Continued Economic Uncertainty Keeps Door Open For Middle-Market Investors

However, the last weeks of July brought a perceptible shift in market sentiment. Earlier in the summer, hopes were high, people were traveling, and CEOs made bold declarations on bringing white-collar workers back to offices. 

Now, concerns about new coronavirus variants, infection rates, and inflation are dampening the optimism that the continued pipeline of historic-level government infrastructure spending should inspire.

We’re back in the realm of uncharted territory — an unstable, unpredictable macroeconomic situation. While that can be disheartening, there’s a tried-and-true approach to commercial real estate investing in just such an environment. It includes structuring transactions with built-in principal and other protections, and looking for unexploited niches in the market.

One such niche is the middle market, with property types encompassing multifamily, industrial, office, retail and hospitality.

Most institutional investors, with hundreds of millions and sometimes billions of dollars to allocate every year, only compete for transactions greater than $100 million. Anything less than $50 million is many times too small to be of interest.

As a result, there is a void in capital markets for middle-market commercial real estate transactions, despite the fact that the middle market accounts for the vast majority of commercial real estate as an asset class. 

This inefficiency presents an opportunity for superior risk adjusted returns for investors who can source and evaluate these kinds of opportunities.

To be sure, sourcing deals in the middle market can be labor intensive. Unlike the mega-deals typically executed by large institutional investors like public real estate investment trusts (REITs), middle-market deals by definition involve smaller, lesser known properties, or properties with no public visibility at all. 

Local knowledge is key to identifying and having access to these “under the radar” investment opportunities. For this reason, many middle-market commercial real estate investors are local operators.

This local specialization, though, is a double-edged sword. Working in a smaller geographical area means a smaller pool of potential deals. It also leaves the local investor more vulnerable to negative trends in the local economy as well as the broader real estate sector. 

This creates something of a paradox: the ideal situation for a middle-market investor is to have intimate knowledge of and connections in the local market, yet be geographically diverse enough to mitigate local market risks.

For those who can square the circle, deal structure should vary depending on the characteristics in the local market.

In high-valued, high-liquidity markets, the optimal approach is to invest lower in the capital stack, taking less risk, and trading upside for principal protection, and one way to do that is through structured preferred equity investments.

In low-valued, limited liquidity markets, the approach is to invest higher in the capital stack, taking on a little more risk as well as more upside potential, through joint venture equity and participating preferred equity investments. 

To maintain further flexibility over the investments in a changing market environment, an investor should retain major decision approval rights, such as exit decisions, capital markets decisions, and revisions to the business plan. 

An investment strategy that can take into account near-term uncertainty means getting into and getting out of investments quickly and easily, or alternatively structuring investments as more risk off to ensure staying power if the markets deteriorate during the investment hold period. It also means sweeping proceeds before the equity on a deal gets a return on its capital.

The demand for capital from middle-market sponsors is increasing with the increase in transaction volume in the middle-market due to the broad macroeconomic uncertainty and the desire by many investors, especially those concerned about future tax increases, to exit their portfolios. 

This dynamic should continue for the foreseeable future and generate attractive investment opportunities.

Sam Isaacson is the president of Walker & Dunlop Investment Partners, an alternative investment manager focused on middle-market commercial real estate investments.