Real estate is an important part of any portfolio, especially for family offices. Real estate has many benefits––from the use of leverage, tax-free growth, and tax deferment to depreciation and mortgage interest deductions, and especially the opportunity for families to build legacy wealth. A good property in a good location can be a long-term family asset, providing cash flow, appreciation, and tax benefits for generations to come. 

Because of these benefits, the question then becomes: How can a family office invest in real estate and maximize the benefits that real estate has to offer?

The options available to family offices are 1) direct investing, (or a subset of direct investing), 2) fund investing, and 3) investing through publicly traded entities such as REITS or individual stocks of real estate and real estate-related companies. For the purposes of this article, we will focus on direct investing through joint ventures, separately managed accounts, limited partnerships, and club investing rather than when the family or family office invests directly and manages the property themselves. 

Choosing the right real estate asset to invest in is more of an art than simply investing in what appears on the latest broker flyer or what is offered during a phone call from a real estate operator. To choose the proper asset and opportunity, one of the best ways to add real estate to your portfolio is to partner with another family office that has created its wealth through real estate. After all, as a family office, this group will also understand the challenges facing your family or family office related to estate planning, transferring wealth to subsequent generations, building a business, and creating or preserving wealth. The question then comes down to: How does a family office evaluate a potential real estate partner?

Although you may want to add a few more items to your list when evaluating a potential partner, the following are five items that real estate investment banking firms and institutions consider before investing with a real estate partner. This should help with your evaluation of a partner as well as touch on some of the areas that should be explored by the family office during the due diligence process.

The five areas are: partner’s experience, partner’s strengths, partner’s track record, economic viability of the investment(s) or opportunity, and alignment of interests with your potential partner.  

Partner’s Experience

What is the partner’s experience? Does the real estate partner have experience in similar types of deals, property types, and geographic markets for the asset that the partner is asking the family office to invest into? Does the partner have an excellent reputation in its field, a focused investment strategy, a proven track record, and management by a team of experienced professionals?  

As the family office will look to its partner for relative expertise in the day-to-day operations of the real estate opportunity, it must have complete confidence in the partner's ability to manage the project not only during good times but also when things don’t turn out as projected or the market changes direction.   

Partner’s Strength

Does the partner have both a strong business balance sheet and a personal balance sheet to complete the suggested project(s) and weather any storms? How many projects does the partner have in their pipeline and how many opportunities are they evaluating monthly to choose from? Is the partner spreading themselves too thin, or do they have the capacity to see each of its projects through to fruition? The last thing the family office wants is to see an investment fail because the partner spread itself too thin or took on too many opportunities because “the market was hot.” Lastly, if you are investing as a Limited Partner or LP, make sure that your documents do not make you liable for any recourse or carve outs as part of the joint venture or investment. This should be standard so that the only financial risk you assume concerns the capital you invested, but it is better to check before the transaction is completed in case a problem exists.  

Partner’s Track Record

When evaluating an investment with a real estate partner, the following questions must be asked: What does the partner’s history show? Have its returns been consistent? How long is its track record? One year? Five years? Twenty years? If the partner’s track record started in 2010, ask whether its success is simply due to a favorable market. Has the partner weathered multiple real estate cycles? If so, how did it perform during those times?    

The track record says a lot—it can give insight into the future relationship with your real estate partner.  Don't take your partner’s word for it; be sure to confirm the track record. 

Economic Viability of the Investment Project(s)

The investment opportunity must be carefully reviewed to ensure it’s economically feasible and the partner’s ability to secure financing, whether it comes from public, commercial, or private sources. The funding sources and profits earned must be legitimate and transparent. In addition, you should understand whether: 

• The project is able to cover operating costs over its lifetime and generate an acceptable rate of return for you and the family office.

• The project is flexible enough to adapt to future changes in user needs, ownership, laws, regulations, and economic fluctuations.

• The project’s financial models proposed to the family office by the partner are aggressive or conservative? Ideally, you should understand your potential returns from three vantage points: the worst-case, best-case, and middle-case scenarios. Too often, all that is presented to the family office is the best-case scenario.

• There are similar properties with similar markers from existing or recent sales: 

• the cap rate projected at purchase or sale;

• any increase in percentage in rent over the estimated time period; and

• construction costs and price per square feet are applicable; for example, if everyone is renting a space for $100/month, the last thing you should expect is $150/month.  

Alignment of Interests

Conceptually, in the majority of partnerships, the family office is considered a Limited Partner (LP) and is a passive partner in the management of the deal. Investment and risk management considerations, for example, are entirely delegated to your real estate partner, who is also considered the General Partner (GP)––but that brings us back to what you are looking for and hoping to accomplish: finding an experienced partner that you can trust and rely on.   

The success of the partnership model relies on the interests of both parties being adequately taken into account. One way to address still-existing shortcomings in the alignment of interests is to implement what we will call here an enhanced alignment model. The goal of such a model is “defensive”: to ensure that the real estate Partner or GP and its managers deliver on the agreed-upon investment objectives, undiluted by other interests. 

The financial structure associated with partnerships varies greatly; however, a typical investment might provide for leverage or debt of 75% on the property (of which should be non recourse to the family office), with the limited partner(s) providing 80%–90% of the equity and the general partner investing 10%–20%. All equity will receive a pari passu return to an agreed-upon level or preferred return, after which the general partner receives a disproportionate share of the returns, referred to as a “promote.” Promotes are negotiated so that the partner, based on leveraged internal rates of returns (IRRs) at the time of refinancing or sale, could earn an additional 25%–50% above a certain equity return. As thehe operator of the asset, the GP is generally able to earn market rate fees for its services, such as development and property management fees.  

Some family offices prefer a simple structure of a “50/50” split with minimal fees going to pay the basic expenses of the transaction. Sometimes, general partners will want to charge fees that may be in excess of what the true costs are for the property. Although it is fine for the general partner to charge fees, you still need to have a good understanding of what they are to ensure a proper alignment of interests rather than a structure that benefits the partner regardless of the investment outcome. The end purpose of fees is to compensate the general partner for the expenses that it occurs, rather than to serve as a profit center.

Conclusion

Forming a partnership with a real estate operator or real estate family office is an exciting way for family offices to gain exposure to real estate as a direct investment, which, is an important addition to any investment portfolio. Such partnerships free the family office from the tedious and time-consuming task of looking at and evaluating enough deals to make a good decision, and to operate the property from purchase to sale. 

Many families have created their wealth in a variety of ways. From chemicals and food businesses to hedge funds, each family’s wealth is created from expertise in its respective industry. Knowing that, one of the best ways to gain exposure to real estate is to find another family office that created its wealth through real estate. After all, by combining a partner’s history, track record, and awareness and understanding of the real estate industry with your capital, one family office can benefit from another real estate family office’s experience and, ultimately, from this important asset class.