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Sources of Commercial Equity Capital

by | May 24

Week 7: Sources of Commercial Equity Capitaland Debt & REIT MarketDr. Isil EROLWhat will we learntoday?• Corporate finance – Businessownership structures.• Who are the main investors incommercial real estate (CRE) –or income-producing property –markets?• Institutional versus noninstitutional investors.• Equity & debt investorsUS Commercial Real Estate MarketSource: Data from Flow of Funds Accounts of the United States Federal Reserve, March 10, 2016, www.federalreserve.gov. Estimate of investible CRE is fromCBRE Global Investors (ww.cbreglobalinvestors.com).Note: $8.8 trillion of investible CRE excludes CRE owned by non-RE companies and by federal,state, and local governmentsCommercial Real EstateØ Direct vs.securitizedinvestments?Ø How leveraged iscommercial RE?Ø 76% of CRE held byprivate markets.Forms of Ownership forPooled Equity Investmentsü General Partnership (GP)ü Limited Partnership (LP)ü Limited Liability Company (LLC)ü Real Estate Investment Trust (REIT)Due to large size of typical real estate investments, investorsalmost always pool their equity capital.Advantages of PoolingEquityüAllows investors to purchase aninterest in larger propertiesüDiversification of portfolioüEconomies of scale inacquisitions, management anddisposition.üAccess to cheaper debtcapitalüExpertise of management teamhired.Disadvantages of PoolingEquityüRelinquish management controlto active manager(s)üMust compensateüorganizer with fees, salary ordisproportionate share ofequity ownershipü lower return on equity, allelse equal.A Quick Tour ofPossible OwnershipFormsTaxationLimited or Unlimited LiabilityManagement & Full controlProfit distributionGeneral PartnershipØAll partners can make operating decisions:ØHow much leverage; when to sell, etc.Ø No separation between ownership & control;lessens potential conflicts of interestØShare of cash flow & taxable incomedetermined by partnership agreementØ“special allocations” permittedØInvestors avoid double taxation (checkcorporations).ØFull liability!General Partnership – DisadvantagesØGeneral partners liable for all debtsØContractual debts, debts arising from legal actions, wrongful actscommitted by other partners…ØSo…personal assets are subject to claims of the partnership’screditorsØResult?ØFairly uncommon & Existing GPs generally have few partners.Limited PartnershipüCreates 2 types of partners: general& limitedüGP who organizes venture isusually a knowledgeable builderor investor – ManagementüLimited liability for LPs;unlimited for GPüLPs cap their personalliability to an amount equalto their total investment.üLPs give up control of management& policy makingLimited LiabilityCompanies (LLC)ØLCC is a hybrid ownership structurethat combinesØ the limited liability for the owners (acorporate characteristic)Ø the tax characteristics of partnershipsØpermit all owners to participate inmanagement (different from LPs).• Limited Liability Companies (LLCs) & LPs are dominant ownershipstructures in property markets.• Real estate private equity funds typically set up as LimitedPartnerships (LPs)• Small, “local” investments marketed to accredited investors typicallyset up as LLCs• The combination of:• single taxation,• limited liability for most, if not all, of the owners,• the ability to provide special allocations of cash flowsare important when investors structure CRE investments.Optimal Ownership Forms?Who are the ultimate equity investors?ØInvestors can hold ownership (equity) positions directly or throughintermediaries.ØFor example: Funds, Limited Liability Companies, LimitedPartnershipsØ Most inventors can’t invest directly.ØFor well capitalized investors, choice of direct vs. indirect involvestrade-offs between:Ø Control; access to managerial expertise; liquidity & risk sharing.Direct InvestmentGives individual & institutional investors complete controlwho leases it, who manages it,how much debt financing is used,when it is sold…But…investor must supply the expertise (management of property/properties)High transaction costsIlliquid market (private property market)As size of investor’s portfolio increases, the economics of direct ownership makemore sense i.e., easier to have in-house experts or hire consultants/ diversify risk/ create liquidity acrossassets classes (stocks, bonds)Also prevalent at smaller end of investor spectrumSingle-family rental homes, duplexes/ Owner-occupied office buildingsLack of diversification vs. local market knowledge?Indirect InvestmentPaying for expertiseAgency costs or conflicts of interestAffordableSome offer liquidity& associated volatilityü Indirect property ownership refers to holding securities in property fundsthat receive capital from income-producing properties & provide returns totheir investors.ü In this way, investors may own small parts of properties, which theycannot afford to buy/own the entire property outright.Who are the ultimate equity investors?Large Investors in CRE that tend to make directinvestmentsMany of them institutional investorsInstitutional Investors in Private Equity Markets• Pension funds• Long-term liabilities well suited to Long-term RE investments• want reliable income from stable real estate investments to pay outretirement benefits• Direct purchases as well as acquisitions through funds(indirect property investments through private RE equity funds or jointventures)Institutional Investors in Private Equity Markets• Life insurance companies– Long-term liabilities a good match for long-term, illiquid, privateRE investments– More active as CRE lenders than as equity investorsUS CRE: A favorite among foreign investorsSeveral high-profile foreign investmentsChina Life Insurance Co. recently purchased a $1.65 billionManhattan office towerBut “real story” lies in growth of foreign investment in small-tomedium sized U.S. CRE properties.Commercial banks and other private financialinstitutions• Majority of these holdings are NOT direct equity investments• They represent Real Estate Owned (REO); that is, RE obtainedby the financial institution as a result of borrower default andforeclosure.“Other” Institutional Investors• Hedge funds, endowment funds, real estate privateequity funds, private REITs.Institutional vs. Non-Institutional Equity InvestorsØ$1.9 trillion (52%) held by (mostly)non-institutional investors.ØRemaining $1.8 trillion (48%) of$3.7 trillion in private equityheld by institutional investors.ØWho are these investors and how dothey invest?Non-institutional Investors in private RE equity markets: High net worth individualsand families that invest “directly” or “indirectly” in JVs/LLCs organized by others.Other Public/Private Institutional InvestorsØReal Estate Investment Trusts (REITs)ØA special type of corporation/specific featuresüPublicly traded REITsüPrivate REITsIn AustraliaØProperty Fundsü investing in property company shares.ØProperty Trusts or Real Estate Investment Trusts (REITs)üInvesting directly in income-producing properties and mortgages; aretraded like a stock.üListed Property Trusts (LPTs) became as A-REITsüUnlisted property trustsØ Property Securities Fundüinvesting in other listed or unlisted property funds.Sources of CRE DebtSources of CRE Debt75% of outstanding commercial mortgage debt (or $2.96 trillion) is privatelyheld by individuals & institutional investors:– Commercial banks– Savings associations– Life insurance companies*– Freddie & Fannie– State & local governments– Equity REITsCommercial Banks are major providers ofCRE Mortgages• Commercial banks hold in their portfolio 46% ($1.84 trillion/ $3.973trillion) of existing CRE debt (private + public).• 62% of private CRE debtSources of CRE Public Debt24% ($1.0 trillion) is publicly traded– GSE-backed commercial mortgagebacked securities (CMBSs)- allmultifamily– Non-government backed (“privatelabel”) CMBSNext Week: Week 8• A Closer Look at REITs in general.• Australian REIT Market• Stapled structure/ Trends in A-REITs• In Week 9: REIT Valuation• Ling Chapter 17• Chapter 14 Rowland: Evaluating Property Funds
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