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Mergers, Acquisitions & Investment Banking for Mid-Market Business Owners
Knowledge Base - Investor
Private Equity Real Estate Investments - Some investors make private equity style real estate investments. Such investors acquire real estate, owning companies or stakes in such companies, rather than invest in individual properties or real estate debt. Another form of private equity real estate investing is the creation of a company, which would then invest in real estate-owning companies, properties, debt or a combination of the three.

Basic Terms to Know - Office, industrial and retail properties are measured in square feet. Buildings can be measured in “gross square feet” or “net square feet.” A 1987 article in the New York Times offered definitions of both terms: Gross square feet - “the sum of the areas at each floor level, including cellars, basements, mezzanines and included are all stories or areas that have floor surfaces with clear standing head room (6 feet 6 inches minimum) regardless of their use.” Net square feet - “the sum of all areas within the perimeter walls of the unit measured to the inside faces of said walls and including all columns, shafts, ducts and risers whether separately enclosed or not.” Apartments, hotels and self-storage facilities can be measured in square feet, but are more commonly measured in units or rooms. For example, an apartment complex may have 200,000 square feet, but would more commonly be described as having 1,500 units. A hotel may have 100,000 square feet, but it would be more common to identify it as having 500 rooms, or "Keys". Properties are often identified not only by their address, city or state, but by the submarket in which they are located. Some submarkets are essentially neighborhoods, such as in Manhattan, which identifies such places as Chelsea, Harlem and Times Square as submarkets. Other submarkets are regions, such as Northern New Jersey or Silicon Valley, in Northern California.

Cap Rate - The cap rate is the initial annual return that a buyer can expect on his investment. It is calculated by dividing the projected net operating income for the first year of the investment by the purchase price. If a building sells for $10 million and generates $1 million of projected net operating income, the cap rate is 10%. Investors can use cap rates to compare the returns of their real estate holdings to the performance of other types of investments, such as stocks and bonds. For some properties, it is important to consider the initial annual return. But for other properties, it is more appropriate to consider the stabilized return – ones that are either not well leased, have leases that are about to expire or are candidates for conversion to other uses. The stabilized yield is determined by calculating a projected yield after the building's performance has been maximized.

Types of Investments - There are a variety of investment types, depending on the level of risk an investor is willing to accept. The safest investments are called “core” properties. These generally seek an internal rate of return of less than 10%. Buyers of core properties use a limited amount of debt, usually less than 50% of a property's value. An example of a core investment would be a retail property with a solid tenant locked into a net-lease of 10 or more years. Another core investment would be a fully leased office building in a historically strong market with a high occupancy rate, such as Midtown Manhattan. The next-safest investments are called “core-plus.” These generally seek an internal rate of return of 10% to 13%. Buyers of core-plus properties often use slightly more debt than core investors, usually from 50% to 75% of a property's value. Core-plus investments are relatively safe, but provide the owner with the opportunity to increase the internal rate of return, in exchange for taking on slightly more risk. For example, a buyer may acquire an office building that is well occupied, but which has several leases expiring over several years. If the building is located in an office market that averages 90% occupancy, a property owner could reasonably assume that his/her building could consistently achieve that level. Core-plus investments also include the need for minor renovations, such as upgraded lobbies, common areas, bathrooms or exteriors. After completing such upgrades, a property owner could eventually raise rates, and in turn, increase the investment's yield. The “value-added” category is next on the real estate market's risk-reward ladder. Value-added properties generally seek internal rates of return of 14% to 17%. Buyers of value-added properties often use debt equal to more than 60% of a property's value. Value-added investments carry some risk, and often rely on a buyer's understanding of market trends, demographics and potential tenant needs to be successful.

Property Repositioning - Other opportunistic investments entail large construction projects, and so-called property repositioning. For example, an investor may buy a large abandoned warehouse in a well-populated area and spend tens of millions converting it into a mixed-use property - perhaps with retail and restaurants on the street level, office space on the lower floors, and residential condominiums on the top floor. Increasingly, U.S. value-added and opportunistic investors are seeking higher internal rates of return by investing overseas. Value-added and opportunistic investments are also referred to as high-yield investments.

