The flexibility paradox in private real estate

Specialized strategies are currently in favor, but a more open-minded approach can better capitalize on market disruption, writes Todd Rich, head of real estate at Declaration Partners.

Whether it be the Savings and Loans Crisis of the 1980s and 90s, the global financial crisis of 2007-08 or the covid-19 pandemic, those that take advantage of market disruption demonstrate a common characteristic: flexibility.

Successful real estate investing has favored those with purposeful flexibility. However, the emergence of real estate as an institutional asset class has given rise to a paradox. To attract capital, investment managers have increasingly narrowed their strategies to differentiate themselves in a crowded universe.

Todd Rich Declaration Partners
Rich: a more restrictive strategy can hurt performance

For institutional investors, dividing the world into buckets provides advantages. Those investors can manage their allocations to different asset types, geographies, or risk profiles by committing to specialized funds. But this specialization comes at a cost. For instance, a manager focused on NYC offices is heavily incentivized to continue acquiring such assets regardless of whether attractive investment opportunities can be found; deviating from the strategy would result in the damning critique of “style drift.”

In an environment where property dynamics can shift rapidly, these restrictions can inhibit investment performance. For those willing to embrace flexibility as an investment mindset, a range of differentiated opportunities emerge that can give rise to more compelling risk-adjusted returns. To explore this in more depth, we break down investment flexibility into four areas: sourcing, structuring, execution and exit /realization.

Sourcing Flexibility

Open-mindedness about geography and property type enables investors to shift focus, benefit from emerging trends, and avoid out-of-favor assets and markets. For instance, an investor willing to invest in multifamily and retail has an advantage in acquiring a mixed-use project over investors with narrower mandates. Similarly, a “core” investor may be unwilling to invest in an income producing asset with an associated development parcel, and a typical developer may dislike the income producing portion of the same property. A flexible investor can outmaneuver those groups and achieve attractive risk-adjusted returns on both portions.

Structuring Flexibility

In a market with no shortage of capital, an investor’s ability to structure investments with flexibility can be a meaningful competitive advantage.

This often comes down to tax structuring. Thinking flexibly about the tax position of a seller and offering creative solutions in the form of joint venture contributions or debt-like instruments, preferred equity, ground leases, or other structures can be one way to expand an investor’s value proposition as a partner and unlock compelling investment opportunities.

For instance, for properties in Opportunity Zones, investors can hold for at least 10 years because of the long-term tax benefits. Such an investor may access an opportunity controlled by a longtime landowner that otherwise would not have developed for some time.

Execution Flexibility

Despite the adage that an asset’s profit is determined at the time of acquisition, execution also requires flexibility. Rigid adherence to the original business plan may not make sense in a rapidly shifting market environment. For instance, a development site in Boston may have been planned for residential or office but may now achieve higher rents/returns if converted to life sciences. Or a movie theater at the center of a retail strip center could perhaps be worth more if redeveloped as townhomes.

Exit/Realization Flexibility

Finally, with a flexible mindset, investors can sell an asset when the time is right instead of being bound by an arbitrary fund life.

Certain fund structures incentivize managers to focus on short-term IRR targets versus maximizing dollar profits. Other funds may be permitted to hold assets longer, but have restrictions that limit the ability to realize profit distributions, such as limits on leverage or joint venture recapitalizations.

For instance, value-add or opportunity funds will typically sell a development project shortly after completion or stabilization. While this can optimize IRR, it does not always allow for sufficient maturation in the property to capitalize on further rent growth or asset appreciation. One alternative is a property-level refinancing and distribution of the additional non-recourse debt proceeds. This can return a significant portion of invested equity in a tax-efficient manner and allow an investor to continue realizing the benefits of ownership of a high-quality, newly built asset.

Creatively employing a flexible investment mindset has been a driver of successful risk-adjusted investing across time. Especially today, amid powerful cross currents of disruption, technological change, and competition, employing flexibility is critical for generating differentiated investment results.