Mid-Market Investment Funds Focus on Tertiary Markets to Remain Competitive Photo by Scott Olson/Getty Images

Mid-Market Investment Funds Focus on Tertiary Markets to Remain Competitive

Fund managers who got the axe from institutional investors, or mega-funds, amidst sweeping personnel cutbacks in 2015 are wasting no time in finding treasure elsewhere, especially if they are talented real estate investors.

Mid-market private equity real estate funds have positioned themselves to have a favorable run in 2016, as they carve out investment niches in second-tier and tertiary real estate markets, say industry professionals.

Markets outside of the six major gateway cities offer unexpected, though solid, prospects for success, especially if savvy investors know what to look for.

What is swelling the ranks of mid-market funds?

But who exactly are these funds, and how does the industry define them? It turns out that the commercial real estate industry doesn’t follow a concrete definition of what a mid-market real estate fund is. There are general parameters, however, that help define these mid-sized firms. Firms in that tier generally have between $100 million to $300 million under management, while some raise as much as $700 million, allowing them to finance the purchase of $1.5 billion to $2 billion in assets, according to David Kessler, national director of the commercial real estate industry practice at CohnReznick, a New York City-based tax, accounting and business advisory firm.

Some of these funds were bolstered with real estate capital after large institutional funds like the California Public Employees’ Retirement System, or CalPERS, made public its plans to reduce the number of managers in its total fund by half, to 100 by 2020, according to press reports. The current fleet of 76 managers is reportedly expected to be culled back to 15 by 2020.

“Because general (non-real estate) investment returns have not been high enough to meet future return obligations, pension funds and other institutional funds have been reducing the headcount of managers as a cost-saving measure, as well as ‘shooting for larger returns’ by looking at increased levels of investment in real estate.”

Finding success among the not-so-rough diamonds

Mention Fargo, N.D. to most people and below-freezing winter temperatures that turn the rolling plains outside of the city into an icy prairie come to mind. The Kilbourne Group, a real estate investment firm, also considered a mid-market real estate investment fund, is driving much of downtown revitalization efforts in the city.

Last year, Kilbourne made about $18 million in commitments to revitalize Fargo, through redevelopments and high-profile purchases, including the Black Building, former home of Sears, and a package of 17 properties downtown. The $18 million estimate is based on appraisals of the properties’ values obtained from Fargo’s assessor’s office, and statements from Kilbourne.

The influx of investment capital is great news for the North Dakota city, but Fargo’s story has national implications too. It is one of many secondary and tertiary U.S. real estate markets whose economic development will continue to attract capital investment from mid-market real estate funds for 2016, the experts say. These markets are not merely consolation prizes for managers who might have been culled from the deep benches of the mega funds.

“Any city where you have an innovation cluster, educational opportunities and where you have non-routine, cognitive jobs being created … those are the kinds of cities that are important to focus on,” says Jim Costello, senior vice president at Real Capital Analytics (RCA), a New York City-based research firm.

Speaking of innovation clusters, Fargo has an expanding technology sector, with one of the nation’s largest Microsoft campuses. It also boasts a low unemployment rate at 2.6 percent, and low income taxes, according to Sperling’s Best Places, a service that provides information on the livability of American cities.

Still too cold? Austin, Texas remains a favorite, with its thriving technology and education sectors, and lifestyle appeal. Investment opportunities also abound in the research triangle of North Carolina, which competes handily with the established economic might of Charlotte. Atlanta, San Diego and Seattle are also attractive, as is Florida’s southwest triangle, which has the highest population migration of any other region in the U.S., Costello notes.

“For investors looking for a long-term hold, some of those markets—especially the ones that are growing nicely—may be able to provide good returns over time,” he says.

Emerging opportunities and unmovable challenges   

Geography is certainly not the only way in which mid-size managers can specialize. Market experts expect some of the mega funds to allocate capital to emerging managers, an industry term for startup investment programs often led by women and ethnic minorities.

Institutional investors are not merely scoring goodwill points by entrusting emerging manager programs with capital, but see them as a way to earn attractive profits while supporting underrepresented investment talent.

And here is a bright spot in fundraising. North American private equity real estate funds that closed from January to November 2015 raised $61 billion in investor commitments, a 42 percent percent jump compared to the same period in 2014, according to an NREI story, citing data from London-based research firm Preqin.

Of course, the road ahead will not be perfectly smooth for mid-sized investment managers. In a recent report, “Trends In Real Estate Private Equity,” consulting firm Ernst & Young noted that investors are cautious and very selective about partnering with unfamiliar funds. Also, the vetting process for those exploring new relationships can be very slow, adding urgency for new funds trying to build businesses.

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