Creating A Small Private Equity Fund In Estonia: Tell Us Your Interest
Creating A Small Private Equity Fund in Estonia: Tell Us Your Interest
Earlier this month, we published an article on the Estonian real estate market and explained why we are heavily investing in this specific country.
Following this article, many of you have reached out and requested that we create a small Estonian property fund for HYL members. This is off the table for now, but it is an interesting idea that is worth considering for the future.
Below, we provide a quick summary of the opportunity in Estonia, explain what such a fund could look like, and present a deal that I am currently evaluating.
Please let me know if this is something that could potentially interest you and we will consider it. You can leave a comment below or send me a direct message on the chat.
Why I am Heavily Investing in Estonia
If you could have bought prime real estate in Luxembourg ahead of it becoming one of the world's richest nations, would you have done it?
That's the pitch for investing in Estonia today.
In 2011, the Estonian prime minister set the goal for Estonia to become one of the Top 5 richest European countries by 2020. The prime minister then directly compared Estonia to Luxembourg, Switzerland, and Lichtenstein.
They did not quite achieve this aggressive goal within the set time frame, but they achieved a lot. As an example, salaries doubled in Tallinn since 2011... Estonia became the country with the most unicorns and start-ups per capita... And it put itself on the map as a business-friendly, tech-savvy nation with world-class digital infrastructure:
"If you go to a little country like Estonia, the whole damn country is on the internet and it’s a very good idea," Charlie Munger said at 2021 Daily Journal Annual Meeting.
It is amazing to think that already back in 2011, the prime minister would look past Finland and Sweden and instead compare Estonia directly to Luxembourg, Switzerland, and Liechtenstein to rival them as one of the Top 5 wealthiest nations of the near future.
What does Estonia have in common with Luxembourg, Switzerland, and Lichtenstein?
They are all tiny European countries that used to be poor up until they started attracting rich people and businesses through attractive tax schemes.
The main difference is that Estonia lost 40 years due to the Soviet time, but it is now quickly catching up and setting itself to become the "Luxembourg of Northern Europe".
Quite frankly, already now it makes much more sense to move to Estonia than to Luxembourg, Switzerland, or Lichtenstein if you are a rich individual from a Nordic country (proximity and culture) or a digital business owner (infrastructure and business climate).
Today, Estonia is still behind, but a few decades from now, we think that Estonia will be perceived as the "Luxembourg of the North" where Nordic rich people and digital businesses come to set up their base. It is already happening right now and we are seeing it first hand.
As a result, the prime assets of Tallinn will explode in value. That's where rich foreigners and business owners want to live, and as the Estonians get richer, increasingly many of them will also want to live in prime locations. The total population of Tallinn is not growing rapidly, but the total potential demand for real estate in the best locations is set for rapid growth as the country gets richer and more people can afford it.
Another good example is Malta, which also used to be a poor European country, but became rich by offering attractive tax schemes. Now take a look at how this impacted the value of its real estate... Limited supply, but rapidly growing demand from a population that became wealthier... Similar dynamics are already in force in Telliskivi / Kalamaja / Old Town and other popular parts of Tallinn, but we are still catching the wave early.
To put it again: if you could have bought prime real estate in Luxembourg ahead of it becoming one of the world's richest nations, would you have done it? That's the pitch for investing in Estonia.
How To Invest in Estonia
As noted in our previous article, there are 3 main options:
You could buy a property directly. I have done it, but wouldn't recommend it unless you have boots on the ground and have a very good understanding of the market.
You could invest in a private real estate fund. I have considered several of them, but have not yet found a manager that I could trust and/or a strategy that I would pursue.
Finally, you could invest in publicly listed REITs and other stocks that have high exposure to real estate. This is the best option in most cases. As an example, I get 100% of my US real estate exposure through REITs. However, in Estonia, there is only one attractive listed opportunity, and it isn't a pure-play real estate investment. It is an infrastructure business that owns a lot of land (Tallinna Sadam).
I invest in it, but wouldn't only rely on this one company to get all my Estonian real estate exposure.
Potential Solution: Creating Our Own "HYL" Estonian Property Fund?
This is what many of you have requested.
There are pros and cons to it.
Starting with the pros:
I am already investing in Estonia and so it wouldn't add too much work. You would directly co-invest in the same deals with me and share the same risk and reward potential. Our interest would be aligned and the fees would be reasonable.
Moreover, when I invest alone, I am limited to smaller deals and end up being concentrated. Together, we would be able to target opportunities in a larger investment universe and also seek better diversification.
Finally, there are also potential tax benefits for you as an investor. As long as an Estonian corporation retains its profits, they are not taxed and can be compounded tax-free. It would also give you access to leverage. Estonian banks are strict and require a track record in Estonia, which I already have.
