Thinking Like an Institutional Investor: Five Things You Need to Know

Today’s Thesis Driven is a guest letter from Jonathan Andrews. Jonathan Andrews is Principal of JJA Real Estate Consulting, an independent real estate consulting and capital advisory practice based out of New York. He has previously held positions at Nuveen Real Estate, Twining Properties, and Arch Companies.

The real estate industry often draws a line in the sand between institutional versus non-institutional investing practices. In many cases, real estate investors and operators will refer to a certain type of asset being "sub-institutional" in scale or appeal, or an emerging asset class succeeding by winning the interest of institutional investors over time.

But concretely, what does it mean when we talk about "institutional investors?" How do their strategies and methods differ from their non-institutional peers? And what are the advantages and disadvantages of following the investment strategies utilized by these players?

In this letter, we will present a condensed understanding of what makes an institutional investor, how they invest, and what lessons can be learned from them.

What is an Institutional Investor?

Institutional investors are large, professionalized investment organizations that specialize in the acquisition, development and management of real estate. These include real estate investment trusts, pension funds, or large scale real estate private equity firms (e.g. Blackstone).

These institutions are distinct from non-institutional players–independent operators, high net worth individuals, and small family offices–which generally have less capital and resources available. In addition, these smaller companies often lack the kind of expertise that one sees in larger organizations, who use sophisticated models, comprehensive data platforms, and perform deep analysis when making investment decisions.

Yet while the non-institutional investor might not have access to the scale of capital available to larger players, the methodologies institutional investors use to acquire and manage assets can be learned and applied by operators of any scale. To better understand this, we’ll explore some unique aspects of institutional investors and how those traits influence their behavior:

1. Scale Matters

Perhaps the most obvious difference between an institutional versus non-institutional player is the amount of real estate each owns and the funds that they have available to invest. An institutional investor generally receives its capital from large institutions such as small-scale pension funds, LifeCos, and sovereign wealth funds that lack the in-house expertise to manage their capital on their own. As a result, these organizations typically deploy capital through investment partners in order to generate returns on their holdings.

The source and volume of these funds shape the strategies and methods that institutional investors pursue. Investments from LPs typically come with narrowly defined return hurdles, investment horizons, and profit shares for the sponsors managing these funds. Because of the sheer volume of capital – and the limited windows in which to deploy it – institutional investors seek the fastest, most efficient paths to deploy capital while simultaneously achieving their target return threshold. This incentivizes investors to think heavily about A) ease of deployment, B) speed of deployment, and C) repeatability/consistency of deployment, when considering what strategies to pursue.

Managing large sums of capital has other implications as well – for example, larger average transaction sizes are often viewed as more effective in putting dollars out quickly, so limits are placed on the minimum deal size an institutional investor would be willing to consider. The scale of capital also affects the appetite of institutional investors to pursue riskier or more complicated ventures.

For instance, a small office might be willing to take on a challenging workout of a distressed property or perhaps a nuanced land assemblage over the course of several years. Institutional investors, on the other hand, will seek the path of least resistance in finding places to deploy money. They will often avoid wasting time on deals that might be "interesting" but would take too much time or risk to execute. While this quashes some of the creativity and ingenuity we often see amongst smaller operators – who often take broken deals and figure out how to make them work – "Interesting" deals don’t align with the priority of making investment decisions based on ease, speed, and consistency.

2. Thesis and Buy Box

Institutional investors’ scale shapes how they define what and where to buy. A predefined thesis and list of criteria for what kinds of deals to pursue simplifies the individual investment decisions and enables a more efficient deployment of capital. Institutional groups are known to publish white papers, thought pieces, and other materials which assess their future vision for real estate and the economy at large. Factoring in such concepts as population growth, market trends, or shifts in the overall economy, investors will make programmatic acquisitions based on these forecasts of specific verticals and markets. Even in my current consulting work acquiring deals for smaller scale investors, investments must always be validated by demographic and market research which go beyond a pure financial calculus. An investor must focus on sectors and product types that have strong demographic support–and a clearly defined business plan–rather than placing capital in an asset, sector, or market which is in a state of decline or contraction.

In today’s market, asset types such as SFR, self-storage, medical office, industrial or multifamily are likely safer long-term bets than (say) class B suburban office. With interest rates rising dramatically over the past two years – driving valuations down across the board – core investing strategies have lost a lot of their luster, pushing investors still active in the market towards an increasingly rare number of value-add or opportunistic deals to pursue. This in turn creates an acquisition bottleneck for workable projects, driving up pricing and making these deals even harder to pencil. While it is certainly a challenging time to responsibly acquire, it makes the analysis of each deal even more important.

3. Macro Analysis

Institutional investors always approach the question of finding a good opportunity by working from the top down. We’ve already established the importance of coming up with a defined thesis, which puts guardrails on the types of assets to acquire based upon forecasts of increasing demand and value. From there, opportunities get winnowed down further until decisions are made for specific deals. A funnel for sourcing transactions might look something like this:

1. Define the Asset Class

What sectors will grow and thrive in the coming decade? Is current demand for this specific product expected to grow or shrink? How will this impact property values over time?

2. Define the User

Taking this further, once the investor focuses on a particular sector – such as build-for-rent apartments – they can define their target user. For example, perhaps they select college-educated Millennial families with household incomes of at least $100,000. Or retiring seniors/empty nesters who are downsizing their current homes and looking to rent out a smaller footprint rather than deal with the hassle of home ownership.

