Traditional funds are at a disadvantage in the face of new competitors, new business models, and an abundance of capital.
Private equity funds play an important role in the real estate “food chain”: They help distribute capital from institutional investors all the way down to the development and operation of the buildings in which most of us live, work, or spend our spare time. Arguably, they also contribute to the economy as a whole by facilitating the efficient allocation of capital based on data gathered from thousands of assets that they own or evaluate each year.
In return, private equity funds collect a significant percentage of the money they manage and the profits they help generate. This profitable position is now undermined by technologies that democratize access to capital and information, shift the power towards new types of operators and aggregators, and call into question the idea of real estate as a relatively safe investment.
Real Estate Private Equity 101 (skip if you already know )
Private equity real estate investments range from direct ownership of whole assets, through partial ownership, all the way to providing debt or acquiring real-estate backed financial products such as mortgages. Unlike investing in publicly-traded stocks, private equity usually involves an active strategy that impacts the way the target asset is managed, positioned, developed, and/or repurposed.
Funds are normally raised with a mandate to invest based on a specific strategy, in a specific geographical region, during a specific period, and must be liquidated within a pre-defined number of years. For example, Carlyle Realty Partners Fund VII consists of $4.16 billion raised prior to 2014 with a mandate to make opportunistic real estate investments in North America. Investment strategies fall into four main buckets, broadly defined by the level of risk and expected returns:
- Core investment in stabilized assets that can theoretically be held indefinitely as a way to preserve value and generate modest returns;
- Core Plus investment in assets with some opportunity for improvement by replacing expiring leases or other minor changes that generate higher returns while having a limited downside risk;
- Value Add investments in assets that can benefit from increased occupancy, improved operation, minor repositioning, refinancing, or creation of new revenue streams to generate significant returns; and
- Opportunistic investments in ground-up development, adaptive reuse, emerging markets, distressed assets, and non-performing debt involving high risk and the potential for hight returns.
A real estate project that began as an Opportunistic investment by a developer with a high appetite for risk comes full circle once it is completed, leased, refinanced, stabilized, and sold to a Core investor who can, in theory, receive a steady income stream without bearing significant risk.
Core No More
Technology is undermining the foundations of real estate value. No asset is safe: Office buildings in midtown Manhattan are under attack by WeWork and Knotel; stores on 5th avenue stand empty due to online competition and changing consumer preferences; and hotels next to Disney World are threatened by AirBnB’s partnership with a local developer.
This means that Core assets are no longer as risk-free as they seem. The assets are not worthless, but their operation now requires more effort and expertise — dealing with shorter leases, offering new value-added services (furniture, community, yoga…), operating specialized software and devices, and fighting fending off disruptive competitors.
Operating real estate assets is becoming a specialized business, merging proprietary hardware and software, and offering significant returns to scale. This means that new types of new operators such as WeWork, Common, and Starcity are building competitive advantages that are relevant well beyond the “shared” or “millennial” niches in which they emerged.
This is less surprising than it sounds: Hotel and shopping mall operation is already a specialized business with companies such as Westfield and Starwood leveraging proprietary technology, brands, and platforms that shift value away from the assets themselves. Similar dynamics are now emerging in the office and residential world.
As operators differentiate themselves with technology, they gain leverage when dealing with investors who can offer nothing other than money. In some cases, operators can even launch their own funds and capture more of the value created from the assets they operate, as Starwood previously did with Starwood Capital and as WeWork recently did with and Rhone Group. This is especially true in a period such as ours, when the world is flush with relatively cheap capital.
Technology also empowers smaller funds and investors by giving them access to data and dealflow that was hitherto difficult to obtain. Increasingly, traditional private equity funds will find themselves pushed towards riskier investments with limited ability to differentiate themselves from competing capital providers. More importantly, they will struggle to manage their assets unless they acquire new capabilities and tools.
Money Talks, But does it Listen?
The risks are clear. Private equity funds are still in a position of strength. But several structural problems are preventing many of them from responding appropriately or in time.
First and foremost, funds don’t have a strong incentive to invest in new capabilities and tools since things are not going too badly. In the short term, the glut of capital might even seem good: New money flows into the hands of the most established players and, for some, it feels like times have never been better.
Second, funds do not respond because, strictly speaking, they aren’t allowed to. As you remember, private equity funds usually have a narrow mandate to invest in assets under a specific strategy and in a specific geographical area. What about investing in technology or acquiring new capabilities and expertise? That’s not part of the mandate. Keep in mind that the assets most funds currently manage were acquired 1–5 years ago with money that was raised from investors 2–7 years ago.
Third, fund managers can use their own profits (as opposed to investor’s money), but that would mean investing in something that would have a limited impact on the fund that they currently manage. It would likely have more impact on funds that will be raised in the future — but those funds might be managed by other partners, and so the current ones have a limited incentive to invest their current profits to that end. Also, the profits of a single fund might not be sufficient to develop a lasting competitive advantage.
Fourth, in some cases, a company may manage several funds in parallel generate enough profits to allow a meaningful impact. But often, different funds are run by different partners with a different focus. Each group of partners is incentivized to maximize its own profits and has a limited incentive to pool together with other partners to invest in something that would benefit all of them. Also, tools that benefit a one fund might not be as useful for another.
Their operational and incentive structure prevents many private equity funds from doing what’s necessary to remain competitive. Consider the opposite approach: Once WeWork opened their first location in NYC, they started investing in their brand and a set of technologies and capabilities that are relevant for a much larger portfolio — even thought they only operated a small office space in one building.
In Part 2 of this article we look at the ways in which fund managers address these challenges, and what enables them to do so. In the process, we’ll see how mixing investment in property, operating businesses, and technology can lead to interesting synergies.
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Dror Poleg works with some of the world’s most innovative real estate investors, operators, and technologists to bring to market products that reshape the way people live, work, and travel. Follow @drorpoleg on Twitter or visit Rethinking.RE for his latest research.