call when they need something done to fix up the property or to do whatever needs to be done. 

Okay. To summarize, the biggest lie in real estate investing is getting rich through owning single-family homes, certainly as a replacement for your day-to-day income.

The Truth About Investing in SIngle Family Homes

In this section, I want to cover investing in fix and flips as part of a real estate investment strategy. 

Fix and Flips are Risky

So, fix and flips can be very risky. A lot of money can be made with fix and flips because there's a potential to get a property at a good value, do the necessary renovations and sell it for a good profit. There's also the opportunity or the risk that you would lose money on fix and flips. 
What exactly is a fix and flip when it comes to real estate investing? 
What people do is they purchase a property from a motivated seller who is trying to sell this property at a discount price. For whatever reason, they need to sell fast. I won't go into that. I cover that in another section, but the challenge is you want to get a property at way below market value.

So, you look at the properties in the area and you determine that the market value for this property is, let's say $400,000. You’re going to want to determine that the purchase price is about 70% of the market value. So that means buying it at $280,000, in this example. Then you'll estimate the cost for the renovations and add that to the purchase price and then determine if there's enough profit in there for you to invest in this property. And once the renovations are done, you would sell this property at a premium price relative to what the market is and there's your profit. 
But there are a lot of unknowns with fix and flip. And as I said, there are a lot of risks associated with them. So, when you first do a fix and flip, what I recommend is you do it with an experienced contractor, or you do it with a partner or with somebody else who's done it and you shadow that person.

Hard to Find Deals

So first, it's hard to find fix and flips. It's hard to find good deals because there are a lot of people just like you out there looking for properties that want to do the fix and flip. And some of these people do fix and flip for a living. Sure, there are some people that are doing one or a year, but there are some people that are doing one a month or more, and they have teams in place. These people know the market, they know how to find these properties and they have a lot of people out there looking for properties for them.

So it's hard to find good deals so you must be looking all the time. 

Estimating the Renovations

The other big risk with fix and flip is understanding what the renovations are going to cost. 
You're going to do your estimate for the renovations. And as I said, you want to make sure you're working with an experienced contractor or an experienced partner. You're going to do your estimate. Then take those estimates and add 25% to 50% on top of what your original estimates are. None of this 5% or 10% margin. You want to make sure your estimates are good. You want to put in a real good buffer. 

Now the other challenge with the renovations is, even though you put in those good estimates, you never know what's going to happen. You never know what's underneath the floorboards behind the walls, in the plumbing or the electrical. Sure, you will get an inspection, but the inspection may miss something. 

The other thing is a lot of these fix and flips are being sold without inspections because you've got a lot of people out there trying to buy these deals. So, if the owner says, as-is, you've got to take that risk. I wouldn't recommend you do a fix and flip as-is to start with. And not buying as-is is going to make your buying and finding a fix property that much harder because you're going to be competing against people who will buy properties as-is, sight unseen and even without an inspection. 

So be careful of the risks associated with the renovations and your estimates of those renovations.

Inspection Delays

The other risk you need to be concerned about will be the delays. One delay you are going to experience is trying to get the inspectors in on time to get the necessary approvals for the work you've done. 

You're going to be doing your electrical work and your plumbing work. And then you're going to try to schedule an inspector. Well, guess what? That inspector may not be available when you need them to be. So now you've got delays and now you've got your people sitting there, these contractors, these workers sitting there waiting for these inspections to be done, or work is done and you're waiting to put this property on the market, and you can't. 

The Current Market

Okay, speaking of the market … that is going to be another challenge. 
You may be working in a very competitive market, meaning there's a lot of inventory out there so it's a buyer's market. So now you've got to put your property on that market, and you've got to compete with all these other people trying to sell these properties and not just people doing fix and flips, but all the property that's out there those buyers are looking at.

So, be careful of where you are in the market. 

The other thing is delays in selling. 

If you have got a property, that you think is worth $400,000, don't put your property up for $425,000 because you think you’ve done a better job and your property is worth more. Ideally, you want to put the property up for sale below market value because you don't want to hold onto this property very long. If you're holding onto these properties because of the delays, I just mentioned, you're going to incur additional expenses. I'm assuming you're going to have a mortgage on the property and you're going to have to pay property taxes utilities. So, all those things contribute to costs associated with the overall expenses of your fix and flip and ultimately your profit or loss. 
Okay. So that's just a summary of the risk associated with fix and flip. And my recommendation is to get a partner or an experienced contractor if this is your first fix and flip.

