Private Real Estate Funds: Structure and Return Sources

A private real estate fund is a closed-end pooled vehicle that buys buildings directly and holds them for a fixed term. Nilgiri Real Assets Fund I, an invented fund, is one: Rs 4,00,00,00,000 of commitments, five assets, and the same four-tier waterfall and ten-year term its manager uses elsewhere. Its money comes from two places and only two: the income a building produces, and the price it eventually sells for.

The shape of the vehicle only makes sense once the inside of it has been looked at, so start with the thing being held. A building is one object. The third floor of an office block cannot be sold to one buyer before lunch and the lift shaft to another after it. No screen shows what the block is worth this afternoon. No buyer stands ready at whatever hour an owner decides the money should come back. Every feature a reader notices about a private property fund, the fixed life, the absence of a daily price, the inability to walk away, is that one physical fact about a building showing up somewhere else. The vehicle is not designed that way because somebody preferred it. A building will not behave any other way.

What is a private real estate fund actually holding?

Think about a household that has put its savings into one shop unit in a market street. The rent arrives every month, and everybody in the street has a view about what the unit would fetch. The rent and the view about the price are two completely different things, and the household knows it. The rent is money in the bank. The view about the price is a conversation. If the household needs Rs 2,00,000 next week, the rent will not produce it and the conversation certainly will not. Somebody has to actually buy the shop, and that takes as long as it takes.

A private property fund is that situation at a much larger scale, run deliberately, with other people's money in it and a written contract around every part of it. Nilgiri Real Assets Fund I is one such vehicle. The fund is a closed-endA fund with a fixed life that does not take new money or return money on request. vehicle, settled as a trust, managed by Nilgiri Alternatives Advisors Private Limited, with Nilgiri Trusteeship Services Private Limited as trustee and Nilgiri Financial Holdings Private Limited as sponsor, all of them invented alongside the fund. The trust is registered as a Category II Alternative Investment Fund. Investors made commitmentsA promise to provide capital when the fund calls for it, rather than money already paid. of Rs 4,00,00,00,000 to it, and those commitments have been drawn in full.

The fund carries the same four-tier waterfall, the same preferred return, the same catch-up, the same carried interest, the same ten-year term with two one-year extensions and the same 2.00 per cent management fee that its manager uses on its private equity vehicle, and each of those terms is covered separately and used here as settled. The novelty is not the structure of the vehicle but what sits inside it: five real assets rather than nine companies, and two sources of money rather than one.

How Private Real Estate Funds Work: what happens between a commitment and a sale?

How Private Real Estate Funds Work

Four stages, in order, and every rupee on a property fund's schedule belongs to exactly one of them. Most arguments about private fund figures are really arguments about which stage the arguing parties are standing in, so name the stage before arguing about the number.

Stage one, capital is promised rather than paid. Investors sign for an amount and pay nothing on the day they sign. Nilgiri Real Assets Fund I gathered Rs 4,00,00,00,000 of such promises. A promise is not cash and does not sit in the fund's bank account. A promise is a contractual obligation to send money when the fund asks.

Stage two, capital is called when a building is actually being bought. Idle cash drags on everything, and the fund pays a fee on a basis that does not care whether the money is working, so a property fund does not want an investor's money until there is a building to put it into. Every private fund's schedule therefore carries a promised column and a drawn column that never match until the very end. At the record date used here, Nilgiri Real Assets Fund I's commitments are fully drawn: Rs 3,75,00,00,000 went into assets and Rs 25,00,00,000 went to fee and expenses.

Stage three, the assets are held, and this is where almost the whole life of the fund is spent. Buildings are let, rent is collected, running costs are paid, and what is left over is the property's earnings line. Five assets are held. Three of them are property, and those three cost Rs 2,40,00,00,000 between them and produced Rs 25,00,00,000 a year of income on that cost.

Stage four, an asset is sold and cash goes back. This is the stage that has not happened yet. No sale of any of the five assets appears at the record date, so the second of the two sources has produced nothing so far, for anybody, on any of them. An empty fourth stage is not a criticism of the fund. An empty fourth stage is the ordinary position of a closed-end property vehicle still inside its life, and it is the single most useful thing to know before reading any figure the fund publishes.

Where does the money come from when a fund holds buildings?

