Equity real estate investments by definition entail investor capital being tied up for some period of time, i.e. real estate investments are illiquid. Investors accept some degree of illiquidity as a trade-off for higher projected (ex ante) returns than other investment vehicles. No sane investor would agree to enter a real estate investment, however, without some end in sight – after all, what good are attractive projected returns if an investor’s money is held interminably? Hence the “exit strategy”, otherwise known as the exit event or reversion, is often a focal point as passive investors consider a project.
Different Kinds of Exit Strategies for Real Estate Projects
- Ground-Up Development – This strategy, carried out by a real estate developer, involves buying land and building a property “from the ground up”. Co-investing passively alongside a developer involves substantial risk, as the property must go through all stages of development before being sold or rented. While these projects are riskier than investing in an existing property, potential returns are correspondingly higher.
- Acquisition and Short-Term Hold – This strategy, referred to by some as “fix-and-flip”, involves acquiring and selling a property for a higher amount over a relatively short time horizon. In this case, returns are predicated on the property’s value increasing quickly – through increased demand in the market and/or improvements made to the property – rather than on sustained cash-flow. Sponsors who seek to execute on this strategy should be savvy with respect to market trends, and capable with respect to quickly adding value to properties.
- Acquisition and Long-Term Hold – This strategy entails acquiring a property, improving it to some extent, and improving cash flow through some combination of decreased vacancy rates and increased rents (via some combination of improvements to the property, better management, and more/improved marketing efforts). In order to attract passive (LP) investors, Sponsors looking to execute a long-term hold business plan must project to sell the property at a profit at some point, often after rents have stabilized and the neighborhood or market has improved in stature. These projects tend to offer appealing cash flow throughout the lifetime of the investment. However, investors face heightened liquidity risk, as their money is tied up for a longer period of time. At EquityMultiple we typically do not pursue opportunities with projected hold periods of longer than 7 years; longer hold periods are often outside the scope of an individual retail investor’s portfolio.
- Cash-Out Refinance, Followed by a Hold – Cash-out refinances operate in commercial real estate much as they do in single-family finance: a borrower (the Sponsor or developer on a project) secures a new mortgage of a greater amount than the existing mortgage. In most cases, substantial value has already been added via renovation or expansion, increasing the appraised value of the property and improving terms for the borrower as they seek to refinance. The borrower will typically use some or all of these proceeds to make further capital improvements. In many cases, the proceeds from a cash-out refinance will also be used to pay down a portion of the LP equity midway through a hold. From your standpoint as a passive investor via EQUITYMULTIPLE or a similar platform, projects that employ this strategy can offer better liquidity, as the Sponsor plans on returning some or most of your principal midway through their projected hold.
- Sale Leaseback Arrangement – This exit strategy is pretty much what it sounds like: the seller immediately leases the property from the purchasing party. The sale of the property is often legally contingent on the subsequent lease agreement. The seller of the asset is therefore able to recoup capital tied up in the property – and deploy that capital elsewhere – while still operating the asset. This tactic therefore functions somewhat like a loan, with post-sale rent taking the place of interest payments.
Considerations for You, the Passive Investor
No matter what kind of exit strategy a Sponsor or developer proposes, you should make sure it is clearly stated, and that the real estate company behind the deal has executed similar plans successfully. The exit strategy is key to understanding the risk factors inherent in the investment. Platforms like EquityMultiple offer investments with varying exist strategies – be sure you fully understand the assumptions in play and ask questions as necessary.
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