Do investors need to pay a fund manager fees and carried interest to assemble a successful real estate portfolio? Or can investors build their own portfolio through individual sponsored real estate investments, reduce third-party costs, and manage the strategy themselves?
This article examines three aspects of building your own real estate portfolio through LP investments: before the wire, after the wire, and maintaining real estate exposure after capital events. It also considers the tradeoffs of outsourcing these responsibilities to a fund manager.
Having a minority stake as an LP in a private placement or real estate deal has a clear line of demarcation. This line is when the investor wires funds and signs the subscription doc. At this moment, control transfers from investor to sponsor. This is a discussion of each phase of the process.
The investor controls all aspects of their approach to investing at this stage. Before a commitment where an investor invests cash into an illiquid investment, such as real estate or private equity, an investor should begin with a clearly defined investment objective.
An investment objective is one of the first paragraphs in a PPM for a fund offering. Every professional fund manager has an investment objective for their offering, and you should too. At a minimum, it allows you to filter through the thousands of real estate offerings in the market and stay focused on your investment objective.
With an investment objective in mind, investors need to source deal flow. This can be sourcing direct ownership of property from real estate brokers or seeking operators offering private placements.
More deal flow is better. The bad deals reviewed give confidence to pursue the more attractive deals. Good deals shed light on market conditions and operators. The great deals combine experienced operators, an attractive market, superior terms, and a formidable property business plan.
Building this pipeline takes time and networking. With real estate and private placements being an opaque market, check size, and ability to close often give the edge to decisive, well-heeled investors over non-committal, smaller investors. Once deals start coming in, investors should expect to say ‘no’ far more often than ‘yes.’
This pipeline must be maintained and grown. Some sponsors maintain detailed investor and potential investor lists which they blast with every deal they source. However, many sponsor groups are reactionary, and they source their next deal and then scramble to raise equity. These sponsors will often reach out to their larger investors first and work their way down their investor list as the capital stack comes together. By being proactive and reaching out to sponsors every couple of months with a quick email: “Do you have any upcoming deals that need equity?” investors may get an earlier look at new deals.
Valoran keeps a straightforward structure. Its primary compensation is the 1.50% management fee and carried interest, which ties much of the Manager's economics to how the investments actually perform. Valoran also absorbs organizational expenses above the $250,000 cap and any placement fees. There is no separate, predetermined layer of fees payable to Valoran — the documents permit market-rate transaction fees where applicable, retained by Valoran and not offsetting the management fee.
Some of the questions to ask of any deal:
Sponsor
What is their experience in this market?
Do they own multiple properties with several successful exits?
Are they vertically integrated?
If not, what is their relationship with their third party property manager and GC?
How much equity are they contributing to the deal?
A meaningful amount relative to the entire equity need is ideal
Who is the anchor investor in the sponsor and the deal?
Market
MarketTerms
TermsBusiness plan
The financial markets are littered with models filled with aggressive modeling assumptions. Any underwriter with several months of work experience can change the assumptions in a bad deal and make it look like the U.S. purchase of Alaska from Russia in 1867. Don’t believe the projections on the page unless you know the inputs.
Ask questions until you’re satisfied with the answers. To start with:
How will the proforma rents be achieved?
What justification do you have for future rent growth? Who knows where 3% came from, but it seems to be the standard rent-growth assumption in nearly every model. Actual rent growth rarely follows a model's assumptions with such precision.
Explain the exit cap. This is the “magic wand” input which can change the IRR of a deal by double digits by moving a fraction of the market cap rate. As an investor, the exit cap should be modeled higher than the current market believes is realistic.
Property
Why is this property an opportunity?
Who is the seller and why are they selling?
Why didn’t the current owner improve the property like the new sponsor claims they will do
This is anticlimactic. After signing subscription docs and wiring funds, the investor receives an email: “Congratulations! The deal is closed.”