Two places, and only two. The first is the income the building produces while the fund holds it: rent collected, running costs paid, and the difference between them. The second is the price somebody pays for the building at the end. Income and price are the entire list. Every clever sentence anybody has ever written about property returns is a rearrangement of those two, and keeping them apart is most of the work.

The income source has a name on a property schedule. The name is net operating incomeA property's rent less the cost of running it, before financing and tax., and it is covered separately as a line of its own. Here it is used rather than explained. On asset 1 of Nilgiri Real Assets Fund I, a grade-A office property, the arithmetic runs as one subtraction: gross rental income of Rs 19,63,44,000 a year, less operating expenses of Rs 4,63,44,000, gives net operating income of Rs 15,00,00,000 a year. Rs 15,00,00,000 is 12.5 per cent of the Rs 1,20,00,00,000 the fund paid for the office. The percentage is this fund's own figure on its own cost and states nothing about property anywhere else.

The price source has no arithmetic at all yet. Nothing has been sold. Somebody will put a value on the office at each reporting date, and that value is an opinion until a buyer converts it. Income is money that has arrived. A price is a number that has not. No amount of care in the valuation changes which of the two categories a figure sits in. The moment the second becomes the first has a name, and it is a realisationThe sale of an asset, which is the moment an estimated value becomes a received amount..

Why must the two sources never be added into one figure?

Because addition destroys the only property that distinguishes them. Rs 25,00,00,000 of collected income plus a number somebody wrote down for a building is a sum, and the sum is arithmetically fine, and it has quietly thrown away the fact that half of it is checkable and half of it is not. Nobody can recover the split afterwards from the total. Losing the split is not a rounding problem or a presentation preference. Losing the split deletes information.

Here is the test that sorts every line on a property fund's schedule, and it takes one second per line. Ask: has the money arrived? Not is it likely to, not is the valuer careful, not is the assumption reasonable. Has it arrived. The answer to that single question splits any private fund's schedule into what can be verified against a bank account and what has to be taken on somebody's judgement, and no other question does as much work.

What does buying a building at 62.0 per cent let change?

Asset 5 of Nilgiri Real Assets Fund I is a retail centre. The centre cost Rs 40,00,00,000 and produced net operating income of Rs 2,80,00,000 a year at entry, being 7.0 per cent on the fund's own cost for it. Seven per cent is the lowest of the fund's three property assets. The centre was also, at entry, 62.0 per cent let, against 88.0 per cent on the office. The market label for an asset bought in that condition is value-addA market label for an asset bought with the intention of improving it., and the four labels that sort real assets that way are covered separately.

The 26 point gap between 88.0 per cent and 62.0 per cent is the whole reason that building was bought at that price, and it is the cleanest statement in this record of where a private property return can come from. Not only from collecting rent on what is already let, but from changing something about the building itself. A building with more than a third of its space producing nothing is a different object from a building with nine tenths of it producing, and it is priced as a different object. The buyer of the first one is not primarily buying this year's rent. The numbers say so: Rs 2,80,00,000 a year is one ninth of what the office produced, on a third of the office's cost.

The record fixes 62.0 per cent at entry and stops there. Whether the retail centre's occupancy later rose is a question the fund's own reporting answers, and a future occupancy, a future income or a future value written down today would be an invention dressed as a fact. OccupancyThe share of a building's leasable area that is let. is also more complicated than one percentage suggests, and is covered separately rather than here.

What do the three property assets show side by side?

Take the three property assets of Nilgiri Real Assets Fund I and put them in one row each. The office cost Rs 1,20,00,00,000 and produced Rs 15,00,00,000 a year, being 12.5 per cent on its own cost. The warehousing park cost Rs 80,00,00,000 and produced Rs 7,20,00,000, being 9.0 per cent on its own cost. The retail centre cost Rs 40,00,00,000 and produced Rs 2,80,00,000 at entry, being 7.0 per cent on its own cost. Together the three cost Rs 2,40,00,00,000 and produced Rs 25,00,00,000 a year, being 10.4 per cent on this fund's own property cost.

Several denominators are available, and they give different answers about the same fund on the same day, so name the denominator every time. Rs 2,40,00,00,000 of property is 64.0 per cent of the Rs 3,75,00,00,000 this fund deployed, and the 10.4 per cent above is measured on the property cost alone, not on everything deployed and not on what was committed. The two infrastructure assets are covered separately.