Should You Invest in Fix and Flips

What is Real Estate Wholesaling?

So wholesaling or real estate wholesaling is about getting a property under contract for a certain price and selling it for a price just a little bit higher than what you have it under contract. 
That little bit higher price, the difference between what you get it for and sell it for, is your profit. So, for example, you may get a property under contract for $100,000 and you assign it to another buyer for $110,000 or $115,000, and the difference between those two is your assignment fee which is your profit. 

Assign the Contract?

Now, the reason it's called wholesaling is that you're not actually selling it to a buyer that is someone that's going to live in it. You're selling it to somebody else who’s going to do something to the property to increase its value. So, for example, you buy a property from a motivated seller or, sorry, you don't buy a property, you acquire a property, or you put a property under contract from a motivated seller. That seller is motivated for many reasons. 

And then you find a buyer who is doing a fix and flip, and you assign that property to that buyer who will then do the fix and flip and will enhance the property by whatever means they think they need to. Whether it's a simple fix and flip, where they just put in new carpets or they just do some painting or there's a major fix and flip where they're going to be moving walls or renovating bathrooms or renovating kitchens. And all that contributes to the overall cost, which ultimately affects their profit. 

And then what that person will do, or that company will do is, once they've renovated the property, they will put it on the open market for sale. And I do recommend putting it on the open market and by the open market, I mean MLS. And then the person that buys that property will be the ultimate owner and that's the retail buyer.

So the person in the middle, the fix and flipper, is the wholesale buyer and you're the wholesale seller but you never really take possession of the property. 

Wholesaling is a Job

So, the challenge with wholesaling is that it's really a job. It's not really real estate investing, because you're out there looking for properties all the time. You're looking for buyers all the time. Its a daily activity. Real estate investing by definition or at least what most people think of as real estate investing is you invest in a property; you sell the property, or you rent out that property. In wholesaling, you never acquire property. You're just looking for deals for other people. 
And there are a lot of people out there looking for similar deals, like what you're looking for. The challenge will be finding the deal or finding the property that somebody else, a fix and flipper, will want.

Motivated Seller

So why are people trying to sell? Why are sellers motivated? Sellers are motivated for many reasons. 

Usually, it’s because they have run into financial difficulty. They may have let the property get out of control, meaning they haven't been maintaining the property. So now it requires a lot of work, and nobody wants to list it because they don't think they can sell it. Or another reason is that they inherited a property. It's a property that they got in a will where a family member died and left it to them. And they’re not really a property manager and they don't really want to carry the property. 

The other thing that's unique about wholesaling is you never want to take control of the property. What I mean is, you never want to purchase the property. You just want to take control of the property. You can take control of the property by putting in an agreement of purchase and sale, that is, putting an offer on the property for a price that you are negotiating with the seller. 

Work with the Seller

And that's really the value that you're providing to the ultimate buyer, the fix and flipper. The value is that you are going to work with the seller to come up with a price that you think you need to come up with to be able to attract the buyers that would be interested in purchasing a property like this. 

So, when you're talking to the seller, you've got to make them aware that you are not necessarily going to take possession of the property. You are just looking for a property for a group of investors. And you should call it a group of investors that you represent because you should be representing a group of investors as a wholesaler. You're not going to be representing just have one fix and flipper that you're looking for property for. You're going to have multiple investors so that when you find a property there'll be a bunch of people that you're going to be able to send this property out to who would look at the property and eventually purchase the property under the terms and conditions that you've negotiated with the seller. So, the seller should be aware of that. 

The Assignment

And then what you do is you put the property under contract using an agreement of purchase and sale and you ultimately will assign that contract. And so that's very clear, you're NOT selling the property.  You're strictly selling the contract to another buyer, the fix and flipper, for a price. And that price is referred to as the assignment fee. 

So that's pretty much what wholesaling is. But I wouldn’t get into wholesaling as a real estate investments strategy. I consider wholesaling a job, not a real estate investment strategy.

