Private Equity Real Estate

Introduction

Private equity real estate is ownership of property through vehicles that do not trade on a stock exchange. This guide describes how it differs from listed real estate, the four structures through which it is commonly held in Canada, how returns arise and how risk shows up, the disclosure and tax rules that shape it, and the areas diligence practice examines. A worked example sets out the arithmetic of leverage and currency.

What the class is

A private real estate vehicle pools capital to buy, operate and eventually sell property: apartments, industrial warehouses, offices, retail centres or development land. Investors hold trust units, partnership interests or shares, and the vehicle owns the property, usually financed in part with a mortgage.

Large pension plans and other institutions have long held real estate as a portfolio component, much of it through private ownership rather than listed shares. The thinking behind that practice is that rents provide a stream of income that tends to adjust with inflation over time, and that an investor with a long horizon can carry assets that cannot be sold quickly.

Strategies are distinguished by how much of the return depends on changing the property: core buys stabilized, leased buildings for income; value-add buys properties with a fixable problem; opportunistic and development strategies take on construction, repositioning or distress. Risk rises along that sequence because more of the result depends on execution.

Private and listed real estate

A listed real estate investment trust (REIT) and a private vehicle can own the same kind of building. They differ in valuation, liquidity, cost and disclosure.

Valuation

A listed REIT's units are priced by the market every trading day. That price reflects interest-rate expectations, sentiment and flows into and out of the sector, as well as the value of the buildings, so it can sit well above or well below the REIT's stated net asset value (NAV) for long periods. In periods of rapidly rising interest rates, listed REIT units have traded at substantial discounts to their stated NAVs.

A private vehicle is valued by appraisal, usually quarterly or annually. Under IFRS, investment property may be carried at fair value, and vehicles commonly value their properties with a combination of internal estimates and external appraisals, often on a rotation so that each property is independently appraised every year or few years.

Appraisal produces smoother reported returns than a market price, but smoothness in the reported figure is not stability in the underlying value: the building's value moves between appraisals, and the NAV reflects the move only later, often gradually. When listed REIT prices fall sharply and a private vehicle's NAV barely moves, the gap has often reflected the timing and method of the appraisals as much as any difference between the buildings.

Liquidity

A listed REIT can be sold on any trading day, at whatever price the market offers that day.

A private vehicle has no market. Depending on the structure, an investor's capital comes back through a redemption program, through distributions as properties are sold, or at the end of the vehicle's life. Private REITs commonly offer redemptions at a price based on NAV, subject to a limit on the cash paid out in any period. Requests above the limit may be paid in notes or other securities, deferred or met pro rata, and the trustees can usually suspend redemptions. Limited partnerships and syndications commonly provide no redemption right at all; the capital stays in until the property is sold, commonly five to ten years after purchase.

Fees

Listed REITs carry their own costs. Some are managed internally, with the costs borne as salaries and overhead. Others pay an external manager, whose fees can include a base fee and, in some cases, an incentive fee tied to performance. An investor also pays brokerage commissions to buy and sell units.

Private vehicles commonly charge fees at several levels:

• a management fee, charged annually on committed capital, invested capital or gross asset value, depending on the vehicle;
• carried interest or a promote: a share of profits above a preferred return, with splits commonly between 70/30 and 80/20 in favour of the investors, and an 8% preferred return common in closed-end funds;
• transaction fees, such as acquisition, disposition and financing fees, commonly charged as a percentage of the price or the loan;
• property-level fees, such as property management, leasing or construction management, sometimes paid to an affiliate of the sponsor.

Property-level fees are deducted before the vehicle's income is counted, so they may not appear in the headline fee. The total cost of a vehicle is the sum of every layer, and how much of the gross return it absorbs depends on that return: a fee charged on asset value is paid whatever the property earns, while carried interest is paid only above the preferred return.

Information

A listed REIT is a reporting issuer: it files quarterly and annual financial statements and continuous disclosure, and analysts examine its numbers. A private vehicle reports to its investors on terms set in its documents, commonly quarterly or semi-annually. Quality varies between sponsors, no market price checks the NAV, and verification depends on the vehicle's audit and appraisal arrangements.

