Alongside global funds that pursue typical ‘large cap’ corporate and portfolio transactions, there are potential performance and diversification benefits to investing in small to mid-size real estate fund managers, especially those pursuing a value-add and/or opportunistic strategy.
Small to mid-size fund managers are typically defined as those which raise funds below $500 million, while emerging fund managers typically operate in the sub $250 million range.
While there are sourcing and due diligence costs, the risk-return, diversification and return potential of small to mid-size funds make such strategies appealing, particularly in the current market environment. The potential advantages are numerous.
Firstly, they tend to operate below the radar, away from the well-publicized portfolio transactions where the processes and information flow remain much more inefficient.
Typically, they focus on single properties at a time rather than a company or portfolio.
They may be close to the ground with local knowledge and contacts, enabling them to source transactions and exploit inherent inefficiencies.
Moreover, they are often vertically integrated and able to execute hands-on value enhancement. Their strategies also tend to be less leverage dependent, meaning they tend toward a more fundamentals based analysis and return profile, representing a closer source of real estate performance and alpha generation.
There are a number of considerations to take into account, however.
Firstly, when considering the small to mid-size and particularly emerging real estate fund manager universe, manager selection is of paramount importance and a key potential source of risk. Private equity real estate vehicles typically have lives of up to, or over ten years and, as a result, long-term manager viability, a fiduciary mindset and alignment with investors is crucial.
Secondly, small to mid-size real estate fund managers’ track records can be much harder to benchmark or verify and the analysis often necessitates the evaluation of key individuals’ performance and a granular understanding of their market and property type focus as well as an asset-by-asset track record analysis.
Thirdly, pursuing a small to mid-size real estate fund manager strategy also demands that the investor can appropriately judge the market cycles, understand the strategies to execute in various regions and blend these strategies together in a wider portfolio to achieve the appropriate level of risk mitigation and avoid hidden correlations.
However, these considerations are not insurmountable to accessing a segment of the market which appears more likely to deliver outperformance and true real estate alpha.
Alignment of interests remains key to manager selection. While smaller real estate fund managers may not have an established institutional framework, the nature of their size has positive alignment implications. The fund sizes are typically commensurate with, or smaller than, the opportunity set which allows for greater selectivity and avoidance of capacity issues. The key professionals typically have very meaningful financial commitments to the fund they manage and are often tightly aligned with investors.
This opportunity set for small to mid-size real estate fund managers is particularly pertinent today. The global financial crisis and following period of anemic growth resulted in a period of ‘creative destruction’ among real estate fund managers. Private equity real estate performance, particularly over the 2006 to 2008 vintage years was generally poor relative to prior cycles and benchmarks.
As a result many funds have been destabilized and suffered loss of personnel and limited in-flows of capital. This, in turn, has resulted in many talented professionals creating new entities aiming to raise conservatively sized funds with a niche focus that correspond with the founders’ track records and expertise.
Today’s low yield market environment has increased competition for assets, particularly higher profile assets and portfolios. As a result, a targeted, fundamentals based ‘one property at a time,’ below the radar screen approach to real estate investing continues to be rewarding.
There is no doubt that small to mid-size or emerging real estate fund managers can be more difficult to source and due diligence needs to be rigorous given the more opaque nature of this universe. However, the return analysis suggests that this less trodden path can produce rewards for those that are prepared to invest the time and effort.