1.3 What is Real Estate Wholesaling

What is a Real Estate Investment trust?
 
A Real Estate Investment Trust is a fund or a pool of money that invests in commercial-type real estate investments either by purchasing them or by funding the investments directly. 
They give everyday people access to commercial real estate who would not normally have access to investing in commercial real estate. 

There are two types of REITs. REIT is the acronym for Real Estate Investment Trust. 

There is the equity REIT and there is the mortgage REIT. The equity REIT obviously invests in equity or properties and mortgage REITs invest in funding or mortgages. 

In general, REITs are an alternative to investing in the stock market. So investing in REITs helps you provide some diversification within your investment portfolio. REITs also provide diversification within the fund because the fund may invest in various classes of REITs creating a hybrid type of REIT. It may invest in equities and some mortgages and different types of equities. 

Types of REITs

There are three types of REITs. 
1.Publicly Traded and listed. You can buy these on a stock exchange such as the New York stock exchange or other stock exchange. The advantage of this type is that they are more liquid because you buy and sell them right there on the exchange. The disadvantage is they usually have lower returns and they're also impacted by any fluctuations in the overall investment market usually because of changes in interest rates
2.Publicly Traded, Non-Listed. These are REITs that are not listed on the stock exchange but are publicly available. You can purchase these through your financial advisor. 
3.Private REITs. These usually aren't available to the individual investor. They are only available to the institutional type of investors, for example, private equity firms. 

Classes of REITs 

Okay. as I mentioned, there are also different classes of REITs, different types of REITs. 
•Office REITs: These are REITs that invest in obviously office buildings, office towers. 
•Industrial REITs: These invest in industrial properties, warehouses and industrial land. 
•Retail REITs: These invest in malls or shopping centers. 
•Hospitality REITs: These invest in hotels and motels. 
•Residential REITs: These invest in multifamily, apartment buildings and garden home complexes. 

And there's a scattering of other types of REITs. And there are REITs that invest in a hybrid of the different types or the different classes that I just listed.

Advantages of REITs

The advantage of REITs over investing directly in real estate is that they are very passive. You don't have any tenants to manage. There are no contractors to manage if doing a fixed and flip and no properties to find if you're doing wholesaling. And REITs are run by an experienced management team, so you don't have to worry about making mistakes yourself. Those activities of acquiring properties and managing those properties are done by the management team.

So, the investor of a REIT owns shares in it, just like when you're buying shares in a company. You do not own the underlying properties or the underlying real estate directly. Not like you do in private equity or when you're buying real estate directly.

REITs are very low risk, but because they are such low risk, they give low returns. REITs will give you low returns, maybe a medium return might be a better way of saying it. So somewhere in the neighbourhood of 4% or 5%. 

REITs pay dividends. And these dividends are based on the profits you get from your rent profits or as well as capital gains from the sale of a property and from principal pay down.

Disadvantages of REITs

The challenge with REITs is that there are a lot of rules and regulations associated with them. Also, the dividends may be non-qualified. This means you may have a larger or a higher tax obligation. 
Another thing with REITs is that they have to pay out a certain percentage of the earnings to their shareholders. And that's usually 90%. The problem with that is they don't retain any capital for growth. And that's why the returns are fairly low.

There are also high fees associated with operating REITs. These are usually in the neighbourhood of 10% to 15%. So, because of these high fees, there is no incentive for the REIT to perform better. 
The other thing is a REIT may be under pressure because they have all this money coming in and they need to buy before they've done their complete due diligence. They have all this excess cash that they have to deploy. 

REITs are an alternative for non-accredited investors as well because of the low entry point versus private equity firms’ investments. 

So those are some of the advantages, disadvantages of REITs and why you should invest in REITs If it makes sense for you.

What are Real Estate Investment Trusts (REITs)?

What is Private Equity? 

Private equity typically refers to an investment fund organized as a limited partnership company with limited partners as investors and a general partner responsible for the management of the fund. 

The reason why it's called private is that its capital is invested in companies that are not publicly traded. These are privately held companies and these companies end up being owned by the limited partners and the general partner. This means that it's not public and it's not traded on the stock market or any exchange. 

