Understanding Private Equity Real Estate Services and Fees
By: Eric Cress, President & CEO, UD+P
Accredited Investors have become more interested in private equity real estate as a sound addition to their portfolios, catching on to an investment strategy that ultra-high-net-worth families have employed for decades. Regulatory changes and new internet-driven marketplaces have created choices for Accredited Investors to invest in private equity real estate. With so many options, it might be hard to understand the roles and motivations of different "players" in the market. This post outlines the primary service providers' roles, incentives, and fees to help investors select their strategy.
Accessing Real Estate Private Equity
Individual investors typically learn about private real estate investing through a wealth manager or an online marketplace. These are their access points to real estate. An investor's access point to private equity affects the services they receive, the returns they make, the fees they pay, and the risk they take. It's essential to understand providers' motivations, expertise, and pricing from the investor's access point down to the actual investment in "sticks and bricks." You can think of these access points and the corresponding providers as a "stack." In general, the lower you go down on the stack, the lower fees you pay, and the fewer services or benefits—including diversification and risk mitigation—you receive. In other words, you typically trade investment return for services and risk-reduction.
Fees are important, not just because they are a "load" on your investment return, but also because of the financial incentive structure for your partners. If I have one piece of advice, make sure to have your partners explain to you how every service provider in the "stack" gets paid so you have a good understanding of their incentives. As Warren Buffet's partner, Charlie Munger, says, "Show me the incentive, and I will show you the outcome."
Real estate investments are investment products complete with retail providers, wholesale providers, and manufacturers. Retail providers have a broad and convenient selection of inventory, wholesale providers have specific products packed with different features, and "manufacturers” produce the investments and sell them up the chain. Figure 1 diagrams the provider "stack."
Retail Layer
Broker/Dealer
Working through a broker-dealer is still one of the most common avenues for private equity real estate investing. Before the advent of crowdfunding, individual investors accessed private equity real estate through their stockbroker or licensed broker-dealer. Licensed broker-dealers from reputable firms generally have arrangements with large private equity funds to place private capital into real estate. Some broker-dealers specialize in "private placement" investments into private equity. They can be quite knowledgeable and explain the nuance and the risks of their investments. Broker-dealers receive a commission from the fund or investment, so they are biased toward investments that pay commissions. Be aware that they have an inherent conflict of interest: their fees can effectively come out of your returns and can be quite large.
Registered Investment Advisors (RIAs)
Historically, RIAs have shied away from private equity, preferring to focus on a suite of financial services, including investment advice, placement in mutual funds, and sometimes individual stocks. Competition from low-cost online "robo-advisors," which promise to provide the same diversified portfolio at very low fees, has forced advisors to step up their game. Some RIAs have started to offer private equity investments, which tend to be more nuanced than just investing in a mutual fund. Many sophisticated investors demand access to private equity and will only work with fee-only advisors that provide access.
RIAs have a fiduciary duty to represent their clients' best interests with no conflicts. It is refreshing to know that you are not getting "sold to" when selecting a specific investment. Also, an RIA considers the client's portfolio, circumstances, and risk tolerance when presenting investments. The downside is that many RIAs that offer private equity investments do not have expertise or specialization in the asset class. So, investors may have to look outside the fee-only advisor's offerings for an investment, which can make the advisor uncomfortable and sometimes affect their compensation if the investment is not under their management. RIAs typically take a fee of 1% - 2% of assets under management and require a $1MM minimum value of assets. This fee comes right out of your annual return but can certainly be worth it if they provide access and expertise.
Unless you are an experienced investor, working with an RIA is an excellent way to go, especially if you can find one that has expertise in private equity.
Wholesale Layer
Accessing investments at the wholesale layer can be enticing because you skip the entire retail layer of fees, but there are sacrifices.
