Private Real Estate Structure: A Primer for Passive Investors

There are many ways to invest in private real estate, including owning the asset directly. But for individuals, one of the most common and accessible options is through investing as a Limited Partner - think passive investor - in a deal that is operated by someone else.

When considering this investment path, it's important to understand how this structure works, what it means for your returns, risk, and responsibilities, and how to evaluate these opportunities intelligently.

The Structure: GP / LP

Most private real estate deals are structured as Limited Partnerships or LLCs.

The General Partner (GP) is referred to as the sponsor, which is the deal's operator. They source the opportunity, arrange the financing, develop and execute the business plan, and manage the day-to-day operations. They are the active participant. This can be an individual or a company.

The Limited Partners (LP) are the investors that contribute capital but don't participate in the operational execution of the deal. They are passive (typically, as there are some nuances based on how significant of an investment the LP makes) and have limited liability.

This structure allows LP investors the opportunity to invest alongside skilled and experienced GPs, without requiring the LP to become active managers or establish the scale and infrastructure necessary to execute the deal at a professional grade.

The Capital Stack: Where the Money Comes From

The capital stack usually includes:

Debt: A senior loan (from a bank for example) that provides between 50%-70% of the total capital needed. Note, this can vary quite a bit.

Equity: Cash from investors that make up the balance of the capital needed. Typically, this will include a relatively small investment from the GP (their skin in the game) and LP investors. The amount of the GP investment can range, but a common percentage of the equity is 10%.

As an LP, the investor is putting capital in the "first loss" position of the stack. This means that the senior debt gets paid first and the common equity gets what is remaining. The GP is the one signing on the loan - meaning they are the responsible party for the loan requirements. Loans can be recourse or non-recourse, or have a certain amount of recourse. A full recourse loan for example means that the GP is held liable for full repayment of the loan. The LP is not. So, the GP is taking on that risk and not passing that risk through to the LP. Said differently, the LP is typically investing their capital in a position where they have no further dollars at risk other than what they put into the deal. There are some nuances here as well, regarding the potential for future capital calls (meaning the GP miscalculated how much capital is needed for the deal and needs to raise more money during the investment period). Most of the time these future capital calls are not required by the LP, but the operating agreement may be structured in a way that incentivizes the LP to be pressured into making the additional capital call. We'll save a deeper dive for understanding operating agreements for another time but suffice it to say that it is important to understand the operating agreement to fully understand you're investment's requirements.

Return Structures: How Money is Distributed to Investors

Most deals include:

Preferred Return ("Pref"): This is a target return that must be paid to LPs before the GP gets to participate in the profits. It's an advantageous structure for LPs designed to protect the LPs. Again, there are variations of this, but a common Pref would be an 8% IRR. This means that the LPs have the priority claims on distributable cash flows until their initial investment amount earns an 8% IRR. The IRR is the compounded annual return. For example, say a deal has a 5-year time horizon and the investor contributed $100k. An 8% IRR would mean that the investor gets priority on the first ~$150k of distributable cash flow before the GP participated in the profit.

Note, that in most circumstances, the GP investment is included in the LP bucket. Meaning that if the GP also invested $100k, then that investment is participating in the same 8% IRR Pref. So, all common equity is treated the same.

Waterfall Structure: This is how the profits are split, beyond the Pref. Once that Pref is met, the remaining distributable cash flows are split between the GP and the LP in a disproportionate way - called the Promote. For example, once that 8% Pref is achieved, the split may say that the GP earns a 20% promote on anything remaining. Note that there is a difference between the "split" and the "promote". If the GP invested 10% of the common equity and they have a 20% promote, they are getting more than 20% of the distributable cash flows beyond the 8% Pref.

This structure provides good alignment for LPs. The GP makes most of their money through the promote. They are incentivized to execute well so they can earn their promote. The higher the Pref, the more protection the LP has in the deal to earn a particular target rate of return.

Why This Structure Works

It is designed to let professional operators do what they do best - execute on real estate deals - and let investors participate in the upside without the active involvement and liability that the GP is responsible for. It works well for investors that want to include private real estate into their portfolios from a more passive role and without requiring the LP to have the experience and expertise to execute at a high level.

Most deals have minimum investment requirements, but over time those amounts have decreased, and it is now possible for investors to allocate smaller amounts of cash into deals. It's rare to invest less than $25k into a deal and much more common for the minimum checks to be +$100k, especially when investing in higher quality operators. It's easier to allocate smaller amounts when there is a direct relationship with the GP.

Be Aware

Not all deals and structures are created equal. It's important to do your homework in understanding the GP, the underlying real estate asset, the market, the capital stack, the business plan, the legal documents (including the operating agreement), and the risks associated with the deal. Passive does not mean blind.

Private real estate investments are structured to give investors access to opportunities without taking on operational complexity. As a Limited Partner, your role is clear. Fund the deal, understand the structure, choose the right sponsor, and let the professionals execute the plan.

The benefit to the investor is the ability to gain exposure to income-producing, appreciating, tax-advantaged real estate without the burden of being in the driver’s seat.

That’s the power of the LP model.