Types of Investors - A variety of investor types target a wide range of real estate investment opportunities. Institutional investors can include banks, insurers, pension systems, endowments and foundations. Foreign institutions are also buyers of U.S. properties. Dutch pensions, for example, have invested in the U.S. for more than two decades. Since the 1990's, German institutions have been active buyers, either working independently or by pooling money into special partnerships. In the 1980's, Japanese financial institutions were big buyers of U.S. properties, especially on the West Coast. Many institutional players contract with third-party advisory firms to help them build real estate portfolios. Advisors can have discretionary or non-discretionary relationships with their investor clients. An advisor with a discretionary arrangement can buy or sell properties within certain pre-arranged guidelines regarding yield, property type and geography. A non-discretionary relationship means the advisor must first obtain approval from the client. Such advisory contracts generally last three or more years, although many institutions have the ability to fire an advisor with limited notice. Advisors don't usually hold equity stakes in the properties they buy on behalf of clients and manage. They earn fees based on the performance of the properties and may also collect bonuses based on gains produced by the sale of the properties.

Types of Private Investors - Real estate is often owned by private investors, including individuals, families and family trusts. Occasionally, a family or family trust may own the land beneath a building. This is most common in older cities, such as New York or Boston. A family or family trust leases the land, generally for 99 years, to the owner of the building. Conceivably, when a so-called ground lease expires, the lease holder could claim ownership of the building. But in practice, leases are renewed long before they expire. Churches and foundations are also frequent common owners of ground leases. Some investors pool their money into special partnerships, such as a group of doctors that collectively invests in an office building they would occupy. Some investments are held in syndicates, in which an investor buys a property and then raises equity by offering stakes in the building. Some investors pool money in tenancy-in-common vehicles, in which the investors don't know one another. Such vehicles pool up to 35 investors seeking to make tax-deferred investments. According to a Dec. 15, 2004, article in Real Estate Alert, “While TICs are not new, they have become more common since March 2002, when the IRS ruled that such interests can qualify for tax deferrals. Under Section 1031 of the Internal Revenue Code, owners, under certain circumstances, can defer capital-gains taxes when selling a property if the proceeds are used to purchase another property within 180 days. The 2002 ruling said that proceeds can be plowed into TICs, fueling interest in the structure.”

Real Estate Funds - Real estate funds are the opposite of syndicates. Rather than finding a property and then raising equity, fund operators raise capital from institutions and private investors and then invest in properties, development projects, debt or real estate companies. Funds can be closed-end or open-end. While closed-end funds stop raising money after reaching their targets and usually have fixed life cycles, open-end vehicles can continue to raise capital over time and operate indefinitely. Funds can seek core, core-plus, value-added or opportunistic internal rates of return. Most open-end funds seek core returns, although the number of non-core open-end funds has increased since the late 1990's.

Developers - Some companies only develop properties, either to sell at completion or to amass a portfolio. Developers may construct a building to be sold immediately to an owner-occupant. Such arrangements are known as “build to suit,” and require construction of buildings that meeting size and use specifications. Other developers are backed by equity partners -- frequently institutions or fund operators. Some developers operate their own funds.

Private Equity - Private equity is a broad term which commonly refers to any type of non-public Ownership Equity securities that are not listed on a public exchange. Since they are not listed on a public exchange, any investor wishing to sell private equity securities must find a buyer in the absence of a public marketplace. There are many transfer restrictions on private securities. Private equity firms generally receive a return on their investment through one of three ways: an IPO, a sale or merger of the company they control, or a recapitalization. Unlisted securities may be sold directly to investors by the company (called a private offering) or to a private equity fund, which pools contributions from smaller investors to create a capital pool. For the above mentioned reasons, private equity fund investment is for those who can afford to have their capital locked in for long periods of time and who are able to risk losing significant amounts of money. This is balanced by the potential benefits of annual returns which range up to 30% for successful funds.

