MIDDLE MARKET REAL ESTATE:
AN INEFFICIENT MARKET PRIME FOR HIGH YIELDS
“Better pricing and better structure in the middle market”
Middle Market Real Estate is an inefficient market with mispriced assets and less risk that results in a fertile opportunity set for investors who are looking for investments with above average yields and low risk. The average transaction size of this market segment relative to the amount of capital seeking to be deployed, together with timing pressure and structural constraints, make it impractical for large institutions to execute middle market strategies. By targeting only small to mid-size equity investments, there are opportunities to capitalize on these inefficiencies and identify mispriced assets with significant growth potential.
WHAT IS MIDDLE MARKET REAL ESTATE?
The differences between institutional and middle market commercial real estate is the market value. A middle market real estate property has a market value below $50 million dollars and usually includes office, retail, industrial and multi-family properties. Properties with market value over $50 million are classified as institutional.
SIZE OF THE MIDDLE MARKET REAL ESTATE:
Transaction volume in the middle market far exceeds that of the institutional market. This is where middle market commercial investors obtain returns. Surprisingly, mega players such as Carlyle, KKR, Colony, and Apollo represent only 5.2% of the commercial real estate market volume, creating a highly competitive environment for these assets.
WHY SHOULD AN INVESTOR INVEST IN MIDDLE MARKET REAL ESTATE?
Under-the-radar market inefficiency creates an attractive opportunity to invest in the middle market:
Asset prices are set solely by the meeting of the minds of the seller and the buyer, who make decisions based solely by their respective circumstances, and having very little if anything to do with the market at large. Therefore, value in the middle market is a moving target.
Investors can increase the value of real estate through management contributing to operational alpha.
Little correlation with macroeconomic market cycles: Due to the occurrence of the owners’ life events (e.g. health, retirement, death, divorce), transactions of real estate assets in the middle market take place at all points in their life cycle with increasing frequency.
High yields: Due to the pricing and structural premiums of the middle market:
Pricing premium: Due to inefficiency of the middle market, some assets are undervalued.
Structural premium: Because middle market real estate operators have fewer financing options they are more inclined to agree to terms that are beneficial to investors (e.g cash flow sweeps that minimize credit risk, minimum multiples, etc.).
RISKS INVOLVED IN INVESTING IN THE MIDDLE MARKET:
Illiquidity Risk: Unlike institutional real estate, middle-market real estate can be harder to liquidate because it is a smaller market. Institutional real estate has a deep market and has a high transaction in the secondary market. Mitigant: Managers mitigate this risk by operating mid cap commercial real estate in large, liquid markets.
Interest Rate Risk: In the past 10 years, we have seen an anomaly where interest rates have been at their all-time low. Now interest rates are expected to increase and will increase exit cap rates, while the flow of funds will remain constant which will reduce the value of the real estate investment. Mitigant: Managers that underwrite to increasing cap interest rates and cap rates are better positioned to withstand this risk.
Execution and Operational Risk: Mitigant: Managers that have experience through multiple real estate cycles understand how to best prepare for the market ups and downs.
THE REAL ESTATE CAPITAL STACK:
The composition of debt and equity in middle market is as follows:
Senior Debt: Senior debt holders have the highest priority of repayment, lowest yield, and first claim of the property in the case of default. Senior debt holders have the least risk.
Mezzanine Debt: A junior tranche of debt has common equity as collateral. Mezzanine debt has higher yields than senior debt.
Preferred Equity: Preferred equity can be classified as either hard preferred equity or soft preferred equity. The former having fixed payments akin to mezzanine debt and the latter having more upside benefits akin to common equity.
Common Equity: Equity holders are least senior but can gain from the upside. Common equity holders in the capital stack also get a claim from the sale of the property.
Special thanks to contributor:
Managing Principal at JCR Capital
Phone: +1 303.531.0202
JCR Capital is an alternative investment manager that provides capital solutions to middle market commercial real estate sponsors. JCR provides joint venture equity, preferred equity, structured debt and bridge loans for value-add, opportunistic and distressed transactions and special situations.
JCR was founded in 2006 and is managed by Jay Rollins and Maren Steinberg. Mr. Rollins and Ms. Steinberg have worked together since 1992, managing capital throughout several real estate cycles and investing approximately $2.4 billion in nearly 400 transactions.