What We Can Learn From the Private Equity Playbook in 2024
Much has been said about the merits of investing in private equity (PE) offerings, especially with SD-IRAs and SD-401(k)s where the expectations of longer-term investing are the norm.
But the last year has taken some of the shine off the industry. The dramatic increase in lending rates by the Feds clearly signaled the end of “cheap” money.
With these changes in mind, is the Private Equity Playbook still relevant and standing the test of time?
Let’s dive in and see what Private Equity (PE) got right from their playbook and what they got very wrong.
The Wrong from the Playbook
Let’s start with what the PE Playbook got wrong.
Is Internal Rate of Return Irrelevant?
The internal rate of return (IRR) has been used to estimate the profitability of a project in a given timeframe. Especially in PE real estate, the IRR has been used as the benchmark for comparing investment returns.
But is IRR now irrelevant? In my opinion, yes and no. Here’s why:
There are two parts to the IRR formula. Part 1 is the rate of return your money is earning based on net cash flow/profit. Part 2 is the rate of return your money will earn based on the appreciation and future sale or refinance of the property.
While Part 1 is quite straightforward, Part 2 can be fuzzy. That is to say, can you always count on a property appreciating? No! For example, if a property generates $500,000 a year and you need to earn 3.5% on your investment, you can afford to pay $14,285,714 for the property.
But if you want to earn 7.5% from the same property, you can only afford to pay $6,666,667 for the same property. That’s a massive difference in what you can afford to pay, which is based on no more than estimates of a property’s rate of return.
So in order to determine the future value of that same property, you have to ask yourself what is the future of interest rates? Interest rates are high right now. What if they don’t come down significantly? For commercial banks holding a mortgage that might be higher than the current market value of the property — this is a real problem.
What Has to Be Scrapped from the IRR Formula?
Future value (FV) calculations that are banking on lower cap rates can no longer be relied upon when calculating IRR. This may turn out to be a classic case of “market happy thinking,” which is a dangerous sense of complacency to hold onto when the market has so clearly changed over the past year.
When FV is taken out of the equation, many IRRs are now actually yielding below CD rates. (Yikes.) And if actual property values decline, the outlook is far worse.
For example, imagine the capital call on a loan for a property that has depreciated when that loan inevitably needs to be refinanced. You will have to pay to stay invested, and you will not be able to sell without a substantial loss.
The Right from the Playbook
While the outlook for some PE offerings is bleak, Private Equity has always prided itself on finding niches in the marketplace and capitalizing on them. That has not gone away. Here are a few of the current niches PE is capitalizing on:
Real Estate: 55+ Housing
Baby Boomers continue to be the driving need for more lifestyle housing changes. Whether it is a 55+ community, smaller homes in warmer climates, or assisted living with both independent and attendant care, Baby Boomers are again redefining the norm in large numbers. This need presents a growing market for PE investors.
Real Estate: Workforce Housing
With housing values having recently gone through a COVID-based round of mega-appreciation, many lifestyle communities can no longer afford to house their infrastructure workforce.
PE investors can fill this gap by funding developments that provide accessible living options for essential workers, thereby supporting community infrastructure and sustainability.
Real Estate: Non-Stick Built Modular Housing
Non-stick-built modular housing is rising in response to the two pressures above. Urban areas are unaffordable for support workers and trade industries, and new construction costs and completion dates remain difficult to predict due to insufficient laborers.
Non-stick-built modular housing is filling this gap, as it can better predict and control construction costs. PE can capitalize on this trend by investing in modular construction technologies that offer fast, cost-effective building solutions for the housing market.
Private Capital
With bank loan windows closed, PE has an opportunity to step in. We’ve seen 10%+ returns now from private capital funds, presenting PE investors with the opportunity to achieve higher returns by stepping into finance projects and businesses in need of capital.
Artificial Intelligence
The industry already acknowledges that AI will be another disruptive technology. They are trying to figure out who or what it will disrupt and what opportunities it will present — especially when it comes to jobs, industries, and investments.
By identifying and backing AI innovations, PE firms can lead the transformation in various sectors from healthcare to finance, generating significant potential returns as these technologies mature and proliferate.
How Chicago Trust Administration Services Can Help
Private equity continues to attract some of the sharpest minds in the industry. As with any investment, they and you can only be accurate in your assumptions for today.
As we peer into the year ahead, the landscape for self-directed investors may be changing, but it is still replete with opportunity. By embracing a thoughtful investment approach, focusing on due diligence, and staying adaptable to the evolving market landscape, self-directed investors can navigate the complexities of the financial world with confidence.
Staying informed about trends, regulatory changes, and technological advancements will be crucial. With the right strategies and a proactive mindset, the year ahead holds the promise of growth, resilience, and success for self-directed investors. By cultivating a network of advisors and tapping into educational resources, investors can make well-informed decisions that capitalize on the opportunities of 2024 and beyond.
At Chicago Trust Administration Services, we understand the complexities that affect your SDIRA. When it comes to private equity, real estate, and other non-traditional investment opportunities, expertise and speed are paramount. With over 20 years of experience, our expertise in self-directed investment strategies allows you to close complex deals quickly.
To see how we can help, we invite you to schedule a complimentary meeting with us by calling 312-869-9394 or emailing steve@ctasira.com.
___________________________________________________________________________
*The content and opinions in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
**CTAS professionals are not financial advisors and cannot provide advice or recommendations regarding specific investment decisions.