But there are downsides as well:
First, the obvious one: this would be an illiquid vehicle with a minimum of a 5-10-year horizon with limited possibility of cashing out until the properties are sold at the end of the investment period. I am fine with that, but not everyone is.
Secondly, you would be making an investment in the Euro-zone, which exposes you to currency fluctuation. I see currency diversification as a good thing, but others may see this differently.
Finally, and perhaps, most importantly, there are legal challenges and costs in setting up such a vehicle, and these costs would need to be shared by the investors. We would likely also need to restrict the vehicle to accredited investors only to keep these costs low, at least initially.
Example of an Opportunity That I am Currently Evaluating in Estonia
I am currently doing due diligence on a 6-unit apartment deal that's priced at €280,000. This is too small to share with other investors, but it is meant to give you an idea of the type of deals that I am targeting in Estonia.
The 6 units are small ~22 square meter (240 square feet) studio apartments. They have all been freshly renovated less than a year ago and include a new kitchen, bathroom, flooring, windows, etc... Everything is brand new.
Two of the studios also include a sauna, which is seen as a big plus here in Estonia:
The building itself is an old traditional wooden house, which is typical of Kalamaja, where the property is located. The house is old, but it is in great shape and has been renovated in 2018:
The location is ideal because the property is right in the center of Kalamaja, which is today the trendiest part of Tallinn. This is where younger people want to live, where expats are moving, and also where tourists want to stay.
It is a short walk from all the top attractions: Telliskivi, old town, balti jaam market, port noblessner, the sea, the beach, etc... and if you want to go further away, there is a bus stop close by:
The 6-units are today rented to a company that operates them on Airbnb. The lease was signed in late 2020 and it has a 5-year term. The rent is €1,800 per month, and importantly, the tenant is also responsible for nearly all property expenses, including repairs, and the rent rises by 5% per year.
As such, it is similar to a net lease property for the coming 5 years with steady rental income, passive management, little capex, and good rent growth.
The cap rate based on the current rent is 7.8%, which is very attractive for this type of property in this location. Typically, cap rates are closer to 5-6% in Kalamaja because it is a very trendy area and it has experienced the fastest price appreciation in Tallinn over the past few years.
And the interesting thing here is that when the lease expires in five years, you have the opportunity to take over the operation of the Airbnb business and delegate it to a property management firm.
We estimate that after all expenses, the cash flow of the Airbnb operation would be closer to €3.500 per month on average, which equates to a 15% cash on cash return.
That's unleveraged, with conservative assumptions, and does not even account for appreciation.
It sounds too good to be true. So where is the catch?
You are correct that there is one.
The 6-units are all located on the basement floor of the property:
This stops a lot of investors.
Basement units are less attractive for residents because they generally have less privacy, more noise, and less luminosity. Moreover, basement units are more illiquid, which makes it harder to sell at a later date.
Even then, I believe that it is an attractive deal. In this specific case, 4 out of 6 apartments are on the side of a building or the court-yard and therefore, they have privacy and limited noise. Only 2 of them are on the side of the street. Moreover, unlike most basement units, these have large regular windows and enjoy good luminosity.
Finally, while this property could be rented to long-term residents, its best use is as an airbnb property, and airbnb guests generally care less about being on the basement level. They are looking for a nice stylish apartment for good value. They won't live there for more than a few weeks so it is not such a big factor for them as they select their airbnb apartment.
Why haven't I bought it yet?
The due diligence isn't over.
I need to talk to the tenant to better understand their plans.
I need to verify that all the work has been made according to norms and that the home-ownership association is fine with the aribnb business.
And finally, the last point, which I suspect could be the dealbreaker: I need to bring in an expert to assess the risk of running into some future humidity/mold issues due to it being on the basement level.
If I knew that all the foundation works were done at today's norm, it wouldn't worry much about it, but this is an old property, and I suspect that the basement wall is directly against the ground, which means that humidity could pose issues later on. (By the way, if you know anything about that, I am happy to hear your thoughts).
All in all, it appears like an unusually good deal, which hasn't sold yet because most investors don't want to buy basement apartments. But if you buy it with the optic of earning passive cash flow and waiting patiently for the area to become in even greater demand, it could prove to be a home-run investment.
Are there risks? Sure, they are. But is the risk-to-reward compelling? I think it beats most investments.
Bottom Line: Let Me Know Your Thoughts
If we created a fund, the idea would be to target this type of investments:
Prime location
Discount to fair value
Opportunity to create value
The main difference is that the individual deal size would likely be 5-10x larger.
Instead of buying one floor, it would be the entire building.
Let us know your thoughts below in the comment section and/or via direct message and we will consider setting up a structure for HYL members.