Article

A Broader Definition of “Institutional-Quality” Real Estate

3Q19

Savvy investors are starting to broaden their view of what constitutes an institutional-quality asset, and in doing so, have uncovered tremendous opportunities that others have historically overlooked.

In commercial real estate, the term “institutional-quality” tends to conjure images of high-quality, Class A products located in core markets. Think of an office building in Manhattan, a high-rise apartment building in Los Angeles, or a state-of-the-art lab building in downtown Boston.

While there’s no standardized definition of “institutional-quality” real estate, it generally refers to a property of sufficient size and stature to merit attention from large national or international investors. These are the product types that draw interest from well-endowed pension funds, insurance companies, endowments, investment banks, hedge funds, REITs, high-net-worth individuals, etc.

But this is actually a quite narrow definition of ‘institutional-quality.’ Savvy investors are starting to broaden their view of what constitutes an institutional-quality asset, and in doing so, have uncovered tremendous opportunities that others have historically overlooked.

An Alternative View of “Institutional-Quality” Real Estate

The commercial real estate industry is as hot as ever, and as a result, institutional-quality assets located in core markets are now out of reach for the masses. That has many taking an alternative view of “institutional-quality” real estate – in this case, looking beyond just the product type or the market, and instead, focusing also on the quality of the sponsor behind the deal.

A commercial real estate sponsor is the person who finds the opportunity, lines up the capital, oversees all building improvements through to stabilization, and otherwise “quarterbacks” a deal from start to finish. As such, the quality of the real estate sponsor is critically important to the success of a deal (and is why all investors should do their due diligence on a sponsor prior to investing).

Increasingly, we’re seeing sponsors move out of the institutional investment world to launch their own companies. Perhaps this is a person who has “retired” from a private equity shop or who has spent the last decade working on real estate investments for a pension fund but has recently moved on to start their own company.

These sponsors – those with experience buying and redeveloping billions of dollars’ worth of commercial real estate – may not be investing in what’s traditionally considered ‘institutional-quality’ real estate, but they’re bringing institutional-quality execution to a project to ensure it results in a top-notch delivery.

Oftentimes, these sponsors are investing in Class B or Class C product types located in secondary or tertiary markets—and for good reason. These are the types of deals that traditional institutional investors tend to overlook. Deal sizes are often smaller and more geographically diverse; they’re the kind of deals that institutions don’t have the bandwidth to find, underwrite and then project-manage through to completion.

Institutional investors are not big risk takers, preferring to seek relatively high returns but seldom at the expense of taking on excess risk.  They have a fiduciary responsibility to the capital they are deploying, whether it comes from endowments or insurance companies or pension funds. Capital preservation to the institution is what wealth preservation is to the high net worth investor; while outsized returns are a goal, the initial investment has to be preserved as a primary objective of any investment. This means keeping a firm eye on market cycles and mitigating the macro-economic effects of the booms and busts of the overall economy.

However, institutional investors have so much capital to deploy that they simply cannot afford to look at every opportunity in the market even if they fit their overall investment criteria.  Evaluating a $200 million investment takes as much work as evaluating a $50 million investment, and with billions of dollars to invest, the typical institution simply won’t look at smaller deals. This restricts them, not only larger projects, but to looking at larger projects with higher dollar values – i.e. in major cities where values are higher.

Sponsors coming from the institutional world and setting up their own shops are not hampered by the burdens of scale their former institutional employers had, and so are free to bring core wealth preservation disciplines with them to smaller projects.  They focus on finding opportunities that have some indication that a real estate investment will continue to hold its value despite changing economic conditions – and they can look to smaller markets, with lower entry pricing to find them.

Instead of investing in Class A properties in core markets that are major employment centers regardless of swings in the market, institutional investing also means extending this investment strategy to secondary or tertiary markets with strong market fundamentals.  For example, student housing complexes. Universities aren’t going away, so demand for student housing is likely to remain high and recession resilient (particularly for more affordable public universities).  This can fit well with the institutional wealth preservation focus, while uncovering value add opportunities that can spike returns.

We’ve seen this strategy deployed countless times in the multifamily sector, as well. World-class sponsors often have an eye for identifying the next “hot” markets. This could be properties located in the inner suburban ring of major metropolitan areas, markets experiencing job and population growth, and/or markets with premier transit accessibility that allows easy access for those needing to travel into the core market for work. Sponsors will often look for Class B and Class C apartment buildings in these markets, identify those with strong, in-place cash flow, and then craft a redevelopment strategy that improves the property to further bolster returns.

A sponsor coming from the institutional world will also bring a database of contacts that may offer investment exits for deals, particularly when properly packaged.  For example, a portfolio of smaller value-add properties in the same geography with the same wealth preservation characteristics can be acquired, improved, stabilized and then sold as one larger package to an institutional investor – often at a premium over the sale price for a single asset. It takes a sponsor with institutional experience & connections to effectively employ an acquisition and disposition strategy like this in real estate investing.

This isn’t to say that institutional investors don’t invest in these smaller markets directly. They too recognize the benefits of working with sponsors who think as they do and will sometimes provide the bulk of the capital needed to support a localized portfolio play. In these cases a sponsor may be able to raise 80% of the equity needed from an institutional investor, and is now looking for people to co-invest in the remaining 20%. This opens the door to individuals looking to invest in high-caliber projects with top-notch partners—opportunities otherwise unavailable to anyone but the biggest investors.

While there will always be huge demand for what investors consider “traditional” institutional-quality real estate, taking a broader view is helpful for those looking to diversify their investment portfolios while still achieving that same focus on wealth preservation. This new perspective can open up many opportunities for institutional caliber investing that were never before considered available.

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