So private equity is an alternative investment class that allows people to diversify or to invest directly into a company and become owners of that company. The private equity fund is a pool of money looking to invest or buy companies. So rather than have shareholders investing in a company, you have these private investors.

And usually, the private equity firm has no operational responsibility. All they do is raise money and buy and sell these different companies. And some of these companies own real estate. These companies become part of the overall portfolio. 

Advantages of Private Equity

So, the big advantage of private equity firms is that they're not subject to public scrutiny. 
This means that they don't have to provide quarterly earnings and they don't have any special reporting requirements. And what this does is that it allows them to have a longer-term approach to better invest and make better decisions as it relates to the overall strategy for the company. 
Private equity firms make money through management fees; through carried interest … that's interest above and beyond what they're going to pay their limited partner; and through any dividend recapitalization.

Private Equity versus Mutual Funds

Private equities are different from mutual funds. Private equities invest in private firms or private companies and mutual funds invest in public companies. So, they are very similar. Just one invests in private companies and the other invests in public companies. 

How to Invest in Private Equity

So, you can invest in private equity directly with the private equity firm or you can invest through an investment advisor. And now they have a lot of these crowdfunding sites where you can invest in a private equity firm.

SEC Requirements

For private equity firms to become classified as private equity they have to file an exemption with the Securities and Exchange Commission (SEC). There are a couple of different exemptions that exist that would allow them to go forward and raise money privately and not have to be a public company. 

Who Can Invest in Private Equity?

Private equity investments are usually available only to accredited investors and sometimes qualified investors. And the initial investment is usually a lot higher for Private Equity than mutual funds or REITs, which we talked about in a previous discussion.

What is Private Equity?

What is Private Equity Real Estate?
 
Private equity real estate (PERE) is a professionally managed fund that invests in real estate specifically, as opposed to investing in private companies.

It's really an alternative investment class specifically geared towards real estate. So rather than investing in stocks and bonds, or even REITs, you could invest in a private equity real estate fund if you wanted to focus on real estate. 

It's like direct real estate investing, except you don't have to worry about any of the management like if you had rental properties. Or you don't have to worry about any of the project management if you're doing a fix and flip. You don't have to worry about any of the risks normally associated with real estate. It's a very low-risk way of getting into real estate.

I say low risk because what's going to happen is you're going to go and you're going to research private equity firms that specialize in real estate, and you're going to find the ones that are performing well. They will have their history available. They'll have a long-term performance history associated with them, that you can research, just like you do when you invest in mutual funds or if you have ever looked at investing in REITs.

Alternative Asset Class 

Private Equity Real Estate is a private alternative asset class, unlike REITs. The reason I say it's private is that REITs are mostly public companies with a public fund. Whereas private equity, just by the nature of the name, is a private company that you can't buy on the stock market. You can only invest in Private Equity directly from the private equity real estate company or through your investment advisor. You could also invest through a crowdfunding site if they are using crowdfunding to find investors. 

And when you invest in the fund, there are much higher returns than REITs. Private equity real estate usually gives you somewhere in the 7%, 8%, 9% or 10% range. Whereas REITs are in the 2%, 3%, 4%, maybe 5% range. As I said, it's better than investing in single-family homes and fix and flips if you're looking for a secure investment with low management and low risk. 

Private Equity Real Estate investing term?

PERE funds invest for the long-term and by the long-term, I mean, usually in the neighbourhood of 5 to 10 years. So, from that perspective, it's very illiquid. Meaning if you want to get out of this investment, it's very hard. There are some of them which do have this off-market place where you can go and find a way to sell your position or your partnership within the limited partnership. But it's very rare that you can get out of a Private Equity investment. It's really a locked-in investment. So you got to be very sure of what you're getting into it's. 

Limited Partnership

A PERE is usually set up as a limited partnership with investors as limited partners and with the general partner responsible for the overall management of the fund, not the properties. There's usually a level of property management and ownership between the general manager and the property. Usually, the real estate that you're investing in is actually a company that is a specific entity company that has been set up specifically to hold one or two properties.

