Beyond Mom and Pop: The three classes of investments
In real estate, size matters. Real estate investments are broadly categorized in one of three groups by their size: Individual, Middle Market, and Institutional. Awareness of these size ranges is important because the players in the game are different in each: the lenders, investors, tenants, and even the type of vendors will be different depending on the size of the asset. For example, the lender on a $500 million glass office tower may be a large insurance company investing their own balance sheet, whereas the lender on a $200,000 single family house is a neighborhood bank that packages the loan to be sold to Fannie Mae.
At the smallest end of the market, investors are aptly called “individual investors” and colloquially known as “mom-and-pop” investors or retail investors. Most commonly, individual investors invest in single family homes, condos, townhouses or apartments buildings consisting of five or less units. Purchase price size ranges in this individual market are generally less than $2 million. Because of their small size, they are greater in number and it is a highly fragmented market.
Middle market sized deals usually range from $2 million to $20 million in size. This size range of deals still opens up to a variety of players, but is restrictive for individual investors. The deal sizes are large enough that it is difficult for even very wealthy individuals to acquire single-handedly. Oftentimes investors are made up of partnerships and syndicates, similar to the investment entities that Rev Projects establishes, to pool a large number of investors together. There are funds and their operators not quite of institutional size that operate in this size range with varying levels of sophistication.
Commercial real estate deals are typically of a larger size than say an average single-family home. Specifically, residential assets are defined as “commercial” if the building has five or more units, whereas non-commercial residential assets are categorized as buildings with four or less units. When the property has five or more units in particular, the size and risk of the loan increases, which sets a new standard for the lending guidelines and financing structure. This is because commercial properties are evaluated for their ability to generate income while residential properties are owned and occupied. With commercial properties, lenders are more concerned with property performance and net worth of the investor. Commercial loans are underwritten based on the asset’s net operating income, while residential loans are primarily focused on the credit of the buyer.
Rev Projects focuses its energy in the middle market. It tends to be the cross section in the real estate market that has the most untapped potential in mismanagement, deferred maintenance, and upside Historically, this market had less investment activity compared and was untapped by institutional investors, but that is not the case today. There is now willing and capable competition in every asset class and size of market. This forces developers to continually refine their methods and skills to target emerging asset classes. Institutional investors have started to competed in this size range in recent years, because they are trying to churn out volume and production to fill up their investment funds, even if deals are smaller than what they would traditionally acquire for their investors. On the whole, deals in the middle market are still not at a large enough scale for the goals of most institutional investors.
Institutional investors target acquisitions of properties that are generally $25 million or greater. They require larger deal sizes due to the type of investors they represent and the size of their funds. The larger institutional investors can raise investment funds of several billions of dollars in size. According to Preqin Real Estate, the amount of “dry powder” or funds available to invest by institutional investors peaked at nearly $371 billion in December 2019.
Investment managers in these large institutional funds must acquire larger asset sizes. Suppose you were the manager of one of a $2 billion fund and you had to allocate the fund to a number of assets. Even with the acquisition of properties with an average purchase price of $100 million, half of it debt and half of it equity, you would still have to acquire 40 properties; it’s hard enough to find even one good deal! If the average deal size dropped to $20 million, it would require 200 acquisitions to fully distribute your fund proceeds—wildly unfeasible for the efforts of a single fund. And you can see why many institutional fund managers don’t waste time pursuing a $20 million deal, no matter how much of a home run the deal may look like; it has little effect on the overall performance of their fund.
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