This is something that has puzzled me as I’ve moved from the AEC side of the business to the finance side.
There is a group of elite, prestigious RE companies. They tend to hire from target schools, and many of the posters here would like to work for them. You know their names: Hines, Brookfield, Related, Tishman Speyer, Boston Properties, and so on. As far as I can tell, they all focus on big, Class-A properties in core cities like NYC, DC, SF, etc. And cap rates in these markets are super low.
This seems like the RE equivalent of MBAs going to work for top hedge funds where they outbid each other for Apple stock. At a certain point, Apple's share price gets way too high. And you'd think the hedge funds would start looking at some boring widget manufacturer in Alabama with a lower P/E ratio.
Why does this situation exist in CRE? Some possible reasons:
1. I’m wrong on the facts. The most elite RE companies actually do have significant exposure to smaller properties in secondary and tertiary markets, and I’m just unaware of this.
2. Don’t confuse “elite” with “successful”. Everyone wants to work for Related because they’re doing Hudson Yards, but there are other large, sophisticated RE companies that are doing better than Related or Hines. You just don’t hear about them as much because they invest in boring things.
3. Yes, large Class-A properties in global gateway cities DO provide the best risk-adjusted returns over the long term. The famous companies above are the best-capitalized and most sophisticated operators, and so they are the ones who can actually execute these expensive, complex deals. Lower-tier companies do smaller deals in secondary markets and earn lower risk-adjusted returns in the process. Sucks to be them.
4. It’s too hard for elite companies to access high yields from smaller buildings at scale. These firms have tons of capital that they need to deploy quickly and efficiently. It’s way easier to do due diligence, negotiation, and closings on several huge high-rises than on hundreds of small buildings. (But why not buy a portfolio of small buildings in one fell swoop after a smaller investor gradually assembled it?)
5. There are operational efficiencies associated with large buildings. It’s cheaper and easier to manage several huge high-rises than to manage hundreds and hundreds of three-families. (Of course, this is just another way of saying that that the risk-adjusted returns are better in the former than in the latter, other things being equal. And a sufficiently large cap rate spread should offset the inefficiency.)
6. The elite companies are reducing their probable returns, but they’re doing so as a hedge against downside risk. The property markets for Class-A buildings in top markets are highly liquid and contain many deep-pocketed players. The elite companies will accept lower returns on their assets because they know they’ll find someone to take them out of a deal at a decent price if necessary. By contrast, there might be only one legit counterparty operating in a smaller market.
(A higher-up at one of the elite firms listed above made this argument to me. I get it, but it sounds more like a first-mover issue than a fundamental financial one. I.e. no one is doing it, because no one is doing it. And you’d think someone would take the risk if the yields are significantly better in a secondary or tertiary market.)
7. The market isn’t efficient. These companies really could make more money buying smaller buildings in smaller markets, but they want trophy assets because their executives are on ego trips.
Something else?
Someone’s feeding you the wrong information brah. Different funds within the same company will target different returns. Blackstone has a core vehicle but also has opportunistic funds that do opportunistic deals. The opportunity fund isn’t going to buy nyc office at a 4 cap.
Yeah, I know that. That's why I said "risk-adjusted returns", not "returns". In an efficient market the opportunistic deal should have a similar NPV to the core deal, since the cash flows should be discounted with a higher discount rate. The higher expected IRR is offset by higher risk.
My point is that these companies have a major bias towards big buildings in gateway cities- for deals across the risk spectrum.
So your question is why do these firms buy properties in major metro areas. Hmm lemme think about that one for a sec rolls eyes
You seem to have answered your own post...multiple times over and intelligently...?
Is this a question?
I think the answers I listed are plausible but I don't know whether they are actually true. And some of them contradict each other so they can't all be true. I'm asking the board.
They all apply, although not all to the same firm, and you can't blanket all teams of all offices of top firms with all of them.
As EliteStudent11 said, many "top" firms have significant holdings in non-significant assets
There are definitely firms you've never heard of that make absurd returns.
There is something to be said for well-built, well-located class A properties. "Location, Location, Location" and all that. The rest of this bullet point is highly debatable, but if large Class A properties weren't lucrative, no one would build or own them.
This is debatable as well, because how you use "harder" and "easier" here can mean different things to different companies, and at this point you're mixing up the acquisitions teams and development teams for these companies, but the idea that there is capital out there that needs to be deployed is certainly accurate.
Also debatable - I don't think it's any more or less cheap or easy to manage multiple large buildings vs. more small buildings. Management is management. Depends on on if it's 3rd party or in-house management too.
Part of this makes sense. Different companies naturally built or buy to different required returns. I don't agree with the market for trophy listings being more liquid than small deals in small markets though. A lot more people can buy a $20MM building than a $200MM building.