That special entity company is the company that manages the property itself and takes care of all the tenants and other management-related activities. And you, as an investor, do not have to worry about that. And usually, the fund does not have to worry about that also. Because all the fund is concerned about is managing the fund and making sure that the investment is performing properly by working directly with the people who are managing the property. 

Types of Private Equity Real Estate

There are different types of private equity real estate investments. The most common are described as Core, Core Plus and Value Add.

Core properties are usually properties that are very stabilized. They are fully rented. They are mostly newer properties. So, they are performing quite well. The problem with Core is although it's low risk, it's also low return because they're asking a higher price for the property.

Core Plus is a property that requires a little bit of work. Maybe some carpets and some painting, sort of like a small fix and flip. They get a little bit better return and of course, they have a little bit more risk.

Then there are the Value Add properties. They are a higher-risk investment. The challenge with the value add is the Private Equity Real Estate fund will put some money into the property, usually, something like $10,000 per unit. This money is used to fix up the unit and then rent it out at a much higher rate. And that's how they are able to increase the value of the property so that the returns on Value Add Private Equity Real Estate investments can be slightly higher.

Just like REITs, Private Equity Real Estate investment funds specialize in different types of commercial real estate. So, you have residential private equity real estate funds that invest in multifamily units or garden homes. You have hospitality funds that focus on hotels and motels, and you have industrial funds that focus on warehouses. And then there are office funds that focus on office buildings.

What is Private Equity Real Estate

What is a limited partnership? 

A limited partnership is the main entity that's used to buy real estate in the private equity world. 
It's a type of partnership with at least one general partner and at least one limited partner. And a limited partner could be an individual or it could be a sole proprietor or a company. So, it doesn't have to be a person. And what's interesting is that the same person could also be a general partner and a limited partner long as there are two legal persons who are partners in the partnership.
 
No profits can be paid out to the partnership if it reduces the initial liability of the limited partners and the general partner. So, you can't pay profits if it's going to reduce your initial contribution. 
A limited partnership is set up such that the general partner in the limited partnership has unlimited liability. That means they can go after that person individually. The limited partners have limited liability and are only liable up to the investments that they put in. 

The limited partnership is a pass-through entity from a tax perspective. And what that means is there are no corporate taxes. Any income that's earned gets passed through to the individual partners and the general partner. 

And it's a very loose setup in the sense that there's no requirement for general meetings or annual meetings. 

Who is the General Partner?

Okay. the general partner in a limited partnership is a part-owner of the business and is involved with the operations and also shares in the profits.

The general partner is responsible for the overall management of the business in the partnership. And so the general partner is responsible for the day-to-day business. And as I mentioned, they have unlimited liability and they are responsible for the financial obligations of the limited partnership, including the debts and any litigation. 

The general partner is a single general partner, but sometimes there are co-general partners in the setup. And again, they are responsible for the day-to-day operations. There are very few day-to-day operations. It's usually low to mid-range administration. 

Now in commercial real estate investing a general partner is a person or a team in charge of the real estate deals and the private equity fund from its inception on through to the end of the fund. In commercial real estate, this could be the real estate development firm. It could be the corporation could be the property manager with years of experience. 

Who are the Limited Partners?

So, a limited partner is somebody that does not participate in the managing of the partnership but enjoys number one, the limited liability which we talked about and is not involved in the day-to-day business. 

The limited partner is generally the investor only, and they are often referred to as silent partners. 
Limited partners invest in capital in exchange for a portion of the profits of the partnership and that's it. The liability of the limited partner is limited to the amount of the contribution that they made as part of their investment. And they share in the profits relative to the amount of the portion of their investment. 

The limited partner contributes money or property, but not services and they have to be very careful. If a limited partner spends too much time giving advice or business direction to the limited partnership, it could be determined that they are acting as a general partner, and they could lose their limited liability. So, they must remain passive to ensure that they don't lose that limited liability protection.

A limited partner has the same rights as a general partner to be able to look at the records, inspect the records of the limited partnership, and receive full disclosure of the affairs of the partnership. 

Can a General Partner be Removed?

So limited partners can remove a general partner. And the purpose of this removal ability is to provide limited partners to be able to replace that general partner if they see that that general partner is not operating to the best of their ability or the benefit of the other limited partners. So, they could have just cause for removal, or maybe they want to replace that general partner for other reasons. And that's called a no-fault removal. 

