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21 Feb, 18 tweets, 4 min read
How do Real Estate Private Equity Deals get structured?

- Capital
- Returns
- Hold Period
- Fee Structures

Here's everything you need to know:
There's 2 main people or groups of people in an investment. General Partners (GP's) and Limited Partners (LP's)

The GP is the person that does all of the work. They find the property, negotiate the contract to purchase the property, perform due diligence, & manage the property.
LP's are also known as passive investors They provide the capital to the GP to go purchase the property.

They should review reports and investment details before making their investment and during the lifecycle of the deal should be reviewing reports and financials.
There's typically 2 classes of equity. The first is Preferred Equity" and the second is known as "Common Equity".

Preferred Equity also short for "Pref" is for the LPs. They are the first equity holders to get paid (besides the bank of course, which is not equity but debt).
Common equity is for the sponsor. Gets paid after the bank and after the Pref equity.

Sometimes, GPs will co-invest alongside LPs so they have both a share of Pref Equity and Common Equity. Some LP's like to see this, because it shows that GP's have financial "skin in the game"
Pref equity can range anywhere from as little as 2% to 12% depending on the type of property, location, and a variety of other factors. Commonly it's somewhere from 6% - 9%.

This means that the LP receives their percentage return first based on their equity investment.
Usually, this is correlated with risk.

4% pref may imply that you are taking on a much lower risk investment, whereas 12% may imply a much higher risk deal.
2 important points:

1. Pref isn't guaranteed. It's stating that this class of equity is given preference relative to the Common Equity in distributing cash flows.

2. Just because a GP is saying they can pay you X% Pref doesn't mean it will happen. Do your due diligence
Let's move on from Equity and discuss the upside: Promote.

Promote is also called "Carry" or "Carried Interest". This is a percentage of profits the GP gets after the LPs get their expected returns.

Promote can vary widely based on many factors ...
Here's a common example:

In a deal, LPs receive 7% pref return annually. After LP capital is returned, profits split 80/20 between LP to GP.

At 13% IRR, defined as "hurdle", the split turns to 50/50. These splits over and above defined milestones are known as Carried Interest
Another thing to look for is the "hold period" - how long will the deal be held?

GP's let everyone know how long they plan to hold the investment. Sometimes it's 3-5 years, other times it's a long-term buy & hold.
Let's talk about incentives on hold period:

GP's can make a lot of money from the promote. But often times, the only way to hit their promote is to return capital back to their shareholders by selling the property.

Is that the best thing for LP's?
Sometimes, holding on to the deal longer-term may be best to continue to generate passive cash flow.

Also, by selling the property you end up paying taxes. And over a long enough time horizon those taxes eat up into the returns that you could have been compounding.
LP's won't often realize this because they generated a great return after 3-5 years of 20% IRR.

But when you go to re-invest those profits, you might not have great investment ideas or prospects. So, they get short-term benefits but long-term may be hurt by this.
@chamath agrees -

"What does IRR mean? Fast money returns can completely decay long-term thinking and sound judgement. I would really just like to compound at 15% per year. If I can do that for 50 years, that's $250 Billion Dollars. Slow and steady."

Fees: Typically it's Acquisition and Asset Management Fee.

Acq fees range anywhere from 1% to 5%. Asset Mgmt fees generally anywhere from .5% up to 2%.

Don't merely get turned off by the fees. Sometimes, people who don't have enough of a track record are charging the lowest
This structure applies to Hedge Funds, VC's, and anyone who is managing capital.

VC's do a 2/20 model (2% fees and 20% carry). Jim Simons did 5/44. He generated 66% returns over 30 yrs.

If you'd rather watch me explain this, click below:

If you liked this thread and want to read more about Real Estate Investing and other Money stuff, click below to subscribe to my newsletter.

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As an LP in any Real Estate syndication, you want to understand how aligned your incentives are with the GP.

The largest misalignment I see today are hold periods. GP's are exiting deals after 3 years, because they hit their promotes. But this harms the long-term oppty for LPs.
GPs hit their promote once they hit a hurdle rate, let's say 13% hurdle.

But usually the only way to hit that hurdle and the GP to be "in the money" is to sell the deal. So, they sell after a few years.
Any tax benefits that investors received during the hold period from cost segregation & bonus depreciation get wiped out when that depreciation gets "recaptured" at the sale of the property. In addition to that you're paying capital gains tax on the sale.
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