Real Estate Private Equity Markets

Real Estate Private Equity Markets Development Projects: THE PLAYERS DEBT SOURCE: Lenders EQUITY SOURCE: Owners and Investors FUNDS DEBT SERVICE CAPITAL FUNDS RETURN ON AND OF EQUITY INFRASTRUCTURE & MUNICIPAL SERVICES PUBLIC SECTOR AGENCIES THE REAL ESTATE ______ Political / Physical / Economic Opportunities & Constraints SKILLS & SERVICES ECONOMIC DEVELOPMENT PROPERTY TAXES & USE FEES DEVELOPER ____________ OPERATOR FEES & INCENTIVES OCCUPANCY COSTS USE & ENJOYMENT THE MARKET ______ Unlevered Required Rates of Return for Various Real Estate Investment Strategies Risk Free Rate Investment Rate U.S. 10-Year Treasury Bonds (5/08) 4.00% Income Strategy Triple Net Leased property 6.00% - 7.50% (+2.0% – 3.5%) 7.50% - 9.00% (+3.50% - 5.00%) 9.00% - 13.00% (+5.00% - 9.00%) 13.00% - 15.00% (+9.00 – 11.00) 15.00% - 20.00% (+11.00% - 16.00%) Core Strategy Fully leased, multi-tenant property High-Yield Strategy Non-investment grade CMBS, mezzanine debt Partially leased, below market rents, renovation Development, lease-up, non-performing loans Value-Added Strategy Opportunistic Strategy Financial Structures Utilized to Own or Invest in Real Estate “Free & Clear” or unlevered – 100% equity, without use of borrowed funds (i.e., mortgage provided by a third party lender) Leveraged – Equity combined with borrowed funds Hybrid – Combines equity, borrowed funds, and mezzanine financing Mezzanine financing may be structured as equity and/or debt Mezzanine finance has substantially replaced convertible and participating mortgage financing Structural Effects on NOI and Cash Flow Land owner (unsubordinated) First mortgage NOI (or Cash Flow) Second mortgage or Mezzanine financing Equity (priority) Equity (subordinated) Land owner (subordinated) Tranches--Slicing a Transaction into Components Priority share of Project Value Capital Markets Slice an Investment into Various Tranches 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Leveraged Equity Mezzanine Commodity Senior Debt Sources of Equity Financing Owner/developer personal resources Friends, family, and business associates Third-party equity sources – High net worth individual investors – pension funds – Opportunity funds, mezzanine investors, hedge funds – Life insurance companies Land owners – Contribution of land in exchange for an interest in the completed property – Option to purchase land at a fixed or increasing price at a future date – Land lease – Seller financing Sources of Equity Financing Direct equity investments and/or equity joint ventures are available for All product types All acquisition models-opportunistic, value creation, rehabilitation, yield, etc. Utilize third-party financing (70% to 80%) Term- 1 to 5 years – Pre-defined exit strategy Joint Ventures Sale and financing transactions are “commodity-like” whereas joint ventures are individually negotiated and tailored transactions A joint venture may be formed to: – Acquire a specific property, a portfolio of properties, or an operating company – Recapitalize an existing partnership – Develop a property Structuring Joint Ventures Each joint venture is idiosyncratic; there are no pre-set terms and conditions Terms to be negotiated include: – Contributions – Preferred returns and “Claw-backs” – “Promotes” – Governance, guarantees (if any), fees and transaction costs and expenses – Winding-up Private Real Estate Equity Capital Markets Range of Required Rates of Return    Equity investor contributes up to 90% of capital required; real estate partner contributes balance Real estate partner’s returns subordinated to equity investor receipt of:  Current return of 4% to 8%, cash-on-cash  Cumulative return (look-back IRR) of 12% to 16% Real estate partner handles day-today operations; paid market rate fees (which increase return on investment) Joint Venture Financing One method public and private real estate operating companies (REOC) are increasingly using to access capital is joint ventures with institutional investors such as pension funds. Involve formation of new, special-purpose entity which is utilized to own the properties of the joint venture. Involve the contribution of existing properties owned by the REOC, acquisition of properties from a third-party, to-be-developed properties, or a combination of all three. Joint Venture Financing If the joint venture involves existing properties owned by the REOC, the REOC contributes the properties at an agreed upon acquisition value while the institutional investor contributes cash. Profit sharing is based on the value of the equity contributed by the parties to the joint venture. Joint Venture Financing Under normal circumstances, the REOC receives an asset management for managing the joint venture as well as fees for property management and leasing the joint venture’s property. Joint ventures have a specified life or term, negotiated among the parties at the inception of the joint venture. Upon expiration, the properties are liquidated either through the sale of the properties to a third party, or acquired by one of the joint venture participants based upon a pre-negotiated formula or right of first refusal. The REOC may receive a disposition fee for selling the properties to a third party. Example Terms of Acquisition Joint Venture Structure: Limited Liability Company comprised of a subsidiary of the REOC and an affiliate of the institutional investor Purpose: To acquire up to $150 million of property Invested Capital: Equity of $45 million, assuming 70% leverage; the institutional investor contributed 75% ($33.75 million); the REOC contributed 25% ($11.25 million) Terms of Acquisition Joint Venture Leverage: 70% of the total acquisition price of the properties Term: Minimum 3 years; maximum 5 years Call Option: At any time prior to the end of three years after the acquisition of a property, the REOC shall have the option to acquire the individual property of cash in an amount sufficient to provide the institutional investor with a 15% internal rate of return on its funds invested in the property Management: The joint venture will be controlled by a committee comprising 5 members, three from the institutional investor and two from the REOC. Terms of Acquisition Joint Venture Fees: The REOC will receive an acquisition fee equal to 1% of the purchase of the properties, management fees and leasing commissions at market rates, a disposition fee equal to 1% of the sale price of properties, and an asset management fee equal to 0.15% of the value of the joint ventures properties. Typical Waterfall Distribution Distributions of Distributable Cash from each project shall be apportioned among the Members and the amount so apportioned to each Member shall be distributed in the following order and priority… Typical Waterfall Distribution First, 80% to Capital Partner A and 20% to OP until Capital Partner A has received a 15% IRR on its Capital Contribution relating to such project; (the initial distribution is pari passu with the capital contribution until the first IRR hurdle) Second, 65% to Capital Partner A and 35% to OP until Capital Partner A has received a 20% IRR on its Capital Contribution relating to such project; Third, the balance 50% to Capital Partner A and 50% to OP Typical Waterfall Distribution The only differences in the liquidating distributions are that the partnership would pay all partnership liabilities and creditor obligations before the waterfall distribution. Typical Waterfall Distribution There also may be a clawback provision in the agreement that is calculated upon liquidation. A typical structure is that if the capital partner does not get the target return (the first IRR hurdle) in aggregate then the limited partners' promote is reduced to achieve that return. In most cases the limited partner would not repay more than they earned above a pari passu distribution of all proceeds. Typical Waterfall Distribution Current Environment: The capital partner has more leverage. This means that the hurdle rates may be higher, the promotes for the LP may be lower and/or fees may be reduced to the operating partner. In certain cases all 3 of these things have occurred. Cash Flow Distributions Current Yield Achieved Up to a 15% cumulative annual yield to the investor Up to a 20% cumulative annual yield to the REOC Thereafter Investor 80% REOC 20% 65% 35% 50% 50% Proceeds of Sale IRR Achieved Investor Up to a 15% IRR to the Investor Up to a 20% IRR to the REOC Above 20% IRR 80% 65% 50% REOC 20% 35% 50%