by Ryan Swehla

Data analysis debunks industry perceptions that larger, more “institutional” assets offer more safety for institutional capital

In a market that has become increasingly frustrated with the dearth of transaction volume, smaller assets are proving to have an edge over their bigger peers when it comes to liquidity. A recent Green Street report profiled that smaller asset sales proved more liquid than larger asset sales in 2023, as well as in prior downturns. This mirrored Graceada Partners’ disposition and acquisition experience, so we conducted an analysis of CoStar sales data in the Western United States. The data set looked at transaction volume for smaller assets between $1 million and $40 million versus larger assets $40 million-plus during the 18-year period from first quarter 2006 through first quarter 2024. The results demonstrate greater liquidity in smaller asset sales across metrics that include:

• Average annual transaction volume

• Volatility in transaction volume

• Peak to trough percentage decline

Smaller assets generate better deal velocity

People have a misperception that secondary and tertiary markets are less liquid, especially during a down cycle, and owners can get “stuck” in assets that they can’t sell when times are tough. But this misconception has much more to do with asset size than market size. The analysis that Graceada Partners conducted shows that larger asset size, whether in a primary market or a secondary/tertiary market, creates greater risk of illiquidity. Liquidity actually holds up better in smaller size assets across market cycles and geographies.

The analysis focused on total transaction volume in the Western United States from Colorado to California, including primary markets; secondary markets such as Denver, Phoenix, Seattle and Sacramento; and tertiary markets such as Salt Lake City, Reno, Boise and Bakersfield. These secondary and tertiary markets are not “one mill towns.” Many of these metros are very investable with large populations between 500,000 and 3 million-plus and diverse economies located along major interstates.

Graceada Partners’ findings are consistent with a recent Green Street report that highlighted the resiliency of smaller value transactions. The firm credited private capital buyers with helping to drive $82.7 billion in sales on assets worth between $5 million and $25 million during 2023. Although smaller asset sales declined 24 percent compared with the prior year, that segment of the market fared better than asset sales above $25 million, which recorded a 52 percent drop, according to Green Street.

Average annual transaction volume Western United States — 2006 to present

Average annual transaction volume:

Analysis of the data shows that smaller transactions dominate the transaction market. The $1 million to $40 million sales generated an average annual sales volume of $34.9 billion — 50 percent higher than the $23.2 billion of $40 million-plus asset sales. When analyze by number of transactions, the comparison is even more stark: 11,535 transactions annually versus 4,468.

Volatility in transaction volume, Western United States — 2006 to present

Volatility in transaction volume:

The $1 million to $40 million segment showed lower volatility in transaction volume at 0.51, whereas the volatility of $40 million-plus asset sales was nearly 4x higher at 1.97. Volatility measures the deviation or swings in the highs and lows of transaction volume over time. With 1 representing the baseline, anything below 1 suggests low volatility and greater than 1 indicates higher levels of volatility. Essentially, transaction volume for $1 million to $40 million assets stays in a tighter, more consistent band. It also swings less violently during market shifts.

Peak to trough decline in quarterly transaction volume — 2006 to present

Peak to trough decline in quarterly transaction volume:

The peak to trough decline in quarterly transaction volume indicates that sales volume in the $1 million to $40 million segment of the market holds up better than larger $40 million-plus assets across the past three cyclical downturns — the global financial crisis, COVID pandemic and recent rate hike cycle.

Although transaction volume clearly dropped off in both categories during those downturns, the smaller asset size group was less negatively impacted. One example that highlights that difference in liquidity is in the first quarter 2009, when not a single $40 million-plus asset in the Western United States traded. Meanwhile $1.6 billion of $1 million to $40 million assets traded during the same period.

Bigger buyer pool fuels liquidity

A key factor supporting liquidity in smaller assets is the fact that these assets are accessible not only to institutional capital, but to private capital buyers as well. This creates a larger, more diverse buyer pool. We have consistently seen across our firm’s 16-year history that deals below $40 million appeal to a broad range of buyers from private individuals and family offices to institutions.

