No, Sponsors Shouldn’t Shy Away From Private Commercial Real Estate Funds

Fundraising for private real estate funds has been lackluster for some time. That shouldn’t dissuade prospective fund managers from engaging in a venture, though. 

Some of commercial real estate’s biggest private equity players and fund managers hit an 11-year fundraising low in 2023, according to data from Private Equity Real Estate. And Pitchbook reports that, globally, the amount of capital yet to be deployed out of private real estate fund vehicles — the so-called dry powder — dipped year-over-year for the first time since the Global Financial Crisis.  

The sky has yet to clear in 2024. Only about $41 billion was raised across the globe for just 83 closed-end fund vehicles through the first half of this year — well below the 10-year annual average of $168.1 billion closed across 676 funds — according to Pitchbook data.   

Fund sizes haven’t evaporated so much as the number of funds raised has fallen off a cliff, as investors pile into large vehicles to chase returns on quality, high-profile assets. That may present unique opportunities for smaller fund managers or for eager sponsors wanting to break into the fund game, especially now that the elevated interest rate cycle has ended and the Federal Reserve has begun to implement an easing policy, making the horizon for the debt space slightly clearer and more attractive.

There are a variety of reasons as to why engaging in a fund structure would be beneficial to smaller or newer managers. A fund with a relatively strong base would provide ready access to capital for nimble investment strategies and perhaps better debt terms for property- or project-level acquisition or development financing. There’s also the potential for fund-level financing — although it carries some additional risk — which could be more cost effective and would allow a sponsor to seamlessly pull from an established credit facility to finance acquisitions or replace short-term loans rather than needing to perpetually secure debt at the asset level. 

A fund structure would also provide a sponsor with the capital resources to pursue more complex or sophisticated investments or projects. And, of course, it gives way to the possibility of greater diversification, among other positive aspects. 

Sponsors, assuming they can already exhibit some level of success in commercial property investment from a portfolio perspective, would gain from bypassing the large, commingled model by first engaging in a less arduous or complex fund structure that would allow them to establish a track record. This could be the formation of asset-specific joint ventures, programmatic joint ventures, fund-of-one or club deals with institutional investors, or focusing on pooling funds from more passive high-net-worth individuals or smaller family office investors. Placement agents — financial intermediaries who help sponsors raise capital — are often more reluctant to work with first-time sponsors, so a new sponsor often needs to focus on investors where they have established relationships.  

It’s important for managers to set a realistic benchmark target for how much capital will be raised, and how, and to prepare accordingly to carry the water from the myriad fees and costs that come with building out the fund. These can include legal, accounting, administrative and marketing costs. The size of the fund must align with anticipated deal flow so that the sponsor can manage expectations, sustain returns to limited partners on schedule, and not risk needing additional funds or commitments.

The bedrock of all of this is the sponsor’s investment strategy. Larger fund managers and private equity firms might have the pedigree and track records to essentially blind-fundraise into a vehicle with a broad investment thesis, but smaller or newer sponsors generally should focus on leveraging their expertise in a specific asset class, niche or geographical region where they can bring their expertise to bear. Fund managers who are prepared to clearly map out to limited partners the strategy and returns they expect to garner from their investments — and when — will be better equipped. 

The tactics and trends around private real estate fund formation have shifted considerably the last couple of years as investors have looked for quality, advantageous entry points into the market, and greater certainty and transparency from the sponsors they’re putting their money behind.

Growth in secondary markets and prices seemingly bottoming out in some CRE subsectors has changed the complexion of the competitive landscape for discount opportunities. This, coupled with the decline in the amount of dry powder ready for deployment, driven by a fundraising lull, means there may be more room for emerging fund managers with established track records and focused strategies who have identified pipeline opportunities.

John D. Wilson is a partner in the investment funds group at global law firm King & Spalding.