And so, the removal is generally implemented through a vote of the limited partners. 
The limited partnership could also be terminated and wind-up business affairs upon a change in the relationship between the partners. And in turn, the partnership may be automatically dissolved according to the terms of the partnership agreement. So, there are basic terms in the agreement to replace the general partner and to terminate the partnership. 

Okay. So that's everything I wanted to touch on as it relates to a limited partnership and the general partner and limited partners.

What is a Limited Partnership

What is the capital stack? 

In simple terms, the capital stack is the underlying financial structure of any commercial real estate deal, specifically in a private equity real estate deal. 

They call it a stack because it refers to the layers that go into purchasing and operating a commercial real estate deal. 

It's primarily made up of debt and equity. And it also lets you know who gets paid and in what order and how much risk each layer carries.

So, knowing the stack is incredibly important when it comes to determining the risk and reward that any given investment in the stack is made.

Here’s a simple way to look at the stack. For example, in residential investing, there are two components. There is the down payment, which is the equity portion. And then there is the mortgage, which is the debt portion.

Capital Stack Layers

The capital stack in Private Equity Real Estate investing is usually made up of four sections and in the following order.

Senior Debt

At the very bottom is what's called the senior debt. It's a first mortgage usually provided by a bank. So, it's the bank loan. It's paid first in any distribution of funds, and should the investment go into any kind of foreclosure or litigation should the fund not meet the loan’s obligations? It's the first one in the stack to get paid. So, therefore, it's the lowest risk, but it also has the lowest interest rate. 

Mezzanine Debt

The next layer in the stack is mezzanine debt and it's a hybrid of debt and equity.

So, what that means is that there is a debt portion paid which is the interest component associated with it. As the profits are made, there's an interest paid on a regular basis. But there's also an equity component. This is where the mezzanine debt usually has the option to convert itself into equity. So, it could eventually own shares in an investment.

The key thing about mezzanine debt is it's not secured. As a result, it's got a higher interest rate with it and earns a higher rate of return than the first mortgage than the senior debt. This is because it's riskier. But, as I said, sometimes it has the right to convert to equity. 

Mezzanine debt is usually temporary. Mezzanine debt usually lasts for about a year. And then the investment will do something to buy them out. That could be a dividend restructuring. Or the mezzanine debt could execute their right and they could convert their debt into equity. 

Preferred Equity

The next layer is preferred equity. This is ownership in the investment and not debt.

This is where the limited partners come in. This is where the investment raises money from individual investors called limited partners in an LP. I say individual investors, but it could also be a company that's in there. So, these are the equity investors which are the limited partners in the Private Equity Real Estate deal which is structured as a limited partnership.

Common Equity

And then finally at the top stack is the common equity or the sponsor equity. 
This is where the owners, the founders, the general partners come in.

So, the lower the stack or the lower the position in the stack, the lower the risk, and by intention the lower the return. The higher positions typically earn higher returns and the result is higher levels of risk.

Example of a Capital Stack

I'm going to walk through a typical stack. Let's say you're going to be purchasing a $10 million property.
 
So, the bank puts up 50% as the first mortgage, which is $5M and earns a 6% return on their investment. So, they make a 6% return on that loan, on that mortgage. The Private Equity limited partnership has an obligation to pay that mortgage or the bank could foreclose.
 
Next, you have a second mortgage, which is the mezzanine debt, and let’s say they loan 20% of the purchase price. So out of the $10M, they are going to put up $2M. And as a result, they're going to get paid a set amount on a defined schedule, just like the 1st mortgage holder. Plus, the mezzanine lender could convert their loan into an equity position. 

The next is the preferred equity. So, this is where the private equity firm is going to go out and they are going to raise money from investors from their limited partners. So, let’s say they raise 20%, which is $2M. And let’s say they are going to get paid 8% on their investment. Now, the advantage here with preferred equity is that they could also get some additional earnings which is the interest from any profits above and beyond what they get paid at their 8% base rate. 