Canadian structures

Private real estate is commonly held in Canada through four structures. They differ in how capital goes in, how it comes out, and how concentrated it is.

Private REITs

A private REIT pools investor capital in a trust that owns a portfolio of properties and pays distributions, commonly monthly or quarterly. It is usually open-ended: it raises capital continuously and offers redemptions, as described above. Private REITs are commonly distributed under the offering memorandum (OM) exemption in NI 45-106, described below.

Assessment of a private REIT centres on four features: whether distributions are paid from operating cash flow or partly from borrowing, return of capital or new subscriptions; how the NAV is set; the redemption terms; and the manager's fees, related-party arrangements and own capital in the trust.

Limited partnerships

A limited partnership is common for a single property or a small portfolio. The general partner (GP) makes the decisions and manages the investment. The limited partners (LPs) provide the capital, and their liability is generally limited to their investment, provided they do not take part in managing the business. Interests are distributed under the OM exemption or the accredited investor exemption, among others.

Because an LP is concentrated in a few properties and one GP's execution, the GP's record carries most of the weight. Some LPs take all capital up front; others take a commitment and call it as properties are bought. A partnership agreement commonly treats a missed capital call as a default with significant penalties. Some LPs distribute cash flow as it is earned, and others reinvest it until the property is sold.

Syndications and syndicated mortgages

An equity syndication raises capital for a specific property with a defined business plan, such as acquire, renovate, lease up and sell, over a stated timeline, through LP interests, trust units or co-ownership. Most use substantial mortgage debt, and the result depends on whether the sponsor carries out the plan within budget and on time.

A syndicated mortgage is a different instrument. Investors share in a loan secured on a property, often one under development, rather than owning the property. Their return is interest, and their risk is that the borrower cannot repay and the security is worth less than the loan, particularly where other lenders rank ahead of them. Securities regulators amended the prospectus and registration exemptions relating to syndicated mortgages in 2021 (Ontario Securities Commission, Notice of Ministerial Approval of Amendments … relating to Syndicated Mortgages, (2021) 44 OSCB 1297, 18 February 2021: effective March 1, 2021 in certain other jurisdictions). In Ontario, oversight of most non-qualified syndicated mortgage investments sold to retail investors moved to the Ontario Securities Commission on July 1, 2021.

Closed-end funds

A closed-end real estate fund raises commitments during a fundraising period and then closes to new capital. It is commonly organized as a limited partnership, with the manager as GP. Its life follows the pattern of other private funds: an investment period in the early years, in which the GP calls capital and buys properties, and a harvest period in which it sells them and returns capital, with extensions available under the partnership agreement.

A fund is a blind pool: commitments are made before the properties are identified. The decision rests on the manager's strategy, record and terms rather than on specific buildings. A fund's vintage year, the year it begins investing, matters in real estate because the prices paid and the financing available when capital is deployed shape the outcome; funds that invest across several years spread that exposure.

How returns arise and how risk shows up

The return on private real estate comes from three sources: net operating income from rents, after operating costs; any change in the property's value between purchase and sale; and leverage, which magnifies both. Each source carries its own risk.

Leverage. Real estate is usually financed with substantial debt. The lender's claim does not shrink when the property's value falls, so the equity absorbs the whole decline. The worked example below shows the arithmetic. Loan agreements commonly include covenants on loan-to-value or debt service, and a fall in value or income can require the owner to add equity, sell, or negotiate with the lender.

Interest rates and refinancing. Property values are sensitive to interest rates. When borrowing costs and bond yields rise, buyers commonly require higher capitalization rates, which lowers the price paid for the same income. A property with floating-rate debt, or with debt maturing in a period of higher rates, faces higher payments or a refinancing on less favourable terms.

Valuation lag and liquidity. A vehicle can report stable values while transaction prices are falling. Investors who redeem at a NAV that has not caught up take value from those who stay, which is one reason redemption limits exist, and when many ask to redeem at once the limits apply when the capital is most wanted.

Concentration and execution. A syndication or single-property LP depends on one building, one market and one business plan. Development adds construction delays, cost overruns, approvals and changes in interest rates during the build; outcomes in development range from large gains to a complete loss of the equity.

