How Smaller Private Real Estate Funds Can Generate Bigger Returns

1. Taking Advantage Of Inefficiency

There is inefficiency in the private markets. The lower end of the market is less efficient than the higher end of the market, enabling smaller managers to deliver real active return on investment.

Private funds that focus on smaller deal sizes are more likely to find and capitalize on pricing mistakes or anomalies. These properties are not as obvious or desirable to a wide range of buyers. Valuations can be more subjective because they are based on local comps and market conditions and done by buyers with different criteria and levels of expertise. This can widen the spread of bidding and asking prices and create opportunities for off-market purchases.

Just as in politics, all real estate is local. A global real estate fund may not have the boots on the ground to see market opportunities, not only in acquisitions but also in marketing or managing a property for a better return on investment.

2. Eliminating Two Layers Of Fees

A real estate fund’s size influences not only its strategic priorities but also its ability to efficiently invest capital. For instance, a large fund with billions of dollars to invest needs to rely on the platforms of other managers to deploy those funds. To do so, large firms often partner with regional operators to invest those large sums of money, maintain a steady deal flow and pay them — and themselves — before their investors. This double layer of fees is one of the biggest reasons for their underperformance. Investing with a smaller manager means fewer middlemen and fewer people requiring a piece of the proverbial pie, so investors have the chance to earn higher returns — and they often do.

3. Alignment Of Interests

The interests of small fund managers continue to be more closely aligned with their investors, especially when the principals are investing their own funds alongside those of their investment partners. Smaller private fund managers generally have a larger share of their net worth on the line and a personal relationship with their investment partners. Both of these factors lead to a manager with far greater skin in the game than a multibillion-dollar manager who may employ hundreds of people who have never met an investor.

What does all this mean for individual investors?

In Preqin’s most recent survey of institutional investors, 72% see high prices and valuations as a key issue facing the industry in 2018. While good deals in private equity real estate are still available, it takes out-of-the-mainstream thinking to find and profit from them. And as I noted above, in recent years, smaller private funds have delivered up to double the return on investment of their large-cap competitors.

There are many quality small managers in private equity real estate, but the industry is not set up to find them. Instead, advisors recommend large funds to investors and note that they are best in class. While this may be true, they are only best in class relative to other large fund managers, and investors may have a better chance of reaching their investing goals by asking their advisors to help them find high-performing smaller private funds. They don’t have marquee names, but they rally their troops around specific goals and set realistic timeframes to execute them successfully.