The internal shares say something the three yields on their own do not, so look at those next. The office is half the property cost and three fifths of the property income, the warehousing park is a third of the cost and 28.8 per cent of the income, and the retail centre is one sixth of the cost and 11.2 per cent of the income. Those three income shares are 60.0, 28.8 and 11.2, and they sum to exactly 100.0 per cent of the Rs 25,00,00,000. The retail centre carries a sixth of the money and produces a ninth of the income, and that is precisely what a building bought at 62.0 per cent let looks like on a schedule at entry.

Why can an investor not simply take their money out?

Picture ten households who put money together to buy one building on a main road. Nine months later, one of them needs cash for a wedding. There is no mechanism by which that household can take its tenth of the building and go. The building will not divide. The only routes are to find somebody who will buy that household's share of the arrangement, or to sell the whole building and split the proceeds, and the second one drags the other nine into a sale they did not ask for.

A private property fund is that, written down properly. An investor in Nilgiri Real Assets Fund I holds an interest in the fund and not in the office, not in the warehousing park and not in the retail centre. Holding an interest in the fund, rather than in a building, is why no redemption exists. A redemption would require the fund to turn part of a building into cash on demand, and a building does not do that. The closed-end shape is not a restriction placed on top of the assets; it is what the assets already were, written into a contract.

The word for the underlying condition is illiquidityThe condition of holding something that cannot be sold quickly at a known price., and it is worth noticing that it explains four separate features at once: the fixed term, the absence of a daily price, the lack of a redemption right, and the fact that capital comes back only as assets are sold. Four features, one cause. A vehicle that promised any of the four would be promising something the buildings inside it cannot deliver.

What does the manager get paid, and out of which source?

Out of neither of them directly, and that is the answer worth sitting with. The management fee of Nilgiri Real Assets Fund I is contracted at 2.00 per cent a year on a basis that steps down partway through the fund's life, a term settled earlier and used here as a fact. The fee is called as capital, like everything else, and paid while the fund runs. The fee does not wait for a building to produce rent and certainly does not wait for a building to be sold.

Put a number on the fee. The fund's commitments of Rs 4,00,00,00,000 have been drawn in full: Rs 3,75,00,00,000 bought assets and Rs 25,00,00,000 paid fee and expenses to the record date. Of every Rs 100 an investor committed to this fund, Rs 93.75 became an asset and Rs 6.25 paid the fee and the expenses. Both figures are exact, and both are stated unrounded. How many years of fee that Rs 25,00,00,000 represents cannot be worked out, because the record does not date it, and a year count produced by dividing one number by another would be an invention rather than a fact.

The carried interest is the other half of the manager's economics, and it works the other way round entirely. Carried interest sits at the end of a four-tier waterfall that pays investors back first, and this fund's four tiers are identical to the ones on its manager's private equity vehicle. The waterfall is covered separately. The point is timing: the fee is paid throughout, and anything beyond the fee waits behind the return of every rupee investors put in.

What is worth asking in twenty minutes with a property fund's schedule?

Reading a schedule is the practical end of the subject, and more people read a private fund's schedule than ever build one. Analysts covering an investor that holds such a fund read it. People inside a manager's own operations read it every quarter. A household that has money in a pooled vehicle somewhere upstream is affected by it without ever seeing it. Four questions, in this order, get most of the way.

First, ask which of the two sources each figure belongs to. If the schedule shows one column, ask for two. A property fund's schedule that cannot separate collected income from carrying value is not a readable schedule, however neatly it is typeset.

Second, ask what has actually been sold. On this fund the answer at its record date is nothing, on any of the five, so every rupee of value beyond the collected income is an estimate. One line long, that answer reframes every other figure on the schedule.

Third, ask which denominator each percentage uses. The fund's property income of Rs 25,00,00,000 is 10.4 per cent on the Rs 2,40,00,00,000 of property cost, and the property cost itself is 64.0 per cent of the Rs 3,75,00,00,000 deployed. Three different denominators are available and they produce three different sentences, all of them true and only one of them the one being claimed.

Fourth, ask what changed in the buildings themselves, and accept a plain answer. The retail centre was 62.0 per cent let at entry against 88.0 per cent at the office. Both figures are facts about the day each building was bought. Anything since is a question for the fund's own reporting, and a reader who has learned to ask rather than assume has learned the thing worth learning here.