Size of Investor Industry - Nearly $135 billion of private equity was invested globally in 2005, up a fifth on the previous year due to a rise in buyouts as market confidence and trading conditions improved. Buyouts have generated a growing portion of private equity investments by value, and increased their share of investments from a fifth to more than two-thirds between 2000 and 2005. By contrast, the share of early stage or venture capital investment has declined during this period. Private equity fund raising also surpassed prior years in 2005 and totaled $232 billion, up three-quarters on 2004. Prior to this, after reaching a peak in 2000, private equity investments and funds raised fell in the next couple of years due to the slowdown in the global economy and declines in equity markets, particularly in the technology sector. The fall in funds raised between 2001 and 2003 was also due to a large excess created by the end of 2000 of funds raised over funds invested. The regional breakdown of private equity activity shows that in 2005, North America accounted for 40% of global private equity investments (down from 68% in 2000) and 52% of funds raised (down from 69%). Between 2000 and 2005, Europe increased its share of investments (from 17% to 43%) and funds raised (from 17% to 38%). This was largely a result of strong buyout market activity in Europe. Asia-Pacific region's share of investments increased from 6% to 11% during this period while its share of funds raised remained unchanged at around 8%. The biggest fund type in terms of commitments garnered was buyout, with 188 funds raising an aggregate $212 billion. So-called mega buyout funds contributed a significant proportion of this amount, with the ten largest funds of 2006 raising $101 billion alone—23% of the global total for 2006. Other strong performers included real estate funds, which grew 30% from already strong 2005 levels, raising an aggregate $63 billion globally. The only fund type to not perform so well was venture, which saw a drop of 10% from 2005 levels. Venture Capital is considered a subset of private equity focused on investments in new and maturing companies. Mezzanine capital is similar class of alternative investment focused on structured debt securities in private companies.

Angel Investors - An angel investor or angel (known as a business angel in Europe), is an affluent individual who provides capital for a business start-up, usually in exchange for convertible debt or ownership equity. A small but increasing number of angel investors are organizing themselves into angel networks or angel groups to share research and pool their investment capital. Angels typically invest their own funds, unlike venture capitalists, who manage the pooled money of others in a professionally-managed fund. Although typically thought of as individuals, the actual entity that provides the funding may be a trust, business, investment fund, etc. Angel capital fills the gap in start-up financing between "friends and family" (sometimes humorously called friends, family, and fools) who provide seed funding, and venture capital. Although it is usually difficult to raise more than a few hundred thousand dollars from friends and family, most traditional venture capital funds are usually not able to consider investments under US$1–2 million. Thus, angel investment is a common second round of financing for high-growth start-ups, and accounts in total for almost as much money invested annually as all venture capital funds combined, but into more than ten times as many companies (US$25.6 billion vs. $26.1 billion in the US in 2006, into 51,000 companies vs. 3,522 companies). Of the 51,000 US companies that received angel funding in 2006, the average raise was about US$500,000. Healthcare services, and medical devices and equipment accounted for the largest share of angel investments, with 21 percent of total angel investments in 2006, followed by software (18 percent) and biotech (18 percent). The remaining investments were approximately equally weighted across high-tech sectors.

Profile of An Angel Investor - Angel investments bear extremely high risk, and thus require a very high return on investment. Because a large percentage of angel investments are lost completely when early stage companies fail, professional angel investors seek investments that have the potential to return at least 10 or more times their original investment within 5 years, through a defined exit strategy, such as plans for an initial public offering or an acquisition. Current 'best practices' suggest that angels might do better setting their sights even higher, looking for companies that will have at least the potential to provide a 20x-30x return over a five- to seven-year holding period. After taking into account the need to cover failed investments and the multi-year holding time for even the successful ones, however, the actual effective internal rate of return for a typical successful portfolio of angel investments might, in reality, be as 'low' as 20-30%. While the investor's need for high rates of return on any given investment can thus make angel financing an expensive source of funds, cheaper sources of capital, such as bank financing, are usually not available for most early-stage ventures. Thus, in addition to funds, angel investors can often provide valuable management advice and important contacts. According to the Center for Venture Research, there were 234,000 active angel investors in the U.S. in 2006.

“As an investor in mid-market companies, when John Nelson contacts me I know his deals are complete, high-quality and warrant serious consideration.”
-Melvin A. Myer
President of Myer Financial Group

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