As a real estate lawyer in the NYC real estate market, I spend a great deal of time connecting clients (and relationships) to one another. Much of the time, these introductions are made between a capital provider and a party seeking capital.
In this vein, I see very much about what is going on and can say generally:
- There is an almost extraordinary amount of capital available to invest in real estate deals. I don’t know if it is a trillion dollars yet, but it is in the hundreds of billions of dollars.
- At the same time, there is a voracious demand for this capital from various sponsors and developers.
However, there is an irony in the following conundrum:
- Most of the capital is chasing larger sponsors and larger deals, which, due to the competition among capital providers, ends up having the investment upside whittled down due to pricing pressures. This makes it harder and harder for the capital providers to find places for their capital, and to a large extent, that capital sits there uninvested.
- Meanwhile, the smaller sponsors – i.e., those who are seeking smaller investment dollars for their deals – are hungry for investment capital but cannot find it, yet, generally, the risk/reward is better for smaller deals.
So at the end of the day:
- Big deals are oversubscribed with capital and overpriced or at least fully priced.
- Small-sized deals are undersubscribed with capital and underpriced, or at least more likely to be underpriced.
Am I making things too simple here?
I don’t think so – I think it really is just that simple.
I have made this point a fair number of times – over quite a number of years – to many capital providers, and the response has been generally that it is just too much trouble to put out capital in small amounts if you have a large amount of capital to deploy.
Of course, that is completely true; however, my countervailing thoughts are as follows:
- It is a lot better to put out small amounts than no amounts.
- The investor will (likely) receive better economics on smaller deals.
- The investor will almost certainly obtain stronger legal protections from a smaller sponsor with less bargaining power.
- The (first small-sized) investment will likely lead to building a relationship with a smaller player, which may grow up to be a bigger player down the line.
- These kinds of investments keep the investor’s team deployed and attuned to what is happening in the market during slow periods.
- Smaller investments allow the investor to train its more junior teammates, i.e., giving them greater responsibility.
- As an added plus, the investor’s economics will be further improved if there is a pipeline of diversified smaller deals that are crossed (for promote purposes).
- Finally, there is an aggregation concept allowing for an upside “pop” on exit, whereby a bunch of small deals are aggregated, which morphs the investment into a larger deal that a bigger player will likely pay top dollar for.
To conclude, if I were investing in a major fund, I would by no means discard my customary investment model, but, in addition, I would also be looking for:
- Sponsors of smaller deals
- With niche products or niche ideas
- Who have a solid track record in the specific niche asset class
- Where the deals are crossed together (for promote purposes) to reduce risk
- In which the investor is overpaid for the risk being underwritten
- Which are not over-taxing as a diligence process, i.e., simpler transactions in terms of structure
Finally, if you are a smaller-sized sponsor seeking a capital partner for your small deal pipeline – or if you are a capital partner who is open to small-sized transactions, I urge you to give me a call and see about creating some small-sized deals with large-sized returns.
Bruce Stachenfeld aka The Real Estate Philosopher™