PART 1: The Trillionaires Are Coming to a Neighborhood Near You

In many communities around the world rent and housing prices are spiraling out of control, resulting in an affordability crisis for the majority of the population. Why is this happening? One big part of the problem lies with the way the current real estate private equity industry is structured. This industry is hugely powerful.

In fact, at the end of 2018 less than 500 institutional investors owned approximately 84% of the entire global real estate market(1).

This means a small number of investors with trillions of dollars in capital control the game. These massive institutional investors have always participated heavily in the real estate market through private equity funds, but they used to solely focus on large office buildings, apartment complexes, and shopping malls. Today, however, these trillionaires are investing in private equity funds that are flipping smaller properties, including single family homes, at an astounding rate. This has pumped up property prices and rents in many places at an unsustainable rate. To slow this down, we’ll have to fundamentally change the way we think about real estate investing.

Meet the Trillionaires

If you follow the money in any large real estate private equity deal, it’s almost always going to lead you to the same place: an institutional investor. That’s where the money originates. An institutional investor is a company or organization that collects money to make investments on behalf of its clients or members. Endowments, foundations, insurance companies, and pension funds are all examples of institutional investors. 

Let’s take the example of a pension plan. Most public employees like educators, firefighters, and police officers make payments each month into a shared pension. The pension then invests that money in real estate and other assets all over the globe. For these pension plans, real estate is a perfect investment because it generally creates stable and predictable cash flow. Pension plans need steady investment returns in order to make regular payments to their retired members.

Thus, it’s not surprising that pension plans and other institutional investors have trillions of dollars invested in the real estate market. If you are enrolled in a pension, you’re probably a part owner, or Limited Partner, in several buildings. Institutional investors have all of the money but they aren't the problem. The real issue is with the system that has been created with the people in the middle…

The Middlemen Effect

Because institutional investors have more money than they could ever hope to invest on their own, they hire real estate private equity firms to do most of this work for them. The manager of a large real estate private equity fund will raise money from several institutional investors and wealthy individuals in order to purchase a specific type of real estate that shows promise over the next few years. Importantly, these funds typically have a life of ten years. After raising money, the manager of a real estate private equity fund will then spend 1-2 years buying properties and will hold these properties for 5-7 years before selling them for a profit and closing out the fund. This means the investors will get their money back, plus profit, within ten years.

When I started buying real estate in Detroit in 2012 I had a front row seat to the real estate private equity world. In one specific deal, I assembled a handful of buildings in a prime location that many people did not believe in at the time. The only way I could get the money for the deal was from a real estate private equity fund who gave me a loan to buy the property. They charged me 18% interest per year and I had to pay the loan back within two years. Yes, 18% interest.  

I later found out the fund manager who gave me the money had gotten it from several pension plans, and he was targeting to pay them 7% per year on their money. That means he was charging me nearly three times the amount these pension plans were expecting as a return on their investment. I was unnecessarily forced to make short-term decisions on the property in order to pay back the 18% interest loan within two years. If I could have removed the middle man and borrowed the money directly from the pension plan for 7% with a longer time horizon it would have given me a lot more freedom to be creative with the buildings, keep rent at a reasonable level, and create long-term stability in the neighborhood where I was investing. Instead, we sold the buildings to pay back the investors before we had wanted to so those buildings couldn’t be developed in a community-minded way. 

Why are the middlemen so expensive?

It turns out the fund manager often isn’t the only middleman in a real estate private equity deal. These massive deals require a high degree of transparency, measurement, and professionalism, but there are too many parties involved between the owner of the property and the tenants. Here’s an overview of the entire team for a standard real estate private equity deal: 

• A fund manager organizes the fund, finds investors, and hires a small team to identify, buy, and improve some properties. They then look to sell the properties as quickly as possible to earn returns for their investors and themselves.
• An asset manager oversees the day-to-day running of the properties and sends frequent reports back to the fund managers. They get paid on a percentage of assets they manage and receive bonuses based on financial performance. They hire additional companies to do the following:
• Tenant leasing - finds new tenants for the building and manages lease negotiations
• Property manager - acts as a point of contact for day-to-day needs of the tenants.

If tenants have any questions related to the building, they contact the property management firm. Often, tenants are not even aware of the other parties.

This management structure is a big problem because it creates a disconnect between the people who own the property and the people who actually live or work there. There is no real relationship between the tenant and building owner. In fact, the owner could be located almost anywhere, with no knowledge at all of the local environment. 