Conflicts. A sponsor that sells its own properties to the vehicle, lends to it, or provides services to it through affiliates has interests on both sides of the transaction. The terms and the disclosure of those arrangements are part of the investment.

Currency. A vehicle holding property abroad, or denominated in another currency, carries exchange-rate exposure, shown in the worked example. Some vehicles hedge it, which narrows the effect at a cost.

Disclosure and regulation in Canada

Interests in private real estate vehicles are securities. They are distributed without a prospectus under exemptions in NI 45-106, most commonly the OM exemption and the accredited investor exemption.

Under the OM exemption, the issuer delivers an offering memorandum in the prescribed form before the purchase. An OM is a shorter and less comprehensive document than a prospectus, and it is not reviewed by a regulator before it is used. It must describe the purchaser's rights, which include a right to cancel the purchase within two business days and rights of action if the OM contains a misrepresentation. Under the accredited investor exemption, no prescribed offering document is required.

Amendments to the OM exemption came into effect on March 8, 2023. Alberta Securities Commission staff described the exemption as used primarily by real estate issuers and collective investment vehicles, and the amendments added tailored disclosure for each (Alberta Securities Commission, Amendments to the offering memorandum prospectus exemption, staff presentation, 6 March 2023). An issuer whose primary purpose is income or gain from leasing or selling real property must now include Schedule 1 to Form 45-106F2. It covers, among other things, each material property, related-party transfers and price differences between them, costs and assumptions for development, future cash calls, and property-specific risk factors. An independent appraisal is required where the issuer proposes to acquire a property from a related party and the acquisition is likely, or, in the circumstances the form sets out, where the OM discloses a value for a property. These requirements apply to OMs prepared under the OM exemption; offerings under other exemptions are not governed by Form 45-106F2.

Diligence commonly consults the Canadian Securities Administrators' national registration search, which shows whether a firm or individual is registered and in what category, and regulators' enforcement records.

Tax mechanics

Tax treatment follows the structure. The general mechanics are these.

Trusts. A trust that distributes its taxable income to unitholders deducts those amounts and generally pays little or no tax itself. Unitholders report the income on a T3 slip, and the components of a distribution, such as income, capital gains and return of capital, are reported separately.

Limited partnerships. A partnership does not pay income tax. Its income or loss is allocated to the partners and reported on a T5013 slip, and partners are taxed on their allocated income whether or not cash is distributed. Losses a limited partner can deduct are restricted by the at-risk rules, generally to the amount it has invested.

Return of capital. A distribution that returns capital is not taxed when received. It reduces the adjusted cost base of the units, so more of the eventual sale proceeds are taxed as a capital gain. If the adjusted cost base of trust units falls below zero, the negative amount is generally treated as a capital gain at that time; for a limited partner's interest, a negative adjusted cost base is generally deemed a gain at the end of the partnership's fiscal period. Return of capital is tax-deferred, not tax-free.

Foreign property. A vehicle that holds property outside Canada may pay or withhold foreign tax. Whether that tax can be credited against Canadian tax depends on the structure.

Diligence practice

Diligence on a private real estate vehicle commonly covers five areas.

1. The sponsor, first, because in a concentrated, illiquid structure its execution drives the result: its verifiable record, team stability, its principals' own capital, and what registration and enforcement records show.
2. The property: location and demand, new supply, tenants and leases, physical condition and capital needs, environmental issues.
3. The capital structure: amount, rate, maturity and covenants of the debt, and debt service coverage if rates or vacancy rise.
4. The economics: every fee layer, the preferred return and split, the source of distributions, and the projection's assumptions.
5. The legal terms: voting and information rights, exit terms, conflicts, and who can remove the GP or manager.

Diligence practice commonly treats some patterns as warning signs:

• a projected return well above what comparable offerings project, with no explanation in the assumptions;
• a stable or rising NAV while transaction prices for similar properties are falling;
• extensive related-party transactions, such as the sponsor selling properties to the vehicle, lending to it, or providing services above market rates;
• no independent appraisals, no audited financial statements, or no recognized service providers;
• pressure language such as "limited availability" or "closing soon", with no substance behind it;
• a structure too complex to trace where the capital goes.

