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Institutionalizing Entrepreneurship

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I’m currently reading Keepers of The Castle. It’s basically just about about leadership in real estate.

And while it commits the cardinal sin of combining commercial and residential real estate (if you don’t know what a cap rate is, then we aren’t in the same business), it does hit on an interesting point that merits discussion.

In the introduction, William Ferguson (the author), argues that while the vast majority of real estate used to be owned and managed by high net worth individuals, the current trend shows more institutional buyers and owners are crowding out the “mom-and-pop” shops of the world. he refers to the phenomenon as the “Institutionalization of Entrepreneurship.” He claims that the entrepreneurial spirit of the small company has been gobbled up and adapted by the big, institutional players in the market.

While I generally agree with that concept, allow me to offer a grain of salt.

Many of the largest and sexiest properties are trading hands among the institutional capital. REITs are selling to pension funds. Hedge funds are selling to private equity funds. Sovereign funds are buying anything shiny and new. All of these players are vying and jockeying for the best and brightest commercial property in each market. They are leading the race down Cap Rate Mountain.

One tier down from those properties, you have the solid B-class, semi-aged properties that tend to draw local institutional capital and private funds. These can be B-class buildings that are well-leased or older A-class buildings that are a little long in the tooth for some of the institutions. These properties are bought, sold, and managed by the local players in any given market. For Atlanta, think Selig and Goddard. These are still nice properties with highly-sophisticated owners that can easily obtain financing.

The lowest tier is where mom and pop live. This is the local liquor store that was built in 1978 or the apartment complex from the 50s that has been owned by the same family since it was built. These are difficult to finance and tend to have leasing or structural issues.

I haven’t finished Keepers of the Castle yet, but I think Ferguson may be referencing the ever-increasing interest of the institutions below thee top-tier of properties and what that may mean for smaller owners. As many of the institutional players have become comfortable with the risks of lower-quality properties and financing for the properties has become more readily available, we are seeing these funds buying B class properties all over town. Hence the perceived “crowding-out” of the smaller, local shops.

To a degree, the argument seems intuitive and almost obvious, but here comes the salt.

Properties age. Tenants leave. Submarkets deteriorate. It has happened and always will happen. There will always be C properties.

And the market isn’t bifurcated into home-runs and strike-outs. There is a plethora of doubles, singles, walks, HBPs, sac flys, and bunts in between. Some owners will always be satisfied with these higher risk properties and their inherent risks. And I don’t envision Calpers wanting to own a liquor store on Briarcliff. There will always be space for Mom and Pop.

So, while I do agree that THAT space is shrinking to a certain degree, there must be a tipping point. There is metaphorical line in the sand that the institutions dare not cross. There is a certain combination of market risk, leasing risk, and property condition that every REIT and fund in the country would cringe about having to justify in its quarterly statement to shareholders. The $1 Billion question is: Where is that line?

How far down the hole will the institutions go?

It remains to be seen, but for now I sense that the line has drawn back up the property food chain. The lack of funding and profound damage caused by the lower-tier properties has given the institutions the bloody nose of their life. They have been knocked down by these losses and are just beginning to get back up. My guess is that they will adhere to the one-bitten-twice-shy rule and try and avoid the lower-tier properties for longer than you might guess.

So, while I agree that there has been a trend toward consolidation of companies and the down-tiering of investment grade capital, I would argue that there will always be a place and need for small-time, local owners.

You may see more nimble, flexible, and aggressive whales, but there will always be minnows. And the ocean is all the better because of it.

– Duke

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