A $5.1T Corner Of CRE Is Struggling To Find Capital

Midsized real estate firms control huge swaths of commercial real estate. There’s just one problem — they are underfunded.

A new report from KKR & Co. states that middle-market CRE sponsors — those with at least 25 properties and less than $1.5B in dry powder — control $5.1T of U.S. real estate but have specialized capital needs that aren’t available in off-the-shelf formats.

“The point isn’t that these groups can’t afford something,” said Ira Shaw, one of the report’s co-authors and a partner at Arctos Partners, which is part of KKR’s new global investing business. “It’s more that those types of capital providers are not available.”

Middle-market players are caught up in conflicting market forces. Historically low sponsor formation and institutional lenders’ desire to diversify could push more money their way, but a renewed focus on income through operations rather than cap rate compression is making smaller firms with less economy of scale less appealing.

Using Preqin and CoStar data, KKR found that around 5,800 middle-market sponsors control more than 24B SF worth around $5.1T. 

That represents around 85% of the institutionally sponsored market and almost a quarter of the broader CRE sector.

In comparison, 27 large-cap sponsors control around $600B of gross property value. The company identified the large-cap investors as publicly traded multistrategy groups with more than $1.5B in dry powder and then filtered by assets under management through Preqin.

While financing is plentiful in private equity, that’s not the case when looking to capitalize general partners for real estate. 

“Large institutions have a hard time deploying efficiently below about $25M, so assets below end up raising from the retail channel or from subinstitutional buyers like family offices and regional insurers,” said Ibis Capital Managing Partner Kevin Van Hoesen, an investment adviser and asset manager. 

Middle-market investors and developers rely on joint ventures, programmatic partnerships, personal capital and transaction-specific relationships with capital allocators rather than closed-end fund structures.

Midsized firms may benefit from a shrinking investment world. KKR’s data shows sponsor formation surged after the Global Financial Crisis. About 2,500 CRE sponsors were formed between 2010 and 2019, nearly 60% higher than the amount founded during the previous decade.

That is partially due to the low-rate environment that preceded it and the lower barrier to entry for real estate versus private equity, Shaw said.

But since 2020, only about 800 sponsors were created. That’s the lowest level this century.

That drop has led institutional capital to focus on less experienced real estate managers.

And giants like KKR, Blackstone, Brookfield and BlackRock are expanding into new markets to try to grow their assets under management. KKR said deploying capital to middle-market CRE firms will help accomplish that goal.  

“There’s a way for institutional capital to serve these sponsors, and that opportunity, and need for it, is magnified by the current environment,” Shaw said.

But even as sponsors scale, capital remains scarce beyond one-off joint venture deals.

Platte Canyon Capital, a middle-market firm that specializes in value-add multifamily investing, has faced challenges accessing capital. The firm pursues distressed assets that are trickier to capitalize.

“The goal post for capital is constantly moving,” Platte Canyon CEO Brennen Degner told Bisnow. “We have a very specific thesis and a bit of a contrarian play that we’re pursuing, and I think that’s made it even more challenging.”

Platte Canyon seeks basis resets of greater than 50% off-peak, and the underwriting still doesn’t always pencil. 

Even for the groups willing to engage, Degner said seller expectations remain well above where equity will deploy.

It’s also proven challenging for many sponsors to find institutional investment for their companies. 

“That is even more difficult to source than capitalizing individual deals,” said Shlomi Ronen, managing principal of real estate merchant bank Dekel Capital Inc.

One middle-market sponsor that attracted an institutional investor is LCN Capital Partners. 

The 15-year-old investment manager was acquired by Goldman Sachs earlier this month in a deal worth up to $410M. But company officials said the only thing that will change for the firm is the scale of its ambition. 

By combining with Goldman, “we can better serve our investing and tenant partners at a scale no independent firm could match,” LCN co-founder Edward LaPuma said in a statement. 

Platte Canyon has also had success with institutional investors, with Degner calling it more scalable and efficient than raising deal by deal. But the firm is mostly seeking acquisition-limited-partner equity, which has proven hard to find. 

Where sponsors once secured multiple equity term sheets after tying up a deal, they now need a strong capital partner upfront.

“You need to know who the partner is going to be before or during the bid process,” Degner said. “Deals are tough to get done when you expect to find the equity afterwards.”

The market may become even tougher for middle-market investors looking for big money. Many of the sponsors formed between 2015 and 2021 were underwriting cap rate compression and cheap debt, not operations. 

“That stopped being attractive when rates significantly moved,” Van Hoesen said. “Operating skill has to be underwritten now, and that shrinks the number of deals that pencil.”

Capital competition has intensified, and artificial intelligence deals have drawn investment away from the middle markets.

That’s a structural change, but there’s also a cyclical element that’s affecting the middle markets. 

The cost of things like fund administration, audits, compliance and reporting has pushed the minimum viable project size up considerably. 

“The shops that used to trade in lower middle-market deals have to chase bigger ones, which means bigger checks, which makes the raise harder,” Van Hoesen said. “That’s the spiral.”