What holding the class involves

The features above describe what holding private real estate involves:

• A long horizon. Capital in an LP, syndication or fund is generally committed until the property is sold, and a private REIT's redemption program can be limited or suspended.
• Illiquidity and valuation lag. Reported values move with appraisals, and there is no market on which to sell.
• Capital calls, where the structure draws commitments over time.
• A return from both income and growth. Rents produce income, and the result also depends on the value at sale.
• Leverage. The equity ranks behind the lender, so changes in value fall on it first.
• Results that turn on the sponsor, which is why diligence practice concentrates on the sponsor's record and alignment.

Allocation frameworks treat private real estate in a few recurring ways, each with its reason. They commonly count a home as part of an investor's real estate exposure, because a home's value moves with the same local market and interest rates. They commonly spread commitments across sponsors, strategies and vintage years, because a single private vehicle concentrates risk in one manager's judgment however many properties it owns. And they commonly match illiquid commitments to capital that will not be needed for the life of the vehicle, because selling early is either impossible or possible only at a discount.

Worked example

Both examples are hypothetical, use round numbers, and describe no property, vehicle or year. They ignore fees, transaction costs, income, taxes and repayment of principal, to isolate one mechanism each.

Leverage

A property is bought for $10,000,000, financed with a $6,000,000 mortgage (a 60% loan-to-value ratio) and $4,000,000 of equity. The value then changes and the mortgage stays at $6,000,000.

At 60% loan-to-value, each 1% change in the property's value is a 2.5% change in the equity ($10,000,000 ÷ $4,000,000). A 40% fall eliminates the equity. As the value falls, the loan-to-value ratio rises, which is what a lender's covenant tests.

Currency

A Canadian investor converts C$140,000 into US$100,000 at an exchange rate of C$1.40 per US dollar and invests it in a US-dollar vehicle. Over the holding period the investment grows 10%, to US$110,000, which is then converted back.

The same 10% return in US dollars becomes anywhere from about 2% to about 18% in Canadian dollars, depending only on the exchange rate. A stronger Canadian dollar reduces the Canadian-dollar return; a weaker one increases it.

Questions to ask

• What share of distributions over the past several years was paid from operating cash flow, and what share from borrowing, return of capital or new subscriptions?
• Who appraises the properties, how often, and what capitalization rates and rent assumptions do the appraisals use?
• What limits apply to redemptions, how are requests above the limit handled, and in what circumstances can redemptions be suspended?
• What fees are charged at the vehicle level and at the property level, which of them go to affiliates of the sponsor, and what does the sponsor earn at several different levels of gross return?
• What is the loan-to-value ratio, when does the debt mature, is the rate fixed or floating, and what covenants apply?
• What comparable properties has the sponsor managed, and can their results be verified?
• What related-party transactions has the vehicle entered into, and were they supported by independent appraisals?
• What rent growth, vacancy and exit capitalization rate does the projection assume, and what happens to the result if each is less favourable?
• How long could the capital be committed, including any extensions, and how does that compare with when it may be needed?

Key terms

• REIT: a real estate investment trust, a trust that owns income-producing property and distributes its income to unitholders; it may be listed or private.
• NAV: net asset value, the appraised value of a vehicle's properties and other assets less its debts and other liabilities.
• Open-end fund: a vehicle that issues and redeems units continuously, as private REITs commonly do.
• Closed-end fund: a vehicle that raises a fixed pool of capital and returns it as investments are sold.
• Blind pool: a vehicle in which investors commit capital before the properties it will buy are identified.
• LTV: the loan-to-value ratio, a property's mortgage debt divided by its value.
• Hurdle rate: the preferred return investors receive before the sponsor shares in profits.
• Carried interest: the sponsor's share of profits above the preferred return, also called the promote in real estate.
• Offering memorandum: the disclosure document delivered to purchasers under the OM exemption in NI 45-106.
• Return of capital: a distribution that returns part of an investor's own capital, reducing the adjusted cost base of the units rather than being taxed as income.

Related reading

• Private Real Estate Investment Strategies
• Private Credit