Hedge funds and private-equity firms dominate commercial real estate and play a significant role with residential space as well. However, when these funds appear in headlines involving a real estate correction, thetends to focus on larger, troubled funds. The recent problems with Bear Stearns' high-performance mortgage-backed hedge funds is a case in point.
Consider, however, that there are far more smaller players in hedge funds and private real estate investment, and they have historically outperformed larger ones. Also, the number of funds with holdings of less than $100 million outstrips those with holdings of more than $1 billion by a margin of more than 2 to 1, according to BarclayHedge and Lipper HedgeWorld, research groups that track hedge-fund activity.
This suggests that even in a market meltdown, funds with larger exposure to real estate appear to fare worse than their smaller counterparts. The reason for the disparity is that smaller funds are generally more closely held with more individual investors than larger funds.
In a recent survey of hedge fund managers conducted by Rothstein Kass, a CPA and human resources consulting firm in New York, both the impact of the credit crunch and the outlook for real estate hedge funds vary almost entirely based on their size. The survey found that the recent credit volatility had a greater negative impact on large funds with assets of $750 million or more than on their smaller counterparts with assets between $100 million and $750 million.
One major characteristic of hedge funds is their strategy of holding counter-risk instruments (such as credit default swaps, or bets that some borrowers will default within a certain period of time), to offset their investment activities. So it's entirely possible for hedge funds to profit in a shaky market. More telling is that 55.8% of smaller funds reported that credit issues and/or market volatility had positive effects on their funds, while only 32.2% of larger firms reported positive effects.
So, what makes smaller funds and investment firms fare better in volatile markets? And more to the point, can this disparity be expected when the current commercial real estate cycle moves to a correction phase?
For one thing, market volatility tends to impact larger funds more profoundly because they depend on highly disciplined institutional money to run their gigantic portfolios. And institutional players have sophisticated global cash management systems that can move large blocks of capital out of an asset almost at an instant.
On the other hand — and much to the relief of some commercial real estate investors and lenders — smaller investment funds have less room to accommodate large untimely capital withdrawals without facing certain collapse.
So these investors are more likely to hold their positions, rather than face the possibility of big losses due to everyday market volatility. This may explain why just over 20% of the large hedge funds surveyed by Rothstein Kass reported a negative impact on their business so far, versus just 8.7% among smaller funds.
Finally, smaller funds are usually privately held and are rarely the subject of investment analysts' reports and, as their larger publicly listed counterparts are. Therefore, smaller funds can better weather market volatility in terms of retaining investors.
Publicly listed real estate investment trusts (REITs) — one of the closest cousins to real estate hedge funds — are now having difficulty matching the returns their holders have grown accustomed to over the past few years. When these REITs begin to turn in lower returns over the next three quarters, they will do so because of rising debt costs and weaker property values. This will be a sign to investors that commercial real estate has officially entered a correction.
For now, the market appears to be successfully averting disruptions, as analysts point to weakness only in certain regional markets, and good performance in rated securitized loans. However, investors would do well to look at hedge funds and REITs to best gauge when and how the next commercial correction will unfold.
W. Joseph Caton is managing director of Oxford, Conn.-based Hartford One Group, a real estate finance consultant.