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date: 17 April 2024

Leverage in Private Equity Real Estatelocked

Leverage in Private Equity Real Estatelocked

  • Jacob S. SagiJacob S. SagiKenan-Flagler Business School, University of North Carolina at Chapel Hill
  •  and Zipei ZhuZipei ZhuKenan-Flagler Business School, University of North Carolina at Chapel Hill


Private equity real estate (PERE) refers to professionally managed pooled investments in the real estate market available only to institutions (e.g., pension funds), private accredited investors, and high-net-worth individuals. In the ownership structure of PERE funds, general partners (GPs) serve as the active fund managers who raise an extensive amount of external capital from limited partners (LPs) to acquire and operate commercial real estate properties. Debt financing, namely the use of leverage, is prevalent in real estate investments and even more so in the setting of PERE funds. Though much empirical research is devoted to PERE fund performance, few studies directly investigate the role of financial leverage in PERE funds.

In an ideal friction-free setting, leverage creates no value and is essentially part of a zero-sum game of rights and privileges between various asset stakeholders. In practice, however, leverage seems far from irrelevant due to the existence of market frictions that could lead to value creation (or destruction) by its use. Financial economic theories indicate that leverage can amplify skill (or the lack thereof), reallocate cash flow rights, and shift incentives in the presence of market frictions. With PERE, existing work provides mixed or little evidence that leverage is employed to amplify skill and consistently hints that its use shifts the balance of benefits toward fund sponsors over their limited partners.

Based on data from Preqin and StepStone, a typical closed-end PERE fund targets roughly 65% debt to the value of total assets under management. Funds managing more risky real estate tend to use more leverage, and there is little evidence that fund terms are adjusted to reflect potential conflicts of interest posed by more intensive use of leverage. Rather, stylized facts raise concerns that the scope for conflict of interest may have increased over the past 10 years. Among these concerns is an increase in strategic longer-term use of subscription facilities. The bulk of evidence in the literature points to robust underperformance of high-leverage funds on a net-of-fee risk-adjusted basis. In other words, there is little evidence supporting the notion that leverage is employed to enhance skilled management and to benefit LPs. This suggests that a significant portion of PERE investors are not optimizing risk-return tradeoffs in allocating investments to high-leverage PERE funds. More work is needed to refine these findings and, more importantly, understand the source of market frictions behind them.


  • Financial Economics

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