Ego 100% plays into it, but I don't think a NYC high rise firm could make more money buying smaller buildings in smaller markets. You have to factor in local partners, travel expenses, time spent on each asset, etc. Too many variables.
Honestly though, again, each of the 7 probably applies to some company's situation.
We do a lot of business with Starwood, lone star, related etc. we are the only one who can provide them $5billion + loan for merger and acquisition. And over 90% of our business are class B/C properties
lol rip on that play
Something to think about is how these elite firms are capitalizing their deals. Most of them are investing money on behalf of institutions (pension funds, insurance companies, etc.), where the emphasis is on safe investments that aren't necessarily going to provide stellar returns but also have little risk of losing money. Class A properties in gateway cities are the assets that best fit the risk profile of large institutions.
This is realistically the #1 reason for this phenomenon, OP. You have to consider the investment strategy of these shops and their investors. Major institutions just don't have a big allocation for highly opportunistic, secondary/tertiary market plays. They tend to prefer other asset classes for higher risk investments, and allocate their real estate capital more towards safe, core deals (i.e. Class A buildings in gateway markets).
Not saying this is the case for all of the top shops or all their funds, but this explains probably 80-90% of it. Ego is also a big factor, and as CRE said, every single one of the points you listed play a role.
Also when a fund gets to be pretty chunky it becomes increasingly difficult to deploy capital with the same irr as a smaller co (usually). There's so much capital sitting around ATM it's nice just to be able to park it somewhere.
Yeah, that is what I was getting at in (4). Obviously it wouldn't be efficient for Hines to start buying up little apartment buildings one by one. But it seems like a smaller local company could assemble a big portfolio of small buildings, get it polished up and operating smoothly, and then sell the whole thing to them in one large transaction.
Maybe a separate way to phrase the same question would be: Why hasn't ownership of smaller buildings in secondary and tertiary markets been institutionalized to a greater extent than it has been?
It's hard to build big scalable systems for that kind of business. Similar reason you don't see companies sub-$2M/$3M EBITDA being bid on by private equity.
This happens, and the people who do it successfully can make a killing based on the portfolio premium. It takes a considerable amount of manpower and operating power to manage all these assets though - don't discount this.
If I had a boatload of cash, I would aggregate large trailer parks, maximize NOI, and sell off the entire portfolio or cash-out reinforce. 200 bps+ portfolio premiums.
This happens all the time (depending on what you mean by small, for multifamily lets say like 75+ units). It's not necessarily Hines or Blackstone but in Canada for example we have Starlight Investments who is the biggest multifamily player in the country ($20B+ AUM). They buy up portfolios in smaller markets pretty much quarterly.
Because those firms have a shitload of money to put to work and it's easier to buy 1 $500M building then 100 5M buildings
Second those that are correcting your assumption that they don't invest in other classes. The OP references trophy assets as something they seek to own, but I see them rather as the ones they prefer to show off and therefore the ones you're just more likely to see. Blackstone doesn't parade stuytown around the way they would another $5 billion acquisition. Can't blame them, it looks like a housing project. And when the big companies do invest in secondary markets, especially as a large company that's easy to paint as a villain, they often hide behind shell companies or do a JV with a smaller local partner that frontlines the deal.
Also, based on price differences, capital would inherently be disproportionately allocated to class A and other more expensive markets anyways.
First off, they invest in trophy properties in large part because they get pressure from their investors to do so. If you have a sovereign wealth fund or pension fund in your capital pool, my guess (well, my anecdotal knowledge) is that those folks pressure you to buy shiny and overpay for it. It's easier for them to say "we bought this 1mm sf office tower!" than to say "we aggregated twenty 50,000 sf Class B properties". This is probably especially true for foreign capital.
Second, a lot of these monster developers started small. Related was built on Section 8 housing throughout the country. There is still a sizable team there that manages those properties and maximizes the cash flow through tax credit re-syndication, HAP contract markups, etc. Gary Barnett founded Extell by parking Jewish diamond money in Midwestern malls and small office buildings. You don't hear about all this because the big developers have great PR departments and it is sexier to get good press for a megaproject than for the awesome refi you just closed on your 100,000 sf strip mall in Tulsa. My guess is those guys are still extracting most of their revenue and value from those properties, even if you don't hear about it.
This. I would guess many of the big sexy projects are not done for RoE, but for fee income and publicity/marketing. Some of these deals only pencil to a 7-9% project IRR... Meanwhile, the suburban office buildings they bought out of REO in 2011 are throwing off a 15%+ YoC...
They definitely do.
6 is the correct answer.
