Many people like to refer to “institutional real estate.” They discuss “institutional-quality” assets, “institutional investors,” “institutional sponsors,” and other similar terms. Given how broadly time is used, it’s worth delving into what it means.
The United States chief executive, Mike Hu, was recently interviewed for this article. Gaw Capital, USA is a significant institutional company whose most recent fund closed at $2.2 billion. Mike spends his days on the ground with various types of institutional investors. He shares his best insights on how we should think about institutional investors, what they’re looking for in deals, what qualifies as institutional-quality real estate, and more.
What is the real estate of institutional quality?
People typically associate institutional real estate with Class A properties in top-tier markets. Consider your San Francisco or Manhattan downtown office complexes. These properties are generally expensive, exclusive, and popular with international investors.
However, the institutional-quality real estate encompasses much more than these prize assets. Retail, multifamily, industrial/logistics, and office space are also included in institutional-quality real estate. It is the definition of the four major institutional “food groups.”
But institutional investors are increasingly investing in alternative asset classes like data centers, self-storage units, student housing, and senior housing.
What distinguishes institutional-quality real estate?
When discussing institutional-quality real estate, it is challenging to make generalizations, especially since not all investors make the same investments. In contrast, some investors won’t have trouble investing in any of the abovementioned assets. Others will only purchase the large, gleaming office building in a gateway city.
Instead, consider institutional-quality real estate along a risk-return spectrum. Core assets like Class A properties have the lowest risk and highest return. Institutional investors will purchase properties along this spectrum depending on their risk tolerances and portfolio objectives.
Consideration of size and scale offers another perspective on institutional-quality real estate. A single-family home, for example, would not be considered an institutional-quality product. Still, a portfolio of 5,000 single-family rental homes would. The critical distinction between traditional investment property and institutional-quality real estate is scale.
What is the definition of an institutional investor?
Institutional investors come in many forms, ranging from sovereign wealth funds to global pension funds, endowments, and foundations to large family offices. We’ll go over the various institutional investors in greater detail below.
All institutional investors share few characteristics, regardless of the type of institutional investor.
For starters, institutional investors typically have large sums of money to invest. A family office could invest $20 million in institutional-quality real estate at the low end of the spectrum. On the other hand, a sovereign wealth fund may be looking to invest at least $100 million. It naturally leads institutional investors to larger-scale transactions, whether a single Class A asset in a prime location or a portfolio of smaller acquisitions that, when combined, provide the investor with scale.
Another distinguishing feature of institutional investors is their sophistication. By sophisticated, we mean that these investors understand the risk-return spectrum very well. They are well-versed in various investment opportunities and understand how much leverage they are willing to have in any given transaction. Most institutional investors have skilled teams, either in-house or outsourced, that specialize in various asset classes, such as commercial real estate.
What are the various kinds of institutional investors?
There are several types of institutional investors, as previously stated. Large family offices, endowments, foundations, international pension funds, and sovereign wealth funds are a few examples.
- Sovereign Wealth Funds: In general, a sovereign wealth fund is a fund that invests on behalf of a state or county. They invest in various products, including real estate, private equity, infrastructure, and equities.
- Foundations and Endowments: These are the most common institutional investors, including investments made on behalf of universities and large nonprofit organizations. Endowments and foundations are typically very knowledgeable investors.
- Global Pension Funds: Global pension funds are comparable to sovereign wealth funds and endowments, except that they invest sizable sums on behalf of private businesses. As the name implies, global pension funds can be found worldwide, from the United States to Europe, Asia, and the Middle East.
- Large Family Offices: A family office is a privately held company that manages investments and wealth for highly wealthy families with assets totaling $100 million or more. Family offices have more or less experienced real estate investment teams than institutional investors.
Portfolio managers are the people who work for these companies. Suppose the institutional investor has purchased real estate directly. They are in charge of allocating capital and managing a direct portfolio. Rather than owning assets outright, some institutional investors prefer to invest in funds.
What does “892 investors” mean?
Section 892 of the United States tax code offers a particular tax benefit for investors in sovereign wealth funds. As a result, they are known as “892 investors.” A majority stake in the equity in the deal. They may be completely tax exempt if they own less than 50% of a real estate deal. This considerable cost savings serves as an incentive for foreign investors to buy U.S. real estate.
Given that so many institutional investors are looking to spend at least $100 million per transaction, they are not surprised to be drawn to high-end, trophy properties. They must invest in costly assets to deploy this amount of capital without owning a majority share of the equity.
