The Benefits of Investing in Institutional Quality Real Estate

By Adam Gower Ph.D.

The Benefits of Investing in Insitutional Quality Real Estate - COMPRESSED

Investing in commercial real estate can take many forms. An individual investor might dip their toes in the waters by purchasing a duplex or small apartment building. Someone else might invest with others in a small retail strip center. Those with significantly more money to allocate, the institutional investors such as insurance companies, endowments, pension funds, and ultra-high-net-worth individuals and families, often invest in what’s known as 'institutional quality' real estate.

 

With the emergence of real estate crowdfunding, many platforms and sponsors wrap their pitch language with the idea that their investors are participating in institutional-quality deals. While that may well be the case, it is important to distinguish between the kind of investing conducted by institutional investors, and that which 'retail' investors are invited to participate in.  While the real estate may be the same, the way these two types of investors participate may not be.

While there’s no universally approved 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. In addition to the institutional investors mentioned above, we also see foundations, investment banks, hedge funds, and REITs drawn to institutional quality real estate.

 

Institutional quality real estate tends to have the characteristic of high-quality assets in major markets. The definition could be expanded to include commercial real estate in secondary markets when that property is of especially high quality, size, and tenant roster. Regardless of location, institutional quality real estate is generally offered at price points beyond the reach of individual investors or smaller partnerships.

 

Or at least, that was the case until recently.

 

Changes to SEC regulations opened the door for the online crowdfunding of commercial real estate deals. What this change means, in practice, is that individual investors are often invited to collectively invest in what are described as 'institutional quality' real estate – a product type, investors are told, that was once only available to institutional investors.

 

The distinction however, is that while the assets being offered to 'retail' investors may indeed be of institutional-quality, the structure of the deal being presented to these investors through crowdfunding can be somewhat removed from the kind of deal an institutional investor would enjoy.

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The Difference Between Institutional Real Estate and Institutional Investors

 

True institutional deals are structured very differently from the way they are in private deals even if they relate to institutional quality real estate in two important ways; one, the transparency and availability of information, and two, the investor's ability to negotiate terms on their own behalf.

 

In the first place, in the institutional investor world, information about deals is much more efficiently distributed and available. There are relatively few institutional players who are, by and large, seasoned, very experienced professionals who all know each other (or at minimum of each other) and depend in part on personal reputation to transact.

 

The availability of information and access to resources to double check sponsor due diligence is far more advanced than in the private sector because institutional investors have vast resources and budgets they can tap, relative to retail, crowdfund investors, to verify assumptions and to compare with market norms and expectations.

 

Secondly, as important, if not more so, are that the terms, conditions and rights and responsibilities of parties engaged in a true institutional quality deal are very different from those offered to retail investors.  In a transaction where not only the real estate is institutional but where all parties are themselves institutions, both sides expect to be represented by expensive, highly experienced attorneys, all fighting for their clients’ best interests.  Sponsors who invest in institutional properties with institutional investor partners find themselves in shared-decision making arrangements, operating buildings by committee, because their equity partners want to have decision making rights over the assets in order to protect their capital.

 

Not only can this be frustrating for sponsors who prefer to have complete autonomy over operations, but the cost of capital is high and institutional investors generally look to default provisions that allow them to take over ownership in the event sponsors fail to perform. To escape these restraints, and for other reasons, seasoned sponsors have opened up the doors to high-net-worth investors as an alternative to seeking institutional capital.

It is for these reasons that while investors have access to institutional quality real estate they need to be sure they are also getting institutional investor quality terms.

With this distinction in mind, and given that this type of investing is so new for most people, many do not fully understand the benefits of investing in institutional quality real estate. 

 

The Benefits of Investing in Institutional Quality Real Estate

Investment in institutional quality real estate can be made in both public markets (e.g., REITs and CMBS loans) and private markets (e.g., direct property investments and mortgage loans). Investment vehicles can include pooled funds, joint ventures and increasingly directly with sponsors who own and operate institutional quality real estate properties.

Here are some of the reasons institutional investors invest in institutional real estate:

 

• Depth of market: Institutional quality real estate tends to attract a consistent pool of deep pocketed buyers and lenders. This means that investors can usually secure top-notch terms when buying or refinancing the asset, and when they’re ready to sell, they have an easier time selling the market given robust interest from national and even international buyers. This is true even in the event of an economic downturn, where investors may otherwise be hesitant to invest in lesser quality products. In effect, this makes institutional quality real estate inherently more liquid than other commercial real estate product types.

 

• Access to better tenants: Institutional quality real estate is usually considered “Class A” product. It tends to be located in premier markets, and construction is of high quality and usually includes cutting edge building amenities. As a result, institutional quality real estate attracts top-tier tenants that are willing to sign long-term leases at higher rates. In the event of a vacancy, it is easier to fill the space with strong, credit-worthy tenants.

 

• More predictable cash flow: Related to the point above, because institutional quality real estate draws established, credit-worthy tenants that often sign long-term leases (typically ranging from 10 to 30 years), investors can expect to earn strong, stable cash flow.

 

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• Better rent growth and appreciation: Because institutional quality assets are concentrated in core markets, investors can expect strong rent growth and property appreciation over time. Commercial properties located in secondary and tertiary markets are more susceptible to wider swings over the course of real estate cycles.

 

• Usually newer product types: Institutional quality real estate tends to be either of newer construction or older properties that have been renovated and well maintained. This is important for investors because the newer the property, the less they’ll need to invest in additional capital or ongoing maintenance expenses. There’s also less risk of functional obsolescence. For instance, an institutional quality industrial property is more likely to have proper life safety systems, cross-docking capabilities, optimized floor to ceiling ratios, etc. compared to a Class B or Class C industrial property.

 

While there are clear benefits to investing in institutional quality real estate, an investor must evaluate whether these benefits outweigh the costs. For instance, institutional quality real estate tends to generate lower returns (ranging from 5-6% depending on the market and market cycle) as robust demand from competing investors tends to drive up prices for these lower risk kinds of assets.

 

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Keep in mind the distinction between institutional quality real estate and institutional investors.

The availability of knowledge is equally shared between institutional investors and sponsors, whereas the crowdfunding sector does not enjoy these conditions. Private capital investors do not have the resources or spending power of  institutional investors and neither do they have the legal representation to negotiate terms and conditions. 

 

The most important thing to look to when investing in an institutional asset is sponsor integrity, motivation and the benefits you derive compared to other investments you may be making - and to keep in mind that, no matter what anyone tells you, in most cases you are not investing ‘like an institution,' even if the quality of the asset you are investing is of institutional caliber.

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