Trends facing real estate private equity

The recession, financial crisis and pullbacks in the credit market have taken a toll on real estate private equity over the past few years.

In our annual global market outlook examining real estate private equity trends, we look at how world events may impact your business, peers and competition.

Changes to fund structuring terms

The private equity real estate market placed a concentrated focus on fund management fees as a result of the economic crisis.

Fund managers face pressure to structure fees consistently with industry norms. Deal terms that were standard before the crisis have been challenged and modified as the sector moves into the post-crisis era.

The pendulum has definitely moved for many managers, although there is some evidence that it’s starting to swing back toward pre-crisis levels.

We’ve found that since the economic crisis, the average preferred return for real estate funds is 9%.

Preferred return level: Funds closed post-crisis

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Comparing the average 2007 terms with 2011 terms

How have the average terms changed since the financial crisis? Use the chart below to see how terms have evolved and to benchmark your business against this data.

Key term 2007 trend (pre financial crisis) 2011 trend
Waterfall structure Mostly deal-by-deal returns Seeing an increasing trend toward full pooling of returns as opposed to deal-by-deal returns, which were
common on the legacy funds
Carried interest 80/20 the typical structure, with a 50/50 distribution to get to the agreed-upon profit split 80/20 the typical structure, with a 60/40 or 70/30 distribution in favor of limited partners (LPs) to get to
the agreed-upon profit split becoming increasingly prevalent.
New trend — carried interest to be reviewed by auditors before payment
Preferred returns Mostly 9% Should be calculated from the day capital is contributed to the point of distribution.
Average of 8.8%
Target returns Levered returns of 20%+ Levered returns of 16%–20%+
Investment period Average of four years Generally now being scaled back to three years
Overall fund period Eight-year period, with option to extend for two one-year periods Evidence suggests shorter fund durations, now six years on average vs. the typical eight year-term precrash,
with the option to extend for two one-year periods
Clawback provisions Generally did not extend beyond the term of the fund The period should extend beyond the term of the fund, including liquidation and any provision for LP giveback of distributions
General partner (GP) commitments Standard of 1% LPs are expecting aggregate GP commitments to be meaningful. This should be contributed through cash and not through the waiver of management fees
Management fees Average of 1.5% of capital commitment during investment period and invested capital after investment period Based on actual costs incurred by the GP on a cumulative basis and capped — with many having .5% on committed capital and 1.35%–1.75% on invested capital, but can go lower depending on size of committed capital and can vary based on commitment period and investment period
Leverage (maximum) Averaging in the 65%–75% range Averaging in the 60%–70% range

Regulatory reforms play a bigger role

The regulatory bodies are focusing on the alternative investment industry, which until now has been lightly regulated.

The new changes may have an impact on the real estate private equity industry to an extent we have never really seen before. What was previously a very immature industry is starting to take on an increased element of operational maturity and is benefiting from better deployment of technology.

Regulations that impact the real estate funds industry include:

  • Dodd-Frank Act
  • Alternative Investment Fund Managers (AIFM) Directive
  • AIFM (Non-EU-based platforms)
  • Basel III
  • Solvency II
  • European Markets Infrastructure Regulation (EMR)

How might investors react to regulations?

As much as investors want to feel a little more secure that their investments are being looked after properly, they don’t want the fund manager to be too burdened or overly focused on compliance with regulations and the increasing costs of running the fund, which will impact their returns.

Very often, when investors place capital with real estate private equity funds, they’re looking for outsized returns, which comes down to speed-to-market and being able to act quickly without having to deal with a lot of cumbersome regulations.

Potential accounting changes

The Financial Accounting Standards Board (FASB) recently issued an exposure draft that would significantly change the way real estate entities account for their investments.

Fair value

The proposal requires investment property entities to measure investment property at fair value with changes in fair value reported in net income.

Investment property entities would present investment property assets and related debt on a gross basis on the balance sheet, and rental revenue and related expenses on a gross basis in the income statement.

Investment property entities would only consolidate controlling interests in other investment property entities, investment companies and entities that provide services to such entities.

The FASB’s proposal would be a significant change for entities that currently follow a historical cost accounting model (e.g., certain REITs), and real estate funds that follow a variety of fair value accounting models.

The proposal would also affect real estate funds that follow the investment company guide and account for their investments at fair value without consolidation.

Investment companies

In addition, the FASB is now also proposing an amendment to the investment company guidance, which funds currently follow.

As the guidance is currently proposed, it appears that many of the funds that invest solely in real estate will fall under the definition of investment property entities instead of investment companies, which would require them to fully consolidate many of their investments based on US GAAP consolidation rules.

Real estate fund managers are going to have to show rental income, real estate taxes, operating expenses, property level debt, etc. on the financial statements—a difference from the way it is presented under the current investment company model.

This proposed change will require a significant amount of effort to obtain and maintain this additional information. Worse yet, if a fund falls under the investment company entity model, as opposed to the investment property entity model, and has a controlling financial interest in an investment property entity, it would be required to consolidate the investment property entity.

This means the fund would not be able to present the net investments on one line; rather, it would show a gross presentation of the assets and liabilities and revenues and expenses of the investment property, which would then result in the presentation being more like an investment property entity.

The investment company may also be required to present noncontrolling interests in its consolidated financial statements.

Real estate fund managers may not have access to the information required to properly prepare consolidated financial statements. Fund managers should consider the proposed changes and share their comments with the FASB prior to the 15 February 2012 deadline.

The following is a summary of our report’s key findings:

  • There is likely to be a long, slow recovery in the real estate funds sector, but distressed deal opportunities will continue, and convergence of the bid-ask spread will foster greater deal volumes.
  • Due to a wave of regulatory and financial reporting changes, the fund operating models will change over the medium to long term.
  • Overall fund terms have not come back to where they were pre-crash, and many real estate fund managers have had to make investor concessions.
  • Investors are now more focused on scrutinizing the real estate fund platforms where they are placing capital. More information will be needed to meet investors’ reporting requirements.
  • For most fund managers, the fundraising process is significantly longer compared to predecessor funds.
  • Fund managers required to register may find their marketability to investors improved.