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Private Equity is a really attractive place to be for young real estate professionals, but if you haven't been in this business before, it can kind of feel like a black box as far as what's going on behind the scenes. Real estate private Equity firms control a lot of the capital outflows and inflows in this industry, and if you want to work in commercial real estate, it's very likely that you're going to be working for or with a company that raises third-party Equity to fund their deals.
So, in this video, I want to pull back the curtain on how the real estate private Equity business model actually works, how you would ultimately fit into this if you were to work in this industry, and if you want to become a real estate entrepreneur, how this entire ecosystem can end up coming together to help you fund your [Music] projects.
So, to step back and define real estate private equity in the first place, this essentially refers to any company that invests in real estate that raises third-party equity capital to fund their transactions. Now, among real estate private Equity firms, there are two separate categories that these companies will fall into: one is the general partner or GP category, and the other is the limited partner or LP category.
And to start with the GP side of the industry first, commercial real estate investment and development firms that are on the front lines of doing deals, so sourcing investment opportunities, buying properties, and managing the business plans of these investments directly, are referred to as the GP or general partner on a deal or fund. And this is going to be the active partner on the deal, doing most or all of the legwork. These firms will then often raise their equity from bigger private Equity firms that act as the limited partner or LP on a deal, serving as the main equity contributors but not contributing to any of the day-to-day responsibilities associated with managing a real estate investment.
And where this gets interesting is that these LPs will then also typically raise their capital from outside sources, effectively creating a third layer of funding with these firms looking to capital sources like pension funds, sovereign wealth funds, or university endowments to fund their investments.
Now, once we have an idea of the different players in this industry, we also need to understand how these deals work from a financial perspective, because this is really where the incentives behind companies getting into this business in the first place start to come into play. First, there are often fees a GP will charge an LP in exchange for finding and managing a deal, usually in the form of acquisition fees, construction management fees, asset management fees, and disposition fees, which all tend to be paid as a percentage of certain amounts.
Acquisition fees will typically fall somewhere between about 1 and 2% of the purchase price of a property. Construction management fees will usually come in at anywhere from between about 4 and 8% of total construction cost. Asset management fees will usually come in between about 1 and 2% of the effective gross revenue generated by a property, and disposition fees will also come in at about 1 to 2% of the sale price of the deal.
And because these fees are calculated using percentage values, this is why a lot of real estate firms will look to buy the biggest deals they can as quickly as possible to maximize these numbers on a whole dollar basis. So, for example, on a $100 million deal with a 1% acquisition fee, that acquisition fee alone would be $1 million, and if this property also generated $10 million per year in revenue with an asset management fee of 1%, this would produce an additional $100,000 per year in recurring fee income.
But where these numbers start to really get big is on the back end of a deal, where the GP is often able to participate in a percentage of the profits over and above their initial equity investment, and this is referred to in the industry as promoted interest. Promoted interest is generated by a GP by exceeding what's called a preferred return, usually related to an IRR or equity multiple value, and this allows a GP to essentially take a larger portion of the cash flows generated by an investment once that LP hits their target returns. The promoted interest percentage itself refers to the additional percentage of the cash flows over those return hurdles that are going to be immediately funneled to that general partner, and this percentage will be earned by the GP regardless of how much capital they initially invest in a deal.
And to walk through a basic example of how this might work in practice, on that same $100 million acquisition, if we were to buy this property all cash, we had a preferred return of an 8% IRR, promoted interest was 30% above that 8% IRR, and the GP invested nothing upfront, here's how the numbers would look if we sold that property for $120 million just one year later after 1 year of ownership. With an 8% IRR hurdle, the LP on the deal would need to be distributed $108 million to hit their preferred return, meaning that the GP wouldn't be distributed any cash up to that point. But then, on the next $12 million of cash flows above that 8% IRR, the GP would be entitled to 30% of all cash flows generated, or in this case, $3.6 million.
And even though this might sound like a one-sided deal for the GP, this ends up being a win-win scenario for both the GP and the LP on the deal, with the LP still generating a 16.4% IRR in this case and $16.4 million in profit. And from there, these cash flows generated by the LP are then often subject to similar promoted interest structures agreed to by their capital partners when they initially raised these funds. This is what's referred to in this industry as a double promote structure, where there are two layers of promoted interest that two different parties earn, and this is one of the biggest incentives for these companies to invest in real estate in the first place.
Now, you might be wondering why these pension funds or sovereign wealth funds don't make these investments themselves. And in the vast majority of cases, this is because these organizations don't have the internal teams necessary to run this entire process. In a lot of cases, real estate allocations for these groups will only be between about 5 and 15% of their total portfolio value, so this sector doesn't tend to be a huge focal point for these organizations. And instead, they'll choose to outsource this to professional money managers to place capital for them, who then either invest that capital directly in real estate themselves or invest alongside an active general partner.
And this ultimately means that in a lot of cases, real estate private equity is investing on behalf of teachers, firefighters, police officers, and other government workers that are relying on a pension to fund their retirement income. And the need to provide this income on a long-term basis is ultimately what sets these real estate investments in motion on such a large scale.
Now, obviously, there are different levels to this, so there are a lot of companies out there that choose to remain small and just raise capital from friends and family. So, real estate private equity doesn't necessarily mean big by default. But in either case, this industry is driven by an investor's need for income and capital growth, and the fees and promoted interest earned by the companies that make these investments.
So, ultimately, there are a lot of moving pieces within real estate private Equity as a whole, but I hope this gives you a better sense of what actually goes on in the industry behind the scenes. And if you are looking to break into this part of the business and you want to make sure you have the technical skills you'll need to land interviews and pass an Excel modeling exam that might be given to you during the process, 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.
And if you like this video and want to see more content on the inner workings of the commercial real estate industry in general, make sure to hit the like button, let me know, and let me know in the comments what other career paths or industry sectors you'd like to see covered in more detail in a future video on the channel. As always, thanks so much for watching guys, I hope you found this helpful. Subscribe to the channel if you haven't already to see more videos like this every single week, and I'll see you in the next video. [Music]