Commercial real estate was not immune. In the uncertainty we face now, you might be wondering if it's best to form a commingled real estate investment fund or pursue a deal-by-deal approach in the COVID-19 era.
Let's take a look at some of the advantages of each and what steps you can take to form a fund in the current environment.
The Advantages of a Real Estate Fund
Most new and emerging real estate investment sponsors have to use a deal-by-deal approach to establish a reputation and track record. If you have built a track record or otherwise have the ability to raise capital for a commingled fund, there are several advantages to doing so.
A fund can make you a stronger buyer for sellers and can help win opportunities in a competitive bidding environment. A fund with committed capital helps you demonstrate that you have funds available and enough dry powder to close a deal within a reasonable time frame. That may entice sellers to accept your offers over others raising capital for each transaction.
When sellers are uncertain about the market and, in particular, the future of the market, sellers do not want to risk a transaction failing because of financing falling through.
A fund can also help you move more quickly. When a new opportunity is available, you can strike fast because you already have capital backing you. And, success can build on itself. As your portfolio becomes more diverse, you can become more attractive to new investors.
Finally, having a fund can help you secure financing in an uncertain market, such as the one the COVID-19 pandemic has created. Banks know that you have other assets available, which makes you a more stable potential borrower.
The Benefits of Raising Funds Deal by Deal
On the other hand, there are benefits to taking the deal-by-deal approach. Doing so can provide a lot of flexibility. In a challenging environment, that flexibility can be a goldmine.
Picky investors sometimes prefer to underwrite and invest in a specific asset. A blind pool, with commingled fund, particularly for an investor investing with a new fund sponsor requires more trust than some investors are willing to provide. As a result, it can be easier in some environments to raise capital for specific assets rather than for a fund.
A deal-by-deal uncrossed approach can also provide a sponsor with bigger upside because outsized returns from one asset aren't mitigated by smaller returns or losses from another asset.
As an example, some of our clients in the hospitality space have found the deal-by-deal approach in the current environment to be a better route. The hotel and resort industry was one of the hardest hit by the pandemic, and many investors are looking to take advantage of distressed hospitality properties.
The amount of capital chasing deals is significant. And, in many cases, investors are sorting hospitality sponsors and opportunities on a deal-by-deal basis with the mindset of maximizing returns on particular opportunities.
Assessing the Difficulty of Finding Investors in the Current Environment
In March 2020, no one was surprised that investors hit the brakes on their financial spending. We were entering unknown waters, and it was unclear what impact the pandemic would have, to say nothing of how long it would last.
Over time, however, confidence has returned. There are now new investment opportunities that weren't available before the pandemic, like the distressed hospitality industry, mentioned above. Investors are more willing to spend, but in-person meetings are a challenge with current restrictions. As a result, investors tend to invest with those they already know and trust.
In the case of the deal-by-deal approach, if you have a new relationship and an investor cannot visit a property before putting money on the line, you might struggle with raising funds. But, innovation is often spawned by adversity. For example, new virtual technology has made it possible to tour assists without actually being on-site.
You may have to look harder to find backing if you're looking at a property that's currently closed or off-limits, but with today's technology, you can overcome even those barriers.
Looking Toward the Future
Will the pandemic permanently affect the landscape of investing in real estate? Most experts say no. When the pandemic is over, the same criteria used to evaluate deals will be back in place, maybe with some new tools for sponsors and investors.
No one knows how long it will take, but markets and revenue will eventually return. Homebuilding, for instance, has bounced back already and is the strongest it's been in decades. It's unlikely that there will be a new normal where the real estate market is altered indefinitely.
However, the pressures of this difficult time may well impact how specific industries operate. As with other industries, hotels and the hospitality industry are likely to focus on being more efficient and managing costs more effectively, which could result in better bottom lines in the future. There may also be changes in the laws, especially with a new presidential administration. Laws relating to tax-deferred/Section 1031 exchanges or capital gains tax rates may change, which will affect investment structures.
Sponsors and investors will need to decide what works best for their goals and transactions. There are advantages to having a commingled fund and benefits to choosing a deal-by-deal approach. How well-established you are might play a role, since that has a significant impact on how easily you can find investors. The good news is that the current environment won't last forever, but it does create substantial opportunities.
Matt Ertman is a partner at Allen Matkins Leck Gamble Mallory & Natsis LLP.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
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