Raising equity for real estate deals has become more challenging in this current environment of rising interest rates. Real Estate equity investors, including Joint Venture Equity Investors, Common Equity Investors, Preferred Equity Investors, Co-GP Equity Investors, and other types of equity investors (“Real Estate Equity Investors”), have become more selective when making investments, partly, due to the following factors:
Higher borrowing costs for real estate operating partners (“Real Estate Sponsors”) can affect the overall profitability of a project, making it less attractive to Real Estate Equity Investors
Rising interest rates signal potential economic uncertainty or a shift in market dynamics that can make Real Estate Equity Investors more risk-averse and hesitant to invest in real estate projects, particularly those with longer time horizons
Other investment avenues, such as bonds and saving accounts, can become more attractive due to higher yields and lower risk compared to real estate investments
Real Estate Sponsors project longer hold periods to realize the full potential of the underlying real estate deal. Real Estate Equity Investors therefore become more cautious about tying up their equity for longer durations, leading to a smaller pool of potential equity partners for long term real estate projects; and
A myriad of other factors, such as the difficulty to obtain debt financing for the underlying real estate opportunities which can cause execution uncertainty to both the Real Estate Sponsors and the Real Estate Equity Investors, future interest fluctuation rate sensitivity, and a reduced ongoing cash flow component
Given the reasons outlined above, it is easy to see why more Real Estate Sponsors struggle today to attract Real Estate Equity Investors to invest in their real estate deals. At Enterstate Capital, our main focus is on obtaining and investing equity in real estate deals, and therefore, we receive feedback from dozens of active Real Estate Equity Investors on an ongoing basis.
The following is a guide that can assist Real Estate Sponsors to stand out above others in this challenging equity capital markets environment. While these items are important at all times, they become even more crucial in times of increased competition for real estate equity capital.
Develop a Solid, Written Business Plan for the Proposed Real Estate Deal:
Sending an excel model outlining returns is NOT sufficient to attract equity capital. So is sending the model along with a Broker Offering Memorandum prepared by a third-party Real Estate Broker that marketed the deal. First, Real Estate Sponsors should create and document a well-structured business plan that will serve as the foundation of the real estate investment opportunity. It is more than just numbers, it is a document that outlines the project’s details, the development or value add proposition, market analysis, financial projections, competitive landscape, management team, and the potential risks and mitigating factors for the opportunity. The document should conduct a comprehensive analysis of the local real estate market, including trends, and demand-supply dynamics. The more detailed and impressive the document, the easier it is to get the Real Estate Equity Investors comfortable with both the Real Estate Sponsor and the underlying real estate deal.
Real Estate Sponsors should not trust that the Real Estate Equity Investor will welcome a call based on a cryptic model or investment overview, but should make sure that their first contact with such investor will make a strong first impression. As the old saying goes, “You Never Get a Second Chance to Make a First Impression.”
Craft a Targeted Equity Capital Raise Plan with a Specific List of Relevant Potential Real Estate Equity Investors:
When Real Estate Sponsors go under contract for a specific real estate opportunity, the clock starts ticking, leaving them with approximately 60-90 days, sometimes less, to identify potential Real Estate Equity Investors, respond to their due diligence items, get them comfortable with the sponsorship team members, negotiate terms, etc. There is a large pool of potential Real Estate Equity Investors across the globe, so, in order to safeguard the Real Estate Sponsor’s resources, they need to get the project pitched in front of the investors who are most likely to be interested in the opportunity. Real Estate Sponsors should NOT waste time pitching to Equity Investors who are not looking for Real Estate investment opportunities in their niche. For example, many Real Estate Equity Investors only seek out acquisitions and would not entertain ground-up development deals, some investors are enthusiastic about heavy value-add multifamily opportunities while others are seeking lower-risk, newer vintage, multifamily buildings.
