Over the last 20 years investment companies have come to dominate the real estate investment and development landscape. But this was not always the case. Prior to the mid-1980s, most funding for real estate came from local people — usually through syndication networks and major real estate families. Insurance companies and side-arms of local banks also invested but almost always directly into the specific property.
Beginning in the early 1990s things changed as the financial industry created and popularized an array of new products designed to increase diversification, specialization, and financial engineering. Products such as publicly-traded real estate investment trusts (REITs), private equity, open-ended investment funds, and various asset-backed securities divorced investors from direct ownership in local real estate. While this institutionalization of real estate investment had many benefits, there have also been some unintended consequences that are just now becoming apparent.
The Rise of Investment Companies
The dramatic rise of real estate as a financial product came directly out of the Savings & Loans Crisis. In the late 1980s, hundreds of local banks called Savings & Loans shuttered, resulting in what was at the time the largest real estate collapse in U.S. history, totaling more than $394 billion in assets.
Unlike the recent 2008 financial crisis, in the S&L Crisis the federal government took over 747 of these failed banks and ended up with thousands of loans and properties under their control. The solution at the time was to create a government-run entity known as the Resolution Trust Corporation (RTC) to asset manage and eventually sell off all the loans and properties back to the private sector.
It took the federal government years to get the RTC in action after the 1987 stock market collapse, by which time it had accumulated thousands of real estate assets on its balance sheet. The challenge then became how to unload the enormous number of buildings that were now owned by the federal government. The government could not simply sell each property or loan one by one. Instead, they had to start selling them in bulk, i.e., pools.
The Government Pools Properties
Because these pools held so many properties, usually all over the country and including all types of buildings (retail, office, industrial, etc.), the sheer magnitude meant that anyone wishing to purchase these portfolios from the government would need to raise large-scale investment funds. So while the logical buyer of a property is a real estate professional, the natural purchaser of a pool is a financial company. One single building is a place. One hundred buildings pooled together is a financial asset. These financial companies, such as the Bass Brothers, JER Partners, and Goldman Sachs’ Whitehall, gathered pools of investors together in order to raise enough money to take advantage of a tremendous opportunity.
In effect, the RTC created by the federal government helped spawn the new industry of asset pooling, in particular “blind pools” of real estate private equity. Not only were private equity funds best suited to purchase these pools of government assets, but they ended up making enormous profits. In retrospect, it turns out the government was selling off these real estate assets at fire sale prices. Often there would be only a few buyers for assets that were returning un-levered yields over 15% on heavily depressed income streams.
Financialization of Real Estate
Once the early private equity funds had successfully proven the model, there was a metaphoric stampede. Real estate private equity grew from a few billion dollars in the early 1990s to a half trillion dollars under management today.
In a separate but related consequence of the real estate recession of the late 80s, most major real estate companies took their assets public on the New York Stock Exchange as Real Estate Investment Trusts (REITs). REITs grew from a few billion dollars in the public markets in 1990 to $500 billion publicly listed by 2013.
The combined trillion dollars controlled by private equity and REITs does not even include Commercial Mortgage Backed Securities (CMBSs) and other asset backed securities pools (e.g., CDOs) that also total in the hundreds of billions. So ten years later, by the early 2000s, the real estate industry had been transformed. The financial professional had become the primary manager and driver of real estate decision-making.
What Financialization Means for Neighborhoods
The financialization of real estate investment has dramatically increased the amount of capital available to developers while at the same time institutionalizing the industry. As a result, the real estate sector is much more professional (with far more MBA graduates than before) and has become standardized as a result. The major real estate investors — from Starwood to Blackstone, Simon Property to Avalon Bay — are multi-billion dollar players and work throughout the nation, owning properties in dozens of major cities.
For all the benefits of institutional real estate investment, one of the unintended consequences was to make the product more corporate. A large-scale, national investment company looks at and analyzes real estate in a very different way than a local individual investor and this corporate mindset ultimately limits what that company builds.
1. Short-Term Outlook:
A private equity fund or public REIT usually has a near-term investment horizon of only a few years. The public markets will price a REIT daily, making it very difficult to look beyond the next quarter. Private equity funds typically last for ten years or more before dissolution, and successful private equity ﬁrms stay in business by raising a new fund every three to ﬁve years. The result is REITs and investment funds look at a 3-5 year period to invest and return profits.
The problem is real estate is a long-term asset. Any successful real estate mogul over the age of 60 will tell you to look more than 10 years into the future to see the true value of real estate play out.
2. Career Risk
Investment companies are in the business of managing other people’s money. In order to deploy hundreds of millions of dollars, the investment company is naturally gathering capital from third-party sources, rather than just investing its own. However, once an investment manager has pooled hundreds of millions — or billions — of dollars, their primary risk is generating a loss that will get him or her fired. So, too often, the investment manager opts to make “the safe bet,” which includes a preference for national corporate chains and a herding into popular asset classes or geographies.
3. National Not Local
Because the investment companies operate at such scale, by necessity they are not based in the neighborhoods in which they invest. The distance from the projects puts the investment manager out of touch with what neighborhoods feel like, and what they need and want. So much of great real estate is about understanding location, which a native will intuitively know better than a visitor.
4. Real Estate by the Numbers
Because financial institutions are focused solely on the bottom line, they have created a mandate in real estate to distill a project down to a financial formula (the “pro-forma”). Every real estate analyst can attest to untold hours spent making Microsoft Excel projections to submit to private equity partners, credit committees, or The Street (i.e. public markets). While analysis is absolutely a necessary part of real estate investment, it too often displaces the tangible and visceral sense of real estate. The investment analyst treats real estate as a financial product, like a bond, rather than as a real place, like a neighborhood.
5. Hot Money
The early private equity funds made a fortune in real estate, creating expectations that those high returns were the norm. Unfortunately, the huge profits were an outgrowth of an unusual period in the 1990s — in other words, they were the exception. Nevertheless, investment funds raise their capital under the premise of achieving, on average, a 25% Internal Rate of Return (IRR), which is a financial metric similar to annual compound return (i.e., approx. a 25% interest rate). Essentially, private equity funds look to double their money in 4-5 years. These aggressive investment expectations push real estate developers to take on more and more debt, increasing their risk, all for the short-term profit (because it is damn near impossible to maintain an annual 25% IRR over the long term in real estate).
So We Created Fundrise
The flaws of corporate real estate investment are a large part of why we created Fundrise. Rather than a model built on middlemen pooling money, Fundrise allows the developer to raise capital at scale directly from individuals. Our aim is to create a new capital source to fund real estate projects that may not fit in the institutional box. Fundrise allows developers to focus on the long-term success of the project and neighborhood, and build a new kind of real estate product focused on the real end user — you.