As real estate investment becomes increasingly popular, investors find themselves surrounded by a multitude of options. Small firms, big firms, REITs, private equity, direct investment — the list goes on, and it lends itself to the question: "where should I invest my hard-earned cash?" While the answer to this question can be complex (after all, choosing a fund manager involves lots of considerations, including trust and experience), there are a few general features that you can expect to vary between different kinds of firms. Priorities, institutional structure, personnel, and more can create real differences in how your investment performs. While we at Birgo Capital believe a small, private equity experience is a compelling way to efficiently align your cash flows and financial goals, there are also benefits to investing with larger firms.
Let's explore some options in the private equity real estate investment space (we’ll talk about REITs and direct investment in an upcoming post).
Large Firm Advantages
The most obvious advantage of investing with a large firm is, well, size. A large private equity firm can execute on larger-scale deals — and more of them — owing to a deep bench and pockets.
This possibility yields a few strengths. First, a large firm is positioned to deploy significant capital to acquire trophy assets — new, prominent Class A properties with strong cash flows and low operations and CapEx risk. A few successful anchor properties can produce strong returns and bolster the bottom line, reducing the impact of any less-successful assets in the portfolio. Especially in established, high-demand regions like New York and Los Angeles, acquiring these properties just isn’t an option for firms with smaller acquisitions budgets. Deal flow is also easier for larger private equity real estate investment firms; buyers that have reputations for being well-capitalized are viewed favorably by sellers in competitive bidding situations, so investing with a large firm has the potential to give investors access to the best deals.
Second, a large private equity real estate firm can control risks on a broad scale by holding a large number of properties. Unexpected blunders and setbacks are far more threatening to a small firm, and one or two storms can capsize the entire ship. On the other hand, firms holding a wider range of properties will have less concentration risk — and therefore face less threat from centralized problems.
Finally, large firms benefit from a deep array of supports. Bringing services like HR, legal, and accounting in-house affords cost-savings.. Meanwhile, a broad network of connections and a large war chest ensures that — should more difficult problems arise — a large firm can either pivot or simply exercise patience in order to protect their investments.
But the Story Doesn’t End There
For some investors, the size of a private equity real estate investment firm can be a liability.
First, there’s no guarantee that the efficiencies generated by large firms’ deal size, bench strength, or risk mitigation get passed on to LPs — one good reason why prospective investors should analyze and investigate fund and fee structures.
Second, a large private equity real estate investment firm may hold well over $10 billion in managed funds. The other side of the “economies of scale” coin mandates that a firm with more under management will, all else equal, be committed to larger deal sizes. Acquisitions targets are mandated by fund size; large funds have large acquisition targets, and this can erode discipline in the investment decision making process.
This ultimately leads to a perspective on projected absolute returns. Smaller funds that can execute careful discipline in deal selection can compose a portfolio entirely of carefully-selected properties, and this will, in general, produce higher return rates. Large firms realize this, of course; the difficulty is that their size does not always position them to utilize this information. A large firm may not have the flexibility to decline to pursue deals that offer a subpar IRR, and so while such a firm will generate returns, they may be lower than those materialized by a smaller, choosier firm.
Larger deals are, by their nature, often efficiently priced with little value add opportunity. In all likelihood, the seller of a 2,500 unit portfolio in a $250 million transaction is a professional investor who has optimally positioned the asset for sale and left relatively little meat on the bone for the next investor. Alternatively, smaller deals where sellers are mom-and-pop investor profiles typically have room for improvement. Large deal sizes can be an inhibitor to outsized returns.
Can Small Firms Access These Deep Value-Creation Opportunities?
Let’s return to the example above. A large firm might access a comparatively deep regional market via megadeals. But a small firm has the flexibility to exclusively obtain the high-return properties, from less-sophisticated sellers, without taking the whole portfolio — and its lower median return. This strategy can work because fewer acquisitions means generally higher acquisition quality. If you show up at the grocery store and need 200 tomatoes, some of them won’t be very fresh. If you only need 2 tomatoes, you can likely find 2 especially fresh specimens.
On a similar note, it’s easier to secure a high-performance asset for a good price when fewer buyers compete to obtain it. Dealing in large portfolios and massive aggregates invites competition from large institutional buyers: every time a national-scale REIT or supersized private equity firm looks to acquire a building, they face property values inflated by a large group of well-heeled buyers. At a smaller scale, this concern is simply irrelevant; buying smaller buildings in a city like Pittsburgh is more affordable, because institutional investors are forced by their size to overlook the best deals in the market — and that means their interest doesn’t drive up prices.
What does that mean for investors interested in small private equity real estate investment firms (dare we say, Birgo Capital)? Absolute returns may be higher for boutiques, because of selectivity and less price competition.
This isn’t to say small firms don’t face their own, unique challenges. Selectivity is a double-edged sword. Deep-value strategies work especially well when few competitors place upwards pressure on prices. However, should a boutique look to expand its reach and purchase the most attractive, visible buildings in a popular market, they may find themselves outbid by a larger firm. Small firms can be choosier in their option space, but the option space itself may be smaller than for large private equity real estate investment firms.
Other challenges that small firms face, which ultimately have the potential to impact investor returns, are limited deal flow, operational risks from a lack of experience and bench strength, issues arising from undercapitalization, key man risks, and lack of brand recognition. Each of these considerations are unique to small firms but can be navigated, and are issues that investors should be mindful of.
Of course, this discussion is not all there is to say. These are only a few of the considerations for prospective investors differentiating between large firms and boutiques.
Especially for large institutional investors, large firms make sense. If you’re managing $5 billion and committed to materializing returns on a 1% allocation of $50 million to a single real estate fund manager, you can’t afford to wait for the selectivity of a boutique. The size of an investment portfolio in total imposes the same constraints that large firms face inherently — and that’s not necessarily a bad thing. Stable, low-risk growth is often key for institutional investors, and large firms are well-positioned to supply just that.
But, for individuals and smaller organizations less concerned with figuring out where to put $50 million, and more concerned with an excellent return on $250,000, a boutique private equity real estate shop might offer superior performance by prioritizing efficiency over volume.
If you’re interested in learning more about the relative advantages of various firm sizes, or discussing an investment with Birgo, schedule a call with us today.