Real Estate Sponsors should know their targeted Equity Investors pool so that they don’t waste time and resources, but more importantly, so that they do not get discouraged making dozens of calls with irrelevant Real Estate Equity Investors that are going to pass on an opportunity just because they do not understand the niche or are willing to assume the risk-reward profile suggested by the Real Estate Sponsor. Oftentimes Real Estate Sponsors reach out to Enterstate after having conducted dozens of calls with Real Estate Equity Investors, only to be rejected based on general investment criteria. They become tired, discouraged, and concerned about the financial resources deployed by them to that point, and this increased pressure unfortunately affects their ability to project a strong conviction in the deal in front of the investors who are relevant to the deal.
A better approach is for the Real Estate Sponsors to spend more time researching relevant Real Estate Equity Investors and understanding their investment strategy. Real Estate Sponsors should look at the following key characterizing investment criteria items with respect to potential Real Estate Equity Investors: (a) targeted geographic markets, (b) targeted property types, (c) risk tolerance, such as opportunistic ground up development, value add investments, core or core plus investments, (d) underwritten returns – some Real Estate Equity Investors have minimum thresholds for the underwritten IRR, equity multiple, yield-on cost, average cash on cash return, etc. Even if the deal presented is quite attractive, the Real Estate Equity Investor will not invest in it, if it does not underwrite to their threshold return levels, (e) hold term horizon, with the understanding that most Real Estate JV Equity investors target a time horizon of three to five years, while some retail investors can be more flexible, willing to tie their capital for seven to ten years, (f) sponsorship team criteria – is the Real Estate Equity Investor seeking a well-established sponsor or are they willing to invest with an emerging sponsor? How many full cycle deals does the Real Estate Equity Investor require the sponsor to have in their portfolio? How many completed deals in the specific targeted market? If a Real Estate Sponsor does not meet the required criteria for sponsorship caliber and track record, they may be barking up many wrong trees, exhausting their time, energy and enthusiasm, (g) investment structure - Real Estate Equity Investors have different equity investment structures representing different risk levels across the equity capital stack, with some preferring to be minority limited partners, while others structuring their investment as Joint Venture Equity, Co-GP Equity, Preferred Equity, and creative Hybrid Pref / Common Equity structures.
Develop a Track Record:
Real Estate is a lucrative investment segment, albeit, illiquid, cyclical, and risky. If this is a Real Estate Sponsor’s first real estate deal, or even a first deal in the specific niche, such as a Real Estate Sponsor that used to focus on acquisitions and is now executing ground up development deals, or a Real Estate Sponsor that used to execute multifamily deals and is now seeking to acquire its first industrial or commercial deal, then they should be aware that many Real Estate Equity Investors, particularly savvy Joint Venture Real Estate Investors or Preferred Equity Real Estate Investors, will be very cautious deploying their limited equity capital with such first-time Sponsor.
There are also many new sponsorship teams that consist of senior executives that used to work with large real estate firms, sourcing, executing and overseeing sophisticated real estate projects at such firms. While their experience in previous capacities certainly matters and showcases their overall professionalism and knowledge, many Real Estate Equity Investors will view them as emerging or first-time sponsors because they established a new entity and cannot present a track record in a principal, sponsorship capacity. In these cases, it may make sense for the emerging sponsor to partner with a more established sponsor that does have the track record and knowledge of the specific market or investment niche to make themselves more appealing to potential Real Estate Equity Investors. Similarly, if this is an established sponsor that is expanding to a newer market, property type, or investment type, it may make sense for them to partner with another establish sponsor that can showcase a track record in this newer investment venture.
If the Real Estate Sponsor does have a track record of successful real estate deals in their portfolio, that are relevant to the presented opportunity, then they should definitely present them to the Real Estate Equity Investor early in the process. A proven track record demonstrates their ability to deliver results and can instill much needed confidence in potential equity partners. Real Estate Sponsors should not just list their current holdings, but should spend the time to conduct an analysis of the profitability of deals that were exited, as well as the current valuation of deals that were not.
Prioritize Communication and Skills and Present a Clear Value Proposition:
Real Estate Sponsors should be prepared to communicate effectively with potential Real Estate Equity Investors. They should be able to address questions, concerns, and provide additional information as needed. Active listening can help Real Estate Sponsors tailor their pitch to potential equity partners' interests. Competition for equity capital is fierce, so the best way to stand out during a call is to showcase a deep knowledge of the target market, the value proposition, the ability to mitigate risks, the budget, the competitive landscape, and other relevant due diligence items. In our experience, Real Estate Equity Investors place a significant emphasis on comps, so Real Estate Sponsors should not dance around questions related to this issue and come prepared with backup comps to support their underwriting.