From the investor’s perspective, this is when the sponsor gets to work and the investor monitors the investment. The sponsor should be sending quarterly reports complete with property financial statements, a description of work being done to the property, property and market commentary, current vacancy, in-place and asking rents.
Investors should never hesitate to reach out to the sponsor with any questions about the property and reporting. Pay particular attention to how the property is performing against the original proforma and track rents, occupancy, expenses, NOI, and renovation pace.
Don’t confuse distributions landing in your bank account with a well-performing asset. In many value-add real estate investments, a significant portion of the total return is realized at sale. This means the asset must be positioned for the highest property-level NOI, because a future buyer is buying the property’s future growth and not your received distributions.
Unfortunately, capital calls do occur for investments. Investors should always have cash ready to fund capital calls, but prior to funding any capital call, they should ask questions of the sponsor along the lines of their initial due diligence. A capital call should trigger a fresh underwriting analysis. Why is additional capital required? Has the original business plan changed? What are the consequences of participating or declining? Investors should approach additional capital with the same discipline applied to the original investment.
At year-end, sponsors will send 1099s or K-1s to investors. Often these K-1s are delayed past the April 15 tax deadline, potentially requiring investors to file extensions for their personal tax returns.
Capital events rarely happen as modeled or on your schedule. Deal-related items like debt terms and market conditions will drive capital events more than the offering memorandum issued prior to the acquisition of the asset.
When capital is returned from an investment, the decision of what to do with funds is the next step on the decision tree. If capital is to remain invested in real estate or private placements, the process of sourcing, underwriting, and closing the deal begins again. The timing of an investor on the receiving end of a capital event and redeploying does not always line up on the investor’s desired timeline. Discipline, patience and continued adherence to the investor’s investment objective are crucial to effectively acquiring new investments after a capital event.
Returned capital creates an opportunity for an investor to reassess and rebalance their portfolio.
Time spent building relationships and sourcing deals can make future opportunities easier to find, but underwriting discipline should never waver.
Investing in a fund removes the need for an investor to source and execute multiple transactions to create their own portfolio. Fund managers run the process of sourcing, underwriting, and closing deals as a full-time business.
A fund manager maintains a network of deal sources, dedicates resources to underwriting, and may be able to negotiate terms unavailable to smaller investors. Depending on the structure, the manager may also obtain control rights over major decisions, oversee investments after closing, provide institutional investor reporting, and consolidate tax reporting.
The tradeoff is another layer of fees and carried interest in exchange for outsourcing much of the portfolio construction and management process.
Investors need to perform their own due diligence on the fund and its manager. Like property-level due diligence, investors need to have an in-depth understanding of:
An investor can create a diversified portfolio of real estate holdings and private placements with a defined plan and attention to execution. The alternative option is to invest in a fund to outsource the process of creating a portfolio. Each approach has its own tradeoffs. The decision ultimately comes down to how much of the investment process an investor wants to perform personally and how much they are willing to pay to have someone else perform on their behalf.
Important Information
This article is provided solely for educational and informational purposes. The views expressed reflect general observations regarding investment analysis, private markets, real estate investing, valuation methodologies, underwriting practices, due diligence considerations, and fund structures.
The information presented is not intended as investment advice or a recommendation regarding any specific investment, manager, property, fund, security, or strategy. Readers should conduct their own independent due diligence and consult their professional advisors before making investment decisions.
Investments in private funds and alternative investments involve substantial risks and are not suitable for all investors. Such investments are generally illiquid, may involve leverage, may have limited transparency, may be difficult to value, and may result in the partial or complete loss of invested capital.
Certain statements contained herein may constitute forward-looking statements. These statements reflect current assumptions and expectations regarding future events and market conditions.
Actual results may differ materially from those expressed or implied due to changes in economic conditions, capital markets, interest rates, tenant demand, property performance, financing availability, governmental actions, and other factors beyond the control of Valoran Capital Management.