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The Benefits of Investing in Institutional Quality Real Estate
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 Retail and Institutional Investors
On the surface, one might think that a “retail” investor is someone who invests in retail properties. After all, that would make complete sense! But the term is actually used more broadly to describe a certain type of investor. A retail investor is someone who invests in stocks, bonds, and other assets – usually for retirement purposes – but who does not do so for a living. Retail investors are not professional investors. They typically invest via a third party, such as a brokerage account or with their financial advisor.
In commercial real estate, it is important to distinguish retail investors from institutional investors, the latter of which are professional investors making decisions on behalf of another group of people, such as for insurance companies, pension funds, university endowments and the like. Historically, there have been some types of commercial real estate deals that are only open to institutional investors, though recently, more of these opportunities are beginning to open to retail investors as well (more on this to come).
Another important distinction between retail and institutional investors is access not only to projects, but also to information about projects. In most cases, institutional investors have access to very detailed information about projects, their markets and their performance through proprietary databases and professional advisors. They also have access to rafts of highly paid lawyers and accountants who not only provide detailed information on deals and their sponsors, but also often engage in lengthy negotiations with sponsors to ensure their clients best interests are being served.
Advantages and Disadvantages of Retail Investing
There are certain advantages of being a retail investor. These include:
- Advantage: Smaller-scale investments. Retail investors can usually invest in commercial real estate with significantly less capital than that required of an institutional investor. Institutional investors, for example, may often only look at deals where the equity check is tens of millions of dollars in size. Few retail investors have that kind of cash laying around!
- Advantage: Deals with varying time horizons. Retail investors will often invest in deals with shorter time horizons, such as 1-5-year repayment periods. This gives retail investors the flexibility to invest in projects that enable them to better preserve liquidity.
- Advantage: Ability to invest in more opportunities. Because the capital requirements are lower for retail investors, they’re able to invest in more opportunities. They can invest $500 in five different ETFs, for example, if they so choose. They might invest another $500 in five different REITs. They’re able to invest much more flexibly in a range of opportunities compared to institutional investors.
- Advantage: Diversification. Since minimum investments in private real estate have come down significantly since the advent of crowdfunding, retail investors can invest smaller amounts in more deals enabling them to diversify their portfolios in a way not before possible.
- Disadvantage: Higher fees. Retail investors usually pay higher fees that institutional investors. Institutional investors, given how much they typically invest at once, have more negotiating power when trying to lock in lower fees.
- Disadvantage: Fewer opportunities to invest in the “best” deals. Some commercial real estate deals are only open to institutional investors. This prevents retail investors from accessing some of the more lucrative deals that are truly off-limits to the masses.
- Disadvantage: Limited if any negotiating power. Investing only a small amount of money in a single deal limits the retail investor's ability to leverage their capital to negotiate favorable terms with a sponsor.
- Disadvantage: Contractual terms. Not having access to the resources institutional investors have, particularly to professional advisors who provide data and advice and who negotiate with sponsors on behalf of their clients, puts them at a relative disadvantage.
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Advantages and Disadvantages of Institutional Investing
There are also pros and cons to institutional investing. These include:
- Advantage: Access to the “best” deals. Everyone knows that institutional investors have the most cash to spend and, when they can, will often turn to them first when needing a major infusion of debt or equity for a commercial real estate deal. This means that institutional investors often get first (and sometimes, the only) access to the most lucrative real estate opportunities.
- Advantage: Scale. Sellers will go to institutional investors when shopping around either larger assets or a large portfolio of assets, rather than trying to sell individual properties one at a time to retail investors. Institutional investors can often access great deals this way, having the capital needed to purchase at scale when opportunities arise.
- Advantage: Programmatic relationships. Having as much financial clout as they do, institutional investors can attract high caliber sponsors who prefer having a single, deep pocketed investor for all of their deals, than multiple investors spread across each deal. This typically provides sponsors with discretionary capital they can use provided they meet certain investment criteria which lends itself to greater flexibility, even if on terms generally more favorable to the investor.
- Advantage: Impact. Given their purchasing power, institutional investors have the ability to influence the market. This is true as it pertains to commercial real estate, but also when buying or selling real estate equities such as ETFs, REITs or mutual funds. When an institution makes a large order for shares, or buys a large real estate portfolio, this action sends a signal to the market and may influence how others invest moving forward.
- Disadvantage: Conservative. Institutional investors are generally capitalized by fiduciaries who are very conservative guardians of their own institution's wealth. Pension fund, insurance company and endowment managers are tasked first with preserving the wealth of their entities first and for the long term. For this reason, during times of economic uncertainty, institutional investors will often pull back from markets and stop or at minimum curtail investment activities until the investment horizon becomes clearer. While on the one hand this is advantageous as it serves to preserve the underlying capital from excessive volatility, it is also disadvantageous because it can miss opportunistic investment periods.
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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.
Who Are Institutional Investors?
The term “institutional investor” is used to describe large organizations, such as banks, endowments, pension funds, hedge funds, pension funds, and exchange-traded funds (ETFs) that make investments on behalf of their members or shareholders. Institutional investors buy and sell all sorts of assets, ranging from stocks and bonds to commercial real estate.
Unlike retail investors, which are more heavily regulated by the Securities and Exchange Commission, institutional investors tend to have more leeway with how, when and where they invest. This is because the SEC assumes that institutional investors are more adept, with more investment knowledge and more resources to protect themselves.
Institutional investors usually make oversized investments compared to their retail investing counterparts. For example, a life insurance company might only consider investing in an office building if they can put at least $30 million into the deal. The size and scale of investments ranges drastically between retail and institutional investors.
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.
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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.
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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.
Pooled Investment Vehicles
With retail investors locked out of deals otherwise reserved for institutional investors, pooled investment vehicles are growing in popularity. Pooled investment vehicles (PIVs) are typically large funds that aggregate (i.e., pool) capital from many – sometimes thousands – of individual investors. The fund sponsor then utilizes that capital to invest in institutional-caliber real estate without necessarily having institutional support.
There are several benefits to investing in PIVs. For one, this opens the doors to a broader array of product types for otherwise retail investors. Second, PIVs have more purchasing and negotiating power than someone would have when investing on a standalone basis. Finally, retail investors benefit from the professional management associated with PIVs.
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.
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 Differences Between Private Capital and Institutional Capital
People often conflate “private capital” with “institutional capital”. While private capital can be institutional capital, the opposite is not always the case.
Simply put, investors use the term private capital to refer to any capital that is held by a private corporation (i.e., not a publicly traded entity). The shareholders of this corporation have agreed to share in risks and rewards of owning real estate together. Those who invest private capital into a deal can receive income distributions in the form of cash flow or other dividends. One benefit to investing in a private corporation is that these companies do not have to disclose financial information to the public. This stands in stark contrast to REITs and other publicly traded entities, which are obligated to issue quarterly and annual reports to shareholders – reports that are made publicly available once filed with the SEC.
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Institutional capital, meanwhile, usually comes from banks, pension funds, insurance companies, and endowments etc. Institutional capital may, but does not have to, utilize private capital. Take a pension fund, for example. Pension funds receive payments from individuals and sponsors, both public and private, and promise to pay a retirement benefit to future beneficiaries of the fund. Pension funds are governed by the Employee Retirement Income Security Act (ERISA), which makes these funds subject to slightly different rules and regulations than if governed by the SEC alone.
Another key difference between private and institutional capital is related to risk tolerance. Private investors often have a higher risk tolerance than institutional investors, which look for “safer” plays. As such, we often see institutional capital lean toward public-traded companies instead of the alternative.
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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