A pension fund commits $200M to a core real estate sleeve and $100M to a value-add fund. Both target the same metropolitan markets and the same office and industrial sectors. Yet their cash-flow profiles, leverage, hold periods, and return drivers differ as much as a leveraged loan differs from a venture investment. This lesson maps how private real estate generates return, how to value it, and where timberland and farmland fit.
Private real estate is equity or debt ownership of physical property held outside listed markets. Each asset is unique. A 200,000 sq ft warehouse in Dallas is not interchangeable with one in Atlanta the way two shares of the same real estate investment trust (REIT) are.
Investment vehicles. LPs access private real estate through:
- Direct ownership: a wholly owned building, joint venture, or club deal
- Open-end core funds (ODCE-style): perpetual life, quarterly subscriptions and redemptions, low leverage (typically under 30%)
- Closed-end value-add and opportunistic funds: 8-12 year life, capital calls and distributions, leverage 50-65%
Common mistakes
- Confusing cap rate with discount rate. A cap rate is a one-period yield on stabilized NOI. A discount rate is a multi-period IRR target reflecting risk. The cap rate equals the discount rate minus expected NOI growth (Gordon model). Trap: candidates use the discount rate where the cap rate is required, overstating value by 20-30%.
- Ignoring capex in NOI. NOI excludes capital expenditures but capex still reduces equity cash flow. Properties with high capex needs (older office, repositioning deals) show strong NOI but weak free cash flow. Trap: discounting NOI rather than after-capex cash flow inflates value.
- Treating timberland income as continuous. Harvest revenue is lumpy. Cash flow may be near zero for years between harvests, then large in a harvest year. Annual yield benchmarks (TIMO income return of 1-3%) reflect this. Trap: assuming a steady 6% yield on timberland and using it for cash-flow matching.
Bottom line
- Private real estate spans core (stabilized income, low leverage, 6-9% IRR), value-add (repositioning, 11-14% IRR), and opportunistic (development or distress, 15-20%+ IRR); leverage and risk rise together
- Three return sources: cash yield, appreciation (NOI growth plus cap-rate movement), and leverage; higher-risk strategies tilt the mix toward appreciation and leverage
- Cap-rate sensitivity: a 25-bp change on a 5.5% cap shifts value about 4.5%; NOI growth, cap-rate movement, and leverage are the core value drivers
- Valuation: income approach dominates (direct cap for stabilized assets, DCF for transition or capex-heavy periods); sales-comparison and cost approaches cross-check; appraisal cadence smooths reported volatility
Exam shortcut
Gordon link: cap rate ≈ discount rate − growth. A 7.5% discount rate with 2.5% NOI growth implies a 5.0% going-in cap. Use this to cross-check whether direct cap and DCF inputs are internally consistent. Cap-rate sensitivity rule of thumb: %ΔValue ≈ −ΔCap / Cap. A 25-bp move on a 5% cap is a 5% value change; on a 7% cap, it is 3.6%.
The full lesson (about 3,818 words, 25 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
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