7 Things to Consider When Investing in an Equity Transaction
If you’re looking for a direct real estate investment with no day-to-day management responsibilities, an equity transaction may be a good choice for you. Equity transactions allow investors to own an interest in real estate without the hassles that come with tenants and properties.
There are dozens of platforms that offer equity investment opportunities out there. The information below may help you decide which platforms and transactions make sense for you. Here are a few things you should know before making your investment decision.
1. Sponsor’s Experience
Finding the right property requires extensive research and due diligence. Whether you are a first-time investor with little knowledge, or a sophisticated investor with years of experience, a real estate company can do some of the heavy lifting for you. Sponsors will identify a property, reposition and manage it to add value, and execute an exit strategy on your behalf.
Experience comes in many shapes and forms: years of experience, assets under management, local market experience, specific property type experience, and more. It is important to understand the qualifications of a sponsor prior to investing alongside one in an equity transaction.
2. Incentive Alignment
A team typically works well when all team members are working towards the same goal. Therefore, it is important to ensure that incentives of different stakeholders are aligned - more specifically the incentives of the sponsor and all other investors.
While investors typically provide the majority of equity capital, sponsors also contribute their own risk capital as equity for a transaction to have “skin in the game” and share benefits and risks. Investors should generally look for sponsors willing to contribute 5-10 percent or more of the capital for the project.
3. Structure of Property-Holding Entity
Equity transactions have various structure types that depend, amongst other reasons, on the type of investors a sponsor seeks to attract and the risks that different parties in a deal are willing to bear. A few common structure types are limited partnership (LP), limited liability company (LLC), and Delaware Statutory Trust (DST).
- In LPs, two or more investors join together to manage an investment. The general partner (GP) leads business decisions and assumes liability for debts. The other partners—the limited partners (LPs) —have little control over regular business decisions and operations, are not liable for debts, and participate passively in the gains or losses produced by the project.
- LLCs are companies that operate like partnerships. They offer a flexible management structure that provides investors with membership interest in the underlying assets. This means none of the participants—neither investing members nor sponsors—will (generally) be financially liable for the venture beyond the value of their respective investments.
- A DST is a trust between multiple parties used to hold property or run business operations. In a DST agreement, real estate can be held, managed, administered, invested in or operated for the benefit of one or more trust beneficiaries in the agreement. DSTs have become a frequent vehicle to facilitate 1031 exchange transactions.
4. Direct, or Indirect – that is the question
Some platforms allow individual investors to invest directly into the property-holding entity, while others organize all investors in a specific transaction into one entity that then invests into the property-holding entity.
While investing directly and individually into the property-holding entity has its advantages (primarily, avoidance of fees and expenses), it also reduces the ability of individual investors to impact the course of business at the property-holding entity.
When investors all pool into one entity, they can vote on major decisions as one, and may receive rights to remove specific parties from managing the property if those are not performing their duties.
5. Understand Fees
Equity transactions can present heavy and complex fee and expense structures. It is important that investors understand how much of their investment is going to be invested in the actual property (vs. other transaction costs) and what are the ongoing fees that they will have to pay throughout the life of the transaction.
The list of fees and expenses is quite long, but here are a few noteworthy ones to keep a look out for when evaluating an investment opportunity: This list of fees is not exhaustive, and we offer that you perform full due diligence and understand how different fees (and other costs) impact your returns when evaluating an equity transaction.
- Acquisition fee – a fee the sponsor charges to find a property, perform due diligence and complete the acquisition
- Asset management fees – a fee the sponsor may charge to manage the asset
- Property management fees – a fee paid to a professional property management company to run the day-to-day operations of the business
- Disposition fee – a fee the sponsor charges when the property is sold
6. Leverage: Your Best Friend or Your Worst Enemy
Real estate equity investors typically earn returns through rental income and capital appreciation. When sponsors use leverage (which is very common) to finance a transaction, these returns are amplified, for better or worse.
If the performance of the property exceeds expectations (for example, it is rented for higher than expected price per square foot and sold at a much higher price than expected), investors may potentially enjoy a significant upside. When things go well, leverage will most likely increase your return as a common equity investor.
On the flip side, if the property doesn’t live up to expectations, investors may face significant losses. In unfavorable market environments, equity investors may lose their entire investment due to foreclosure or a liquidation of the property at a low price.
To fully understand your priority to receive payments as an investor in an equity transaction, you must understand your rights as an equity holder on the top of the capital stack.
7. Tax Reporting and Deductions
Even if passive investors don’t have direct management responsibility for the property, certain expenses, such as depreciation and certain operating expenditures, may be tax deductible. Different deal structures have different tax rules, so it’s important for investors to understand how an investment will affect their personal tax situation.
- In limited partnerships, general and limited partners individually report and pay taxes on their share of the profits. Because limited partners are not active business partners, their share of income is not considered earned income and they do not pay self-employment taxes.
- Typical LLCs are generally classified as partnerships under federal income tax rules, so they are not directly subject to federal or state income tax. Members are required to report, on their own income tax returns, their allocated share of the LLC’s taxable income or loss.
- Because DSTs are recognized as separate from owners, they are typically listed as either a trust or business entity for federal tax purposes. The IRS explains how to differentiate between the two: “To determine whether DST is a trust or a business entity for federal tax purposes, it is necessary, under § 301.7701-4(c)(1), to determine whether there is a power under the trust agreement to vary the investment of the certificate holders.”
When it comes to your investments, you want to invest with sound information and a clear understanding of the deal structure. Make sure you review the offering materials for any investment you are considering, and ask the sponsor if you have questions about their deal.
Use your best judgment, but also trust your instincts. If something sounds too good to be true, it probably is.
Investing in real estate through partnerships and other pooled capital structures gives investors an opportunity to diversify their portfolio, while maintaining their ability to select individual investment deals.