While there are many benefits to real estate investing, private real estate investments do entail illiquidity, i.e. having investment capital tied up for some length of time (particularly with longer-term equity investments). We accept non-liquidity as a tradeoff for relatively high projected (ex ante) returns than most other asset classes. No rational real estate investor would enter a deal, however, without some end game; though we accept some degree of uncertainty with regard to the term of an investment, there must be a light at the end of the tunnel that makes business sense. Hence “exit strategies”, otherwise known as an “exit events” or “reversions”, are always a key factor as passive investors evaluate real estate projects.
Different Kinds of Exit Strategies for Real Estate Projects
Acquisition and long-term hold
This strategy entails acquiring a property, making value-add upgrades, and improving cash flow through some combination of decreased vacancy rates and increased rents (via some combination of better management, improvements to the property, and more/improved marketing efforts). In order to attract passive (LP) investors, Sponsors looking to execute this kind of 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. Initial and exit cap rates are central to this calculus.
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 relatively-long term. EquityMultiple typically does not seek opportunities with projected hold periods of longer than 7 years.
Acquisition + short-term hold
This strategy, often colloquially referred to as “flipping” 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 are typically well-capitalized, and operating with a wealth of market data acumen.
While a shorter hold means, by definition, more liquidity, this strategy is predicated less on adding value over time, so tends to yield lower absolute profits.
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.
This strategy, carried out by a real estate developer, entails acquiring land and building a property “from the ground up”. These investments entail 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.
When considering co-investing alongside a ground-up developer, consider the “full suite” capabilities of that developer; the skill set of a successful ground-up development firm should span construction, legal (including command of local zoning and building strictures), finance, and marketing/sales.
Sale Leaseback Arrangement
These exit strategies are, effectively, what it sounds like: the seller of a property immediately leases the property from the purchaser. 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 put that capital to work for other purposes – while still operating the asset. This tactic therefore functions somewhat like a loan, with post-sale rent in lieu of interest payments.
Considerations for You as a Passive Investor
No matter what kind of exit strategies a Sponsor or developer pursues, you should make sure it is clearly stated, and that the real estate company behind the deal has a track record of executing similar plans. Before carrying through with any investment, make sure you understand the exit strategy and all risk factors that could impact it.