Direct Private Equity Fund Investing
Finding opportunities for direct private equity fund investing can be difficult. Many investment funds are not set up to work with individual investors unless their investment commitment is large, in the $1MM+ range. Funds may be unable to provide personalized service and answer small investors' questions. However, they may be a good option for those who can write a multi-million dollar check or have the time or staff to do the research and watch over their investment. For smaller investors who want to research and select fund investments directly, crowdfunding or finding a Co-GP fund partner might be an option (see below).
Private equity funds typically earn their money through a combination of asset management fees and performance incentive fees (in the form of promoted profits or a share of cash flow). You have probably heard of the "2 and 20" compensation model where fund managers earn a 2% annual asset management fee and 20% of an investment's cash flow. These managers generally provide deep expertise, and they can and should be paid well. Still, this structure has an inherent conflict of interest as managers earn their annual 2% asset management fee even when the investment is not performing. The argument for an annual asset management fee is that they need to "keep the lights on" during hard times to manage your investment well. While that may be the case, it is when times get tough that good managers truly differentiate themselves.
Crowdfunding
Crowdfunding companies are the new kids on the block. Like other fintech firms, they disrupt the financial industry by "eliminating the middle-person." Crowdfunding companies provide a marketplace where small investors can connect directly with investment funds, developers, and asset managers while bypassing RIAs, broker-dealers, and traditional funds. Initially, crowdfunding sites had the reputation of attracting unestablished developers and asset managers that did not have the track record to access an established funding source. But as of late, some crowdfunding sites, such as Crowdstreet, have attracted well-established developers and sponsors. The downside with these crowdfunding marketplaces is that investors are truly on their own. Crowdfunding companies do some vetting, but investors are responsible for researching and selecting individual investments and will need to construct their own diversified portfolio if they are not investing in a fund. Crowdfunding fee structures vary, but they are generally not based on the performance of the investment. They don't have a financial incentive to rigorously underwrite investments, nor do they have a fiduciary obligation to look out for the investors' best interest.
Co-GP Fund
Co-GP investment funds have been around for a while but were generally small and fractured. Lately, companies like Urban Development Partners (UDP) have been working to make Co-GP investments more widely available. UDP has a vertically integrated model in which investors work directly with a developer/sponsor by investing in a fund vehicle that then places capital into a portfolio of investments. Depending on the size of the fund, it can diversify by asset type and geography, thereby offering the risk-mitigating benefits of a diversified portfolio.
Again, the incentive structure is critical here. Most other developers earn a developer fee and an asset management fee to deliver and manage a project, along with a plethora of other fees that are not performance-based. So, their incentive is to raise capital and complete the project, not necessarily protect your investment. Also, keep in mind some of these fees may be "buried" in the project costs and not obvious. Urban Development Partners handles the incentive problem by tying the vast majority of its compensation to investment performance. The company only makes a profit when investors make a profit. Again, always ask your advisor about incentives.
Manufacturing Layer
Direct Building Investment
Finally, investors can work directly with a developer/sponsor to make a direct limited-partnership investment in real estate. For "institutional quality" assets, this option is generally limited only to large investors. However, there are many small shops and startups that are looking for capital to develop 4-unit, 8-unit, and 12-unit projects. These are generally "friends and family" investments where the purpose is beyond financial, with an underlying goal of helping someone break into real estate development. For obvious reasons, these investments tend to carry more risk, but it is possible to find a "hidden gem," especially if the project is in a location that the investor knows well. But be prepared to spend a fair amount of time monitoring the investment, and don't expect timely detailed reports.
Summary
In summary, the different layers of investment access providers vary in what they offer in several key areas. Investors should make sure they have a good understanding of their service providers, from their access-point to the "sticks-and-bricks," in these areas:
Service
Assess the provider's access to a wide range of investment opportunities. Access to an array of investments can help improve your selection. The provider's expertise-backed research and information are essential. Finally, reporting is an important service and quality cue.
Risk
Diversification—among geographies and asset types—is an important risk mitigator. Established firms have access to the best partners and contractors, which is vital to performance.
Incentives and Fees
Some providers have clear conflicts of interest. Make sure you understand them. How does each party get paid? Remember, "Show me the incentive, and I will show you the outcome."