3. Choose a Geography

Once the product and target audience for the strategy has been determined, the investor could go about ranking the top fifty municipalities in the US based on some of the following metrics: population size, average age, family size, median income, school scores, cost of homeownership, proximity to nearest metro area, etc. They would then consider the historic and forecast growth rates ascribed to each. These different rankings are then filtered according to what best fits the selected target user base.

4. Understand Supply/Demand Dynamics

Informed by population and demographic information, an investor will make an assessment of local supply and demand dynamics in the market. How much and what kind of development is planned or currently ongoing? Is there a threat of oversupply/falling demand in the next five years? If new product is coming online, is there likely to be parallel population growth to absorb it (and not decrease the value of existing assets)?

Other factors can also inform an investment decision; for example: How difficult is it to bring new product online in a given market? Are there high barriers to entry via restrictive zoning ordinances/governance, or is it a more open and amenable municipality?

5. Evaluate Market Trends

At this stage, an investor will validate underwriting assumptions and begin analyzing the deal. They’ll define average rents, vacancy, assumptions, cap rates, etc. for similar products in that target location.

By running through these high level questions and factors, the investor builds a framework to quickly determine which deals are actually viable and which aren’t. This is distinct from many non-institutional players who skip right to Step 5 in this process. It is potentially dangerous to only focus on markets or asset types that one knows well, and only utilize back of the envelope calculations for understanding basic deal metrics when making decisions. While a deal might make sense locally, it might not represent the smartest deployment of capital across the broader market. The result is incurring inappropriate risk in the deal, rather than taking a macro approach and considering broader opportunities.

4. Micro Factors

Just as an institutional investor brings a high-level framework to evaluate deals, they’ll bring a similarly structured approach to the business plan and execution. An institutional approach seeks out repeatable strategies, balancing maximum and efficient deployment of capital with appropriate risk adjusted returns.

For example, an investor specializing in net lease might already have deep relationships with a variety of national and regional credit tenants;hence, they may be willing to take on re-leasing risk at distressed or vacant properties. This could translate into a reproducible strategy around acquiring and re-tenanting assets, capturing the value pop in the process. Similarly, a group that focuses on suburban office to self-storage conversions might look for certain attributes in an existing asset (i.e. physical dimensions of the space, as-of-right zoning for redevelopment, etc.), which would allow them to use the same template and strategy again and again. The goal is always ease and repeatability of execution at scale.

Returning to the differences between an institutional versus non-institutional approach, a smaller investor is more at liberty to pursue one-off opportunities that offer great returns but aren’t necessarily repeatable situations. While it is important to remain nimble when faced with a good deal, most institutional players will first pursue projects that are "down the fairway," align with their overall business plan, and can be executed in a predictable timeframe. Clearly this comes at the cost of potentially missing out on special situations in investing, but the demands of efficient and regular capital deployment will generally need to come first over any single asset – unless, of course, it is a transaction of such size and profitability that it warrants attention on its own.

5. Capital Flows and Allocations

Finally, it’s important to consider that institutional investors must consider diversification and exposure when constructing their overall portfolio. Portfolio managers will take care to balance out the demands of particular sectors, geographies, and investment risk profiles in their existing asset pool when considering what deal to do next. The goal is to achieve a moderate strategy that avoids overconcentration in any one asset, city, or sector, while simultaneously achieving their targeted returns.

Institutional investors may also be operating under mandates from their own LPs to shift their portfolio allocation, leading to some investment decisions that may seem counterintuitive to non-institutional players. In many, these allocation decisions are made through the fundamental macro analysis we discussed in (3) above. For example, many institutional investors are still operating under post-pandemic mandates to shift their ownership portfolios from office into multifamily, selling down office assets and using the proceeds to purchase core multifamily. In many cases, this has resulted in institutional investors buying multifamily deals at cap rates that wouldn’t make sense to non-institutional investors.

Conversely, a local investor who only knows about multifamily development in a particular market might stick to that wheelhouse regardless of where we stand in the cycle. This can be either profitable or foolhardy depending on the broader macro conditions present at any given time. Yet even for those small players who appreciate the importance of diversification, when one has fewer funds to allocate, it can be challenging to create a balanced portfolio. For example, if an individual only has $10 million in the bank today to deploy, they can’t go out and make geographically diverse investments in retail, manufactured housing, and industrial outdoor storage. They may be forced to pick and choose between specific properties they wish to acquire as they assess the attributes of any particular deal. It is therefore not difficult to understand why non-institutional investors often specialize in a single asset class or geography: they don’t have the capital, time or expertise to spread across numerous investments or cities.

Working with institutional investors–whether as a GP, a partner, or a vendor–requires understanding how they make decisions and think about the world. The challenges of deploying capital at scale require a different, more systematic approach to identifying the themes and categories that scale. This has implications for developers looking for institutional partners as well as emerging real estate asset categories.

Smaller investors can also take lessons from the institutional investor’s approach. Utilizing a rigorous and methodical approach in filtering opportunities, streamlining a business plan, or focusing on publicly available data to make intelligent investment decisions are tools available to the everyday investor. Working out a specific set of investment criteria and strategies is something available to even the smallest of sponsors, and can help make sense of real estate’s large investable universe. That way, when they make a bet, they can be confident it’ll be the right one.

—Jonathan Andrews