Good post. All of your reasons play a role, but I think #4 and #6 are the most impactful. The scale factor is a huge consideration. There's no point to making higher returns if it means making less money because you had to leave cash idle.
You ask why not buy a large portfolio of smaller buildings after a small investor assembled it; well I think that's a valid investment but I think all of that curating, improvement and consolidation by the smaller investor is value-add that will reduce the cap rate on that combined asset. Also, there may be only a few such investments available, which means the biggest players haven't had the chance to build up the diligence skills in that area. That adds risk.
Could it also be that Class A buildings offer better leverage ratios? I'm not in the the space, but my intuition would be that if Class A buildings have a demonstrated lower risk (to your point #6), then they should be able to do the deal with a smaller equity check as a % of purchase price.
I would imagine leverage ratios are lower because YoC can be low enough to where 8.0% DY / 1.2x DSCR doesn't pencil above 60% LTC...
We invest in more secondary market development, and general economics are 65% LTC and ~150 bps development spread resulting in 3-5 year hold periods with project LIRR's ranging from 18 - 25%...
Lenders loan the money at L + 250-300 bps drawn as needed and expect to maintain 1.25x DSCR coverage upon stabilization (they want to see 25 bps of cushion give or take). If you need to upfront reserve money for operating deficit and interest reserve, it better be capitalized appropriately in the pro forma.
That could certainly be the case and I'm not surprised if it is. My intuition would be that typical LTC limits would be raised for something that's less volatile. But not the first time that a reality of the finance world (expecially in lending) cuts against common sense.
It's about scale, liquidity and return/risk. If you need to deploy hundreds of millions/billions of equity per year you need to focus on Tier I markets to put your capital to work. Most of these investors are finite investors, meaning they have a 5 - 10 year time horizon to return capital to investors. The Tier I markets offer more liquidity than say Salt Lake City. Lastly, you know you have a relatively safe investment over the long-term by buying in Tier I markets whereas a Pittsburgh could go in either direction.
A. U. M.
They raise and raise and raise. They gotta put that money out. Big boys are the easiest and fastest way to do that.
6, but also keep in mind you associate these assets with the top players. Buying these assets has a lot to do with image. Therefore, you expect these top tier firms to take down deals in these markets. But for every 3 cap, the firms will need a high cap to balance out the returns (dependent on a firm by firm strategy basis or portfolio theory). These low cap new buildings with the safety tape still on the toilets will be postered by the buyer firm and the deal will also get public press for the firm as a big deal in a top market. But when the same firm is buying a fair building in a lower class market, it won’t get that public press coverage and that fair building will certainly not make the front page of the investor deck.
Agreed with other comments saying that scale is a huge consideration. At a certain point, these large managers become driven by AUM fees as much as they are by promote / carry. As others mentioned, even diversified managers like Blacktsone wants to be able to offer a product to core investors, many of whom make allocations of no less than $100mm at a time.
Also, many of these large managers are holding these assets in their open-end core ODCE funds that are structured to offer liquidity, diversity, stability, and a preference for income over capital appreciation. The Morgan Stanley Prime fund, for example, is over $20 billion in assets and has an investor base of major public pension funds, sovereign wealth funds, etc.
These large brand-name groups sometimes need to hold these positions in large, Class-A assets in top markets at low leverage because they are the most liquid and can be aggregated into this product for these LPs. More of a structuring necessity than them just "accepting" lower returns
Source: Work in REIB
I think the comment about some developers, uhhummmm, being vain, and wanting to build/own a "cool" and "visible" asset certainly plays into it...IMO the asset that most accurately relates to this thread are hotels. I've only underwritten, in detail, a few...but every consultant I've spoken with says the same thing -- "If you want vanity and pride in ownership then by all means build an Oriental or Ritz Carlton. But if you want yield and value, best stick with the 3-4 star Marriott style." Granted, yields on high lux hotels might have been hit harder than other asset classes due to technology, airbnb, etc...but I think fundamentally the concept still applies. When underwriting those high-end deals...you just look at your development budget (mainly the fees, FF&E, etc.) and think...no way in hell can I generate X% return with this upfront load...I would need to achieve 80% occupancy at $$$ rents that are 2-3x the market average! To a degree, the same concept applies to other asset classes as well.
I think the other argument that hasn't been stressed quite as much in this thread is preservation of capital -- which ties to the comments regarding "location, location, location". Your yields in some cases might be lower, but in the end you will still own a new building in a great location...it's never going to get mothballed.
Lastly, and this is more due to the current market cycle and where we are, expensive high end deals are being chased by the firms that have the OPPORTUNITY (which is a big plus as mentioned above regarding breaking barriers to entry) because construction prices are simply too high to build a class B/C asset in most cases. Renovation is the play for that level of deal.
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