Further, each one of these parties in a real estate private equity deal charge fees and have their own incentive structures—these fees can equal more than what the pension fund itself is earning on the investment. These additional costs make it more expensive to own and manage a property, which puts additional pressure on the fund manager to deliver big returns. These costs get priced into rent, which means they are passed on to tenants.

These Institutions are Coming to a Neighborhood Near You

In a sobering report, “Who Owns Rental Properties, and is it Changing?” from the Joint Center for Housing Studies at Harvard University, the authors provide data on rental housing ownership in the United States from 2001 to 2015. Large buildings have always been owned mostly by investment groups, the report shows, including institutional investors. Even back in 2001, non-individual investors owned 87% of all apartment buildings with 50 or more units in the country. 

But a huge change is taking place right now in the ownership of smaller buildings. For buildings with 5 to 24 units, ownership by non individuals nearly doubled between 2001 and 2015, from 35% to 62%. 

Investors are even starting to snap up single family homes at an alarming rate. While just 28% of single family homes were purchased by non individuals in 2010, that number had ballooned to 49% in 2015. 

The data clearly shows that today the real estate private equity system is gobbling up an ever-increasing share of the housing sector and that footprint is expanding fast. Single-family households, which serve as the bedrock of our neighborhoods and communities, aren’t actually owned by single families anymore. Between 2011 and 2017 some of the world’s largest private equity funds spent more than $36 billion on more than 200,000 homes. The problem is the private equity fund managers who control these investments tend to have an incentive structure that results in short-term profit maximization that is not aligned with the best interests of the communities where the real estate is located. If building owners believe the best way for a property to make money is for it to be sold every 5-7 years, they will continue to create instability throughout our communities. This trend of non-local, institutional ownership creates a real risk to the long-term stability of our neighborhoods and there are no signs that this alarming trend is slowing down any time soon.   

The Birth of the Global Real Estate Marketplace

For the first time in history, real estate is transitioning from a highly localized business to a global marketplace. How is it that an institutional investor based in Shanghai can buy a fifty-unit apartment building in Wyoming, a ten-unit apartment building in New Jersey, and five single-family houses in Vancouver, BC all in the same week? The answer: technology. Today’s investor can monitor listings, check financing options, cross-reference zoning regulations, access market forecasts, and submit offers without ever having to set foot in the local community. 

A decade ago a Shanghai investor interested in a property in New Jersey would have had to physically travel to the city, inspect the land, and visit a county or state building to pull files on ownership details, taxes, and other publicly available information. Today, an investor can get all of this information (and more) in real-time by simply swiping left or right. The game has changed, and it is not slowing down. 

Ironically, the original goal of all this technology was to empower individual property owners. These apps and websites, known in the industry as property technology or “proptech,” were supposed to level the playing field and give everyday people access to the same exact information available to the big real estate private equity firms. But these investment funds have the resources to hire entire teams of analysts whose sole job is to pour through this vast sea of data and find the very best investment opportunities. That’s why private equity funds are actively buying more real estate and increasingly able to outbid and move quicker than smaller buyers. It is clear that the drawbacks of technology are outweighing the benefits as the rate of institutional ownership of smaller properties has skyrocketed in the last few years. These private equity funds are increasingly boxing out individual and local real estate investors in their own real estate markets.

So what can we do about it?

Looking Ahead

There’s no doubt that institutional investors have positively impacted the real estate industry in many ways. They can invest in large projects that most other investors cannot afford, they can weather short-term losses, and they are afforded the ability to have a long-term mindset on their investments. Institutional investors actually have many of the characteristics of the perfect landlord: an unlimited amount of money and a need for slow, steady returns over a long period of time. The problem isn’t with the investors themselves, but rather, with the system they are using to invest their money. The issue is with how the real estate private equity market is structured, where fund managers often line their pockets with management fees, always focused on raising their next fund. This setup requires multiple management layers, which creates additional costs that are passed on to tenants and fosters an impersonal and disconnected culture.This incentive structure perpetuates short-term thinking and profit maximization, which leads to runaway rents and sky-high property prices. 

The good news is there’s already a possible solution to this problem we can borrow from the world of infrastructure investing. We just have to start thinking of real estate more like infrastructure. Part two of this essay explains how we might be able to that.

(1) Preqin August 2018 Real Estate Spotlight Newsletter: https://docs.preqin.com/newsletters/re/Preqin-Real-Estate-Spotlight-August-2018.pdf