Transparency is key in building trust and credibility between the Real Estate Equity Investor and the Real Estate Sponsor. Therefore, Real Estate Sponsors should be open and transparent about all material aspects of the proposed real estate investment opportunity.
Real Estate Sponsors should also clearly articulate the benefits of partnering with them. Benefits can include the real estate deal’s potential to generate attractive risk-adjusted returns, their track record of success, or expertise in the local real estate market.
Establish a Strong Online Presence:
This is a digital world, and an impressive digital footprint has proven to be more important than ever following COVID-19. A professional online presence, including a well-designed website and active social media profiles, such as Linkedin, can enhance the Real Estate Sponsor’s credibility and make it easier for potential Real Estate Equity Investors to research them and learn more about their backgrounds and projects. A Real Estate Sponsor without a website, or one that cannot be found on Linkedin, becomes an enigma, and therefore less attractive, to a large pool of Real Estate Equity Investors.
Design an Equitable Equity Structure and Prepare to be Flexible in Negotiation:
The equity sharing structure should be fair and motivating for both parties. Real Estate Sponsors should show how profits will be shared, usually through a suggested waterfall, and create an arrangement that aligns everyone's interests toward a common goal. Excessive fees or an aggressive waterfall can be major turnoffs to Real Estate Equity Investors. Many Real Estate Equity Investors want to ensure that Real Estate Sponsors are motivated mainly through the promote and not through high acquisition, development, asset management, or property management fees. For example, acquisition fees typically range from 1-3%, asset management fees are typically 0.5-1.5% of gross property revenues, and property management fees, assuming that the Real Estate Sponsor also acts as the property manager, need to be in line with offers from third party property management firms in the market.
“Put your money where your mouth is” - most Real Estate Equity Investors, particularly JV Equity Investors and Preferred Equity Investors, require Real Estate Sponsors to contribute at least 5-10% of the equity in the deal, in the form of a GP commitment. Real Estate Sponsors should not expect more than 95% of the equity commitments to be funded through third party investors, and expecting that, is a major turn-off to such investors.
Get Help from Professional Real Estate Equity Capital Markets Firms:
The increased competitive landscape has made it more difficult than ever to source quality equity capital for real estate deals. As noted, Real Estate Sponsors typically have 60-90 days, sometimes less, to get a deal capitalized, creating significant pressure on them. Managing all the elements outlined above, such as putting together a relevant investor target list, researching leads, and scheduling calls, can be a daunting task in such a short timeframe.
Real Estate Sponsors can consider utilizing the services of professional equity capital markets firms that specialize in marketing such relevant deals. These equity capital markets firms are typically more strategic in their approach to sourcing equity, and have the capabilities to cast a wide net in their investor outreach.
When considering whether to engage a third-party equity capital markets intermediary, Real Estate Sponsors should ensure that such intermediaries are properly licensed to conduct such capital raising activities.
Final Thoughts:
Attracting Real Estate Equity Investors requires patience and persistence. By following these key steps and tailoring them to the specific investment opportunity, Real Estate Sponsors can create an appealing proposition that entices potential equity partners to join them in their real estate ventures.
Real Estate Sponsors should always seek professional advice and ensure legal compliance throughout the process. Perhaps more than all, they should have a strong conviction in the proposed deal and be truly excited about it. No one wants to invest with a Real Estate Sponsor who is lukewarm about a proposed real estate deal. Excitement is contagious and can help to attract likeminded investors.
Important Disclaimer: Enterstate Capital, Ltd. (“Enterstate”) published this article to convey general information about our services and not for the purpose of providing any investment, legal or tax advice. Strategies mentioned herein may not be appropriate for you. Past performance does not guarantee future results. All investments include risk and have the potential for loss as well as gain. You should consult an investment professional regarding your own situation. Nothing in this article should be considered an offer of securities or the solicitation of an offer to acquire securities of any type.