How Small Real Estate Equity Funds Find Big Returns

The billion-dollar deals and marquee names of big investment firms can be hard for investors to resist. Yet in private equity real estate, often it’s the smaller, more nimble funds that deliver the better return on investment.

This David-versus-Goliath challenge plays out in private equity real estate funds that focus on all strategies, from investing in core, core-plus, value-add and opportunistic properties to assets that generate fixed income streams. There’s clear evidence that individual investors can gain a wealth-building edge when they bypass the marquee-name heavy hitters. Niche real estate equity funds show their power not with brute force but with a slingshot.

To prove the ability of smaller private equity real estate funds to build wealth, we analyzed 10 years of real estate return-on-investment data from Preqin, an industry leader that tracks the performance of alternative assets. Our review covered private equity real estate funds that made their first investments between 2005 and 2015. For funds with more than $1 billion or more in assets, we found that the average net internal rate of return (IRR) was 5.7 percent. For real estate equity funds with less than $200 million in assets, the net IRR was 11.2%.

Our results echo an earlier analysis by Preqin, which showed that funds of less that $500 million in size that began investing between 2005 and 2011 posted median returns of 5.9%--more than double the 2.3% return for funds over $1 billion. Preqin also noted that “there are likely to be many reasons for this, with smaller managers potentially more nimble when making investments and newer firms more motivated to prove their worth.”

In other words, when you’re looking for larger returns, it can pay to invest with smaller private equity real estate funds. In recent years, these fund managers have delivered up to double the return on investment.

What explains their ability to beat the giants of the real estate private equity world? From my 10-year perspective as co-principal at Origin Investments, I see four reasons why smaller size has made us a leading real estate fund manager:

1. Strategic focus. Malcolm Gladwell argues that David wasn’t really such an underdog in his battle with Goliath. He had years of sharpshooting success with a high-velocity weapon, namely his slingshot. In the same way, private equity real estate funds can beat their larger peers when they adopt a well-defined strategy. Origin’s approach targets properties with a value-add profile, one in which improvements build value.

Sharp focus and the ability to be nimble can pay off handsomely. For example, when we found

Arium North Point, an older Class B apartment complex with a Class A location in suburban Atlanta, we were able to acquire an asset below replacement cost. By renovating the clubhouse to add high-end amenities such as business and fitness centers, upgrading the interiors and controlling costs, we were able to improve net operating income and earn a 40 percent IRR and a 2.6x multiple on invested equity when we sold Arium North Point three-and-a-half years later.

2. Flying under the radar. A real estate fund with billions to invest tends to look exclusively at billion-dollar deals. The problem is, there are fewer bargains to be had in the world of trophy properties and this makes it harder to generate strong returns.

We have found that a smaller target price range, such as $10 million to $40 million, offers real estate investments that have been overlooked by the larger firms and will benefit from a disciplined improvement plan or a change in marketing.

A good example is Chicago’s Lux24 residences – in which a small brokerage firm sought buyers for a struggling condo project. Our team saw an opportunity in a location that was adding a transit hub and new tech employers, including Google. So we took on this overlooked property and converted it to apartments, realizing a 57.5% IRR and yielding more than triple the value for investors that went into the deal.

3. Efficient and effective execution. Reputation, size and investor expectations compel big firms to attempt to maintain a high level of performance across a slew of core income-generating properties, value add investments and opportunistic new construction all at once. However, there is a greater possibility of losing focus when managing a vast number of properties all under one roof.

Smaller real estate fund managers often have a lean-and-mean mentality. We hire skilled experts from respected firms to help us execute disciplined business plans, and let them do their jobs. Bureaucracy tends to drag down big-firm performers--they wind up managing their personnel and not their portfolios. They pilot a big ship that’s hard to maneuver. Small firms can turn on a dime.

Origin’s relationships in the Atlanta market and “boots on the ground” observation helped us spot hidden potential in Marquis River Trace, an apartment complex in growing Fulton County. We were able to structure a deal that engaged local partner Crown Holdings Group and allowed it to retain land for future development. Origin’s participation in the property’s purchase, improvement and sale generated a 68 percent IRR and a 5.8x multiple on equity.

4. Alignment of interests. Smart real estate fund managers motivate excellence by compensating their teams based on performance rather than simply assets under management. Everyone at Origin has “skin in the game,” a payout structure that’s unusual among big real estate fund managers. When their real estate investments perform well, they’re winners as well as our investor partners.

Origin’s smaller size means my partner and I are able to take a personal stake in all of our deals. I share my investors’ investment goals. They benefit from my personal commitment to the investment strategy, and my discipline at limiting risks that would put our combined funds in jeopardy.

In one of Preqin’s own recent studies, a majority of investors say that attractive investment opportunities, particularly in real estate, are harder to find than a year ago. Our results show that good deals in private equity real estate are still available, but it takes out-of-the mainstream thinking to find and profit from them.