In addition, private capital buyers tend to move very differently than institutional buyers. For example, during the recent rate hike cycle, many institutions moved to the sidelines for various reasons, one of which was dealing with the denominator effect and trying to manage their real estate exposure within broader investment portfolios. In contrast, family offices and individuals continued to actively buy.

Among those private capital buyers, the motivations for buying and selling are often external to and unrelated to market dynamics. On the sell side, private capital may be motivated by estate planning, death of a patriarch or a need to dispose of properties to increase liquidity. On the buy side, they may have sold a business and want to invest proceeds in real estate assets, or perhaps they need to acquire a property to complete a 1031 exchange.

As a case study in this dynamic, Graceada Partners sold The Edge at Lakewood, a 196-unit apartment property in Modesto, Calif., in December 2023. The marketing process occurred during July and August, which one could argue was the quietest time in the market from a transaction perspective. The asset attracted 104 prospective buyers that accessed the data room, 12 offers, and five best and finals representing a mix of institutional and private buyers.

The property ended up selling to a private 1031 exchange buyer and resulted in a gross IRR of 26 percent and an equity multiple of 1.78x for investors. This was one of three assets the firm sold in 2023, arguably the most illiquid period in more than a decade.

Taking advantage of market inefficiencies

Smaller assets, particularly those located in secondary and tertiary markets, tend to be dominated by private ownership groups. These owners tend to be less sophisticated and less efficient, giving institutional operators the opportunity to buy assets with an immediate pick-up in value. Part of that opportunity comes from buying assets at a good basis with below market rents, which in our experience can be anywhere from 15 to 40 percent below current market.

That does not mean that private investors are not good owners and managers of assets. But oftentimes they simply don’t have the resources, expertise or investment objectives of institutional investors with entire teams focused on revenue management and investment optimization.

For example, Graceada Partners sold another asset in 2023, 915 B Street, a 108,960-square-foot multitenant industrial property in Sacramento. We purchased this property in 2021 from a family that had owned it for more than 40 years. Rents were more than 40 percent below the current market, with all tenant leases expiring in the near term. We were able to bring the rent roll to current market in 16 months and took the asset out to the sale market in January 2023 amid continued interest rate uncertainty and just ahead of the Silicon Valley Bank collapse.

Despite that market turmoil, the listing attracted 49 potential buyers, both institutional and private, who accessed the data room, and we received six offers. The property ended up selling to a private capital syndication group at a 6.0 percent cap rate, generating a gross IRR of 33 percent and equity multiple of 1.70x for investors.

This transaction highlights another important trend. Industrial has been the darling property type for institutions over the past several years, and they have moved further into secondary and tertiary markets to acquire assets. However, in this case, institutional buyers couldn’t compete with private capital, which shows how aggressive private capital can be even during a time of dislocation.

Why big isn’t always better

Institutions have traditionally focused on buying larger assets for a few reasons. There is a perception that there is more safety in owning large “institutional” assets. We would argue that there is actually less safety because fewer buyers are able to write those big checks, and those sophisticated institutional owners are more apt to play defense and pull back from new investment during down cycles.

Additionally, there is efficiency in being able to deploy capital at scale. Institutions often view smaller assets as a very inefficient way to deploy capital because they need to do the same amount of work on diligence and underwriting on a $25 million deal as a $100 million deal. And with a greater institutional LP emphasis on direct ownership and deal-by-deal co-investment, resource allocation dictates a natural movement toward larger asset size. But efficiency can often be at odds with safety, liquidity and alpha generation.

The smaller end of the market tends to be more inefficient, meaning there can be more opportunity to capture bigger returns with lower risk. But it requires institutions to develop larger internal infrastructure or invest through firms who have the expertise, knowledge, relationships and access. In the secondary and tertiary markets where we operate, this is even more critical.

Institutions have a history of being slow to react to opportunities, such as was the case with capital moving into alternative sectors such as self-storage and single-family rentals that are now a common part of institutional portfolios. There is an education process that helps institutions recognize the opportunity set in front of them. This is where the market is at today in regard to smaller assets and markets. Institutions are becoming more aware of the advantages smaller assets offer in terms of liquidity, value creation and alpha generation, and they are looking at ways to deploy capital into that sector more efficiently.

Why it Pays to Think Small