What characteristics of a deal do institutional investors seek?
Institutional investors are motivated by various factors, including security, yield, and prestige. The most prominent investors, especially abroad, are often more interested in gateway cities’ low-risk transactions. They are far more likely to purchase a stabilized office building in New York, Chicago, or Los Angeles than buy an asset in Kansas City.
Security and prestige are important factors for these investors.
Meanwhile, family offices may be more willing to invest in value-add or alternative assets to maximize yield. Again, it is dependent on the individual investor’s goals.
The sponsor of a deal is also significant to institutional investors. The sponsor and fund manager will typically conduct extensive due diligence given the stakes. Before signing an agreement, this process usually entails several in-person and on-site meetings. Many institutional investors, particularly pension funds, will hire a third-party consulting firm to help them conduct due diligence (both investment-level D.D. and operational D.D.). They’ll want to know about capital distributions, risk and compliance protocols, etc. “…the less sexy side of the business,” Mike Hu says.
How does the procedure work when dealing with institutional investors?
As previously stated, most institutional investors devote significant time and effort to vetting a deal before investing. The institutional investor will ordinarily have to go through an investment committee to obtain final approval, depending on the deal’s merits, sponsor, and fund manager. After the contract agreement specifies details such as the format of the partnership agreement, finish the legal paperwork.
Institutional investors occasionally, but not always, rely heavily on consultants. Many people will not invest unless a consultant has approved it. Consultants such as research teams, accountants, and attorneys supplement the investors’ due diligence. Consultants may be used when the investment team requires more specialized knowledge during a specific stage of the D.D. process. However, many institutional investors handle all aspects of underwriting and due diligence in-house without the assistance of consultants. It is entirely dependent on the institutional investor’s bandwidth and capacity.
Lawyers are always present on both sides of a transaction.
Some transactions have more “hair” than others. For example, suppose an institutional investor cannot legally invest in a specific product type or geography. In that case, the deal must include a carve-out to accommodate that. Otherwise, the general partner may decline the carve-out and risk losing the investor. In any case, these are the nuances that lawyers assist parties in resolving.
What qualities do institutional investors seek in a fund manager?
Fund managers like Mike Hu and the Gaw Capital team serve as fiduciaries for their investors. They may help with deal sourcing and underwriting and always ensure an opportunity is in line with the fund’s investment philosophy.
It is critical for institutional investors that fund managers and the sponsors with whom they work have a track record. They will assess the G.P.’s previous deals, their performance, and projected returns for sales that have not yet been sold. Institutional investors want to know the good, the bad, and the ugly, including any bad deals the sponsor has had. This stage of the due diligence process frequently involves site visits and may include contacting the sponsor’s references.
It takes time to “get to know you.” A GP’s time to close a deal with an institutional investor can range from two months to ten years.
At any given time, some variables, including the current state of the economy, will affect an institutional investor’s desire to collaborate with a G.P.
What dangers come along with investing in institutions?
Institutional investing is risky for both the general partner and the institutional investor.
Institutional investors prefer long-term investments, according to the G.P. They have good patient capital. Institutional investors are sometimes forced to make short-term decisions that harm the G.P… The value of an investor’s real estate portfolio could have increased if their equity portfolio had decreased during the free fall of the equity markets in March 2020.
It can lead to an imbalance in the overall portfolio composition, which can be problematic for institutional investors who must stay within certain limits. During that time, investors might be compelled to sell some assets, which might not be the right time. It can impact the G.P. because it forces the G.P. to sell assets they would not want to sell at that time due to economic conditions beyond their control.
Meanwhile, institutional investors are constrained by their constraints. They are not always as quick to react as other investors. Given the size of their typical investments, there is frequently more red tape to navigate to secure required approvals. Endowments and family offices have a little more wiggle room and can move more quickly; this is particularly true for sovereign wealth and global pension funds.
Finally, institutional investors, according to Hu, are limited to the top tier of deals. They will not consider small-scale investments. Because making a deal worth $5 to $10 million or $100 million requires the same amount of time and effort from the institutional investor, they almost always choose the most critical deals available. It limits the types of investments they can make and the real estate sponsors with whom they can collaborate.
The Conclusion
Understanding institutional investors’ business practices and the institutional-quality assets they invested is crucial. Mike Hu taught us not to get too caught up in the terminology. The term “institutional” has a strict definition.
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