Get Niche or Get Out

I read a white paper this week from McKinsey entitled Real Estate Builds on New Terrain. It argues that real estate isn’t going back to what it once was, but something different. The following quote struck me as hugely important.

“For midmarket GPs, the strategic choice is increasingly stark: either scale up through mergers, acquisitions, and partnerships, or specialize deeply (such as by sector specialization, geographic advantage, or proprietary sourcing relationships). Managers caught in the middle—without the balance sheet of scaled players or the differentiation of specialists—can expect harder going.”

Wow. The generalist without a sufficient balance sheet is dead. Why? Because they won’t be able to raise capital. And in an environment where operations are more important than ever to generate returns, those with scale (and who self-manage) will be the ones to garner investor trust. Let’s look at the specializations McKinsey mentions:

Sector Specialization

The macro investment thesis doesn’t work today, at least not in multifamily. Perhaps it works in a sector like Industrial Outdoor Storage (IOS) where the vacancy rate is 2.5% and, according to CRE Daily, “is no longer an overlooked corner of industrial—it’s a supply-constrained, infrastructure-light asset class with outsized pricing power, making it increasingly attractive for investors hunting durable yield in a tight logistics landscape.”

A sector is niche when you have to explain what it is and why people are interested in it. You don’t have to explain apartments to investors, but industrial properties with excess land to store equipment are hot right now. Those who were early to this, or can repurpose their properties to reclassify in this sector, are likely doing well. You have to be more than a multifamily generalist unless you have scale, which I’ll come back to.

Geographic Advantage
This is why Calvera Partners has returned to the San Francisco Bay Area as its primary focus. We’ve invested there for the past 16 years, many of our investors are located there, and we understand the market and see it change in real time. It’s also a place not many investors can make sense of. Local and state rental ordinances, tough permitting processes, older property vintages, seismic retrofitting, and changing political headwinds make it hard for new investors to come into the market. The numbers suggest they should be there, but the list of headaches is too long for outsiders to get comfortable.

The same can be said for people who specialize in markets like Seattle, Portland, or New York City. Those markets each have their own political challenges, but some will navigate them well, and make good investment returns as a result. A geographic advantage doesn’t have to be a market that scares people away; it could be a well-known market like Raleigh-Durham. If you’re established there, have local resources, local knowledge, and a history of generating good returns, that’s an advantage, too.

Proprietary Sourcing Relationships

Everybody says they have this, but few actually do. At best, GPs have a broker or two in their local market who brings them deals before everyone else sees them. In order to stay top of mind, the GPs will have to actually acquire deals. If not, the broker will move on to the next group who says they’re hot to transact. Another source of deal flow today is lenders. More deals are being foreclosed on, and relationships with banks and bridge lenders could yield interesting transactions. We’re focused both on lender relationships for distressed deals and our long-standing broker relationships for not only sourcing off-market deals, but winning marketed deals as well.

Scale

This is so difficult to accomplish in real estate without significant time or capital. It’s also the siren song of investment managers across disciplines. What money manager wouldn’t rather manage $100 million or $1 billion of assets instead of $10 million? There’s a reason emerging manager funds exist. Because smaller firms often produce higher investment returns than their large manager counterparts. Smaller firms are not yet interested in building a fee-generating machine, nor will the market allocate enough capital for that.

A larger pool of capital is nice, but I think operating control is much better. Scale can provide investment stability. It may not generate outsized returns, but it can minimize the downside. I see larger multifamily firms that effectively self-manage their properties and have better occupancy, lower expenses, and stronger cash flow distributions. They’ve created a system and culture that only their scale and history allow. They can have geographic diversity because their specialty is scale.

For multifamily firms starting out today, I’d focus on a particular geography and grow there until sufficient scale is created to self-manage. Once that company is vertically integrated with a coherent system, I’d explore similar markets to branch out to. Or, maybe just check out industrial outdoor storage and hop on that train while the multifamily train largely remains in the rail yard, waiting to get back on track again.