And then finally, the common equity portion of the stack, which is the actual investment from the owners, from the founders, from the sponsors. And that only leaves 10% that they would have to invest from their own capital. So, 10% of $10M is $1M. So, to purchase this property, the owners would only have to invest $1M and they would arrange for financing from all those other different levels of equity and debt. Keep in mind most banks will have minimum requirements that they would want to own to put up so the owners will have some “skin in the game”. This ensures they have something to lost.

The thing about common equity though, is that the sponsors only make money after profits, but they also get paid from other sources. For example, they get paid fees. Sometimes there's an acquisition fee and a management fee. And then there's also a carried interest which means they will get a portion of interest above and beyond all profits after paying any debt and equity obligations. And then they also can get paid if there's a dividend recapitalization.
 
So that's what a capital stack looks like in private equity real estate investment for a commercial real estate deal.

What is the Capital Stack

Private Equity Returns. 

What are private equity returns?

Basically, how do people make money inside a private equity real estate investment or fund? 

So, there are several investors involved. And it's based on the capital stack that we talked about earlier.

Senior Debt Private Equity Returns

So, in the capital stack, starting at the bottom is the senior debt lender. These are banks that lend you money, or they could be private lenders, but they are people that are putting in probably the most capital in the investment and in the form of debt. And they make money based on the interest they charge for providing that loan. 

And the other people that make money with the loan would be the originators and they earn an origination fee. So, any mortgage broker or somebody that facilitated or originated the loan also makes private equity returns 

Mezzanine Debt Private Equity Returns

Mezzanine debt lenders make private equity returns the same way as the senior debt lenders in that they make interest on the loan that they provided.

Also, with the mezzanine loan, there might be some origination fees paid to another mortgage broker or loan coordinator. Plus, if the mezzanine debt holders convert their debt into equity, they have the potential to make private equity returns from the profits of the investment over a period of time, when the final sale of the investment is made and when the final sale of the real estate is made.

Preferred Equity Private Equity Returns

Next in line in the capital stack is the private equity investors. And these are the limited partners. These are the people that are supposed to be making the most private equity returns, or at least where most of the profits are being distributed. 

So, they get what's called a base return or preferred return which usually is in the 7% to 8% range. Preferred return is the return that is promised by the private equity real estate company as the minimum amount that the investors will receive before any additional profits are distributed to the general partners.

So, what happens is the limited partner investors will get their base return and then above and beyond that, they will usually get a return, an additional return from additional profits from the investment. 

So, let's say they have a preferred return of 7% and the overall profits from the investment come out to let's say, 20%. Okay. So, that's a difference of 13%. And that’s 13% shared between the general partners and the limited partners. The general partners usually get about 20% of that 13%. And then the balance, the 80%, goes to the investors, the limited shareholders, the limited partners. 

So, the shareholders who are the limited partners which are the overall investors, the silent investors, get their base 8% plus they get 80% of any additional profits above and beyond their base amount. 

Common Equity Private Equity Returns

And then finally, the common equity, which is the equity that's owned usually by the general partners. And for their portion of their investment, they would get their return on their portion of the profits earned in the private equity investment. 

Private Equity Firms

The general partner is usually the private equity firm, and they also get paid fees. And these fees are usually acquisition fees and disposition fees and management fees which are part of the private equity returns. 

Acquisition fees are fees that these firms get paid when they go out and acquire a property. 
So, if they purchase a property for, let's say, $100M and they get a 2% acquisition fee, they will make $2M in that acquisition. 

As well as when they went to sell the property. If they sold it for, let's say $200M, they would get another, let's say 1%. So, they would make another $2M on the sale of the property.

And finally, they usually get a management fee of, anywhere from 1% to 4%. So, let's say if they got a 1% fee, they would make another $1M a year just on the management of that property. 

And then finally they would also get a portion of the overall profits called carried interest. This is above and beyond what they contributed to the investment. 

So, in the scenario, I talked about earlier, there was an additional 13% of profits. The private equity firm would make 20% of that 13% of the total profit. 

Dividend Recapitalization

And then finally, there's something called dividend recapitalization, which is where a special dividend is paid to all the shareholders by issuing new debt. Now that's a more complicated scenario, but it's used to provide liquidity to shareholders without impacting any of the ownership.

Jim Pellerin