Matt breaks down some of the challenges, opportunities, risks, and rewards that affect SBRE entrepreneurs and investors.
The definition of a Small Balance Real Estate (SBRE) entrepreneur is anyone running a real estate asset based business model that requires raising capital on an ongoing basis in order to fund his or her deals. The SBRE entrepreneur has two fundamental constraints. The first of these is procuring sufficient deal opportunities that meet his or her criteria. The second of these is accessing the capital necessary to fund these deals reliably. The former precedes the latter, but they are always wholly interrelated. As any seasoned SBRE entrepreneur knows viscerally, there is always some degree of imbalance in the equation – either too much money and not enough deals or, seemingly more often, too many deals and not enough money to fund them all. It never seems to reach perfect equilibrium and managing this dynamic is among the most challenging aspects of running an SBRE enterprise.
It is well known to SBRE entrepreneurs that the High Net Worth (“HNW”) investor is the primary target audience to capitalize their deals. For the sake of this analysis, I would put HNW investors into roughly three basic categories – those with a $1M – $5M net worth (the “Accredited” group), those in the $5M or $10M up to about $40 – 50M or so in net worth (the “Qualified Purchasers” or “QP” group) and those with a net worth of $50M or more (the “ultra-high net worth” or “UHNW” group). Beyond this level it can generally be said that we are moving into the “family office” realm, a segment of the HNW investor market being targeted with increasing frequency by SBRE entrepreneurs (mostly with limited success so far, in my experience).
From the HNW investor point of view, there are a variety of consequences, both positive and negative, to these two fundamental constraints of the SBRE entrepreneur, and much depends on the specific approach of the investor. These investments represent a significant opportunity to generate excellent returns. These returns should, of course, be considered in a “risk-adjusted” context which, in the world of SBRE and alternative investments in general, can be very difficult for investors to determine with accuracy. Those HNW who understand real estate fundamentals, capital structures, and other key aspects of these investments will generally be able to significantly outperform those who do not unless the latter are able to pick the right managers. And many SBRE entrepreneurs look very much the same even though they may be very different.
There are three basic areas that HNW investors want to consider when evaluating SBRE investments – the sponsor (or manager, originator, etc.), the deal(s) themselves, and the ongoing ability of the HNW investor to monitor their investment. All of these are important and one or the other of them may be more or less important than the others depending on the factors involved in the specific situation. For example, if the HNW is investing in a specific asset, is well capable of underwriting it for him or herself, and is the only investor in that deal, then underwriting the sponsor becomes somewhat less important. If, on the other hand, the HNW is investing in a pooled investment fund over which he or she has no control of the assets being chosen nor how they are managed, knowing a great deal about the manager and having strong ability to monitor the investment is much more important. If the HNW is taking a small piece of a large deal, it is very helpful to making good decisions to understand a great deal about both the asset and the Sponsor. Knowing as much as you can is, of course, always a good idea in any situation. But there are practical and functional limitations on what data can be ascertained and investors thus have to make decisions with less than perfect information.
As both a fund manager raising capital from HNW investors and an active investor in the SBRE arena (loans, equity, and other funds), I have a deep appreciation for the nature of both sides of this equation. My experience is that HNW investors have significantly varying degrees of understanding and capability in assessing managers and deals. The three groups write checks of different sizes, have different approaches to their investing with SBRE entrepreneurs, and different levels of investing sophistication and understanding (often owing more to their particular business or professional background than level of net worth). Regardless of category, some enjoy being involved, have the time and inclination to do it, and want to pick and choose the individual deals into which they place their money. Some do not enjoy spending time reviewing and underwriting deals and prefer to leave the decision making up to the sponsors/managers. Each of them has different likes and dislikes that drive the way in which they will engage with the entrepreneur. It is important for the SBRE entrepreneur to understand these differences as well as his or her own proclivities for working with the various types.
One of the great things about SBRE is the sheer variety of options available to the HNW investor. In the world of 506 Regulation D SBRE offerings, there is an almost unbelievable array of product types, asset and sub-asset classes, size ranges, capital structures, geographic locations, and other differentiating characteristics of investments. There are individual deals specific to one investor, individual deals syndicated to multiple investors, and pooled funds with multiple assets and multiple investors. Within these there are open-ended and closed-ended funds, Series LLCs, Reg Ds, Reg A+’s, REITs and more.
Learning how to sort through them is the challenge for many HNW investors, including the Accredited, QP and UHNW variety (and even many family offices). Some are already excellent at this – typically those who are or were themselves heavily involved in real estate in their professional lives and now spend most of their time at it as an investor. Others are new to the SBRE world and have less ability and capacity to pick and choose individual deals. Either way, there are many quality, competent, and capable SBRE entrepreneurs seeking capital for their deals as part of their daily reality of running that SBRE enterprise. There are also much less competent, less careful, and/or less honorable players who can look a lot like the former who are also looking for the same HNW investors. Smart investors are wise to learn how to discern the difference.