Hedge Funds and Their Impact on Mom-and-Pop Investors

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Back in May I wrote an article titled “Smart Money Woke Up – Now What.”  The basic theme was that my market changed almost overnight when the well capitalized hedge funds started actively buying.  In the article I highlighted how I was going to outsmart them by being nimble and learning where they weren’t playing in my market.

In this article I am going to highlight my thoughts on the good, the bad and the ugly of Hedge Funds’ impact on mom-and-pop real estate investors.  

The Impact of Hedge Funds on Real Estate Investors

The Ugly:

The simple truth is that no mom-and-pop investor can compete head to head with a hedge fund when they are deploying capital in a rapid fashion.  We also need to realize that hedge funds usually act like schools of fish that swim together – meaning that when your market is found as profitable by one hedge fund it will quickly be flooded with dozens of funds looking to deploy capital.  Thus, freezing out the majority of mom-and-pop investors almost over night.

The Bad:

The truth about most hedge funds is that they are looking to achieve single digit returns or yields.  The thought being, in this low yield environment we live in, they can earn 7-9% on large piles of capital.  Whenever the market turns they can reap huge capital gains, juicing their total returns tremendously.

I also believe many hedge funds will follow the strategy outlined below for maximum return:

First, they will deploy capital and buy assets for cash with zero leverage.  Then, as asset prices firm, they will secure 60-70% Loan-To-Value loans and refinance out 100%+ of their initial capital.  Lastly, they will spin these, now debt encumbered assets, off as a REIT to the investing public after which they will be wildly successful, since all of their capital was returned in the previous step.   The final step is pure profit; these guys are not called smart money for no reason!  They have the capital and they have the time to wait for the market to turn.

The Good:

I see tremendous upside in having hedge funds in my market for several reasons.  First and foremost I believe having large and frequent buyers in my market validates what I have been doing for 4+ years.  A side benefit of having hedge funds buyers involved, means prices will rise, inventory will dry up, and we can get out of this mess faster.  Granted, as I stated in “The Ugly” section, it is hard to compete with these buyers.  

Now What?

My advice is simple, don’t compete with them, but benefit from their activity.  The mom-and-pop investors simply have to figure out where the hedge funds are playing and invest somewhere else.

From what I have seen, hedge funds are simple creatures that target a pretty strict set of criteria when they buy. In my market, this means they are all over newer properties built after 2005.  It also means they like single family homes over multifamily units and, finally, they frequently buy on the court house steps.

In the end if you invest in a market that is flooded with hedge fund buyers, you can sit on your hands and complain while you hope they blow up because they are overpaying, or you can use speed and nimbleness to your advantage.  I have heard from many people who say they can’t wait for these hedge fund buyers to blow up and become tomorrow’s desperate sellers. I see very little chance that hedge funds buying with cash will blow up. I know they are overpaying by 10-20% in many cases but I suspect they are setting a new market value instead of truly overpaying.  

Remember: Hedge Funds are simply turning piles of cash that are currently producing a negative real return when you factor in inflation, into high yield assets (Rental Property) that have substantial equity kickers. That’s genius if you ask me!!!

All that said –  I look forward to kicking their ass in my market while they do all the heavy lifting of increasing values across my portfolio by 20-40%!!!!  I will continue to buy assets that produce 20%+ yield, leverage Private Capital to fund acquisitions, and supply the best rentals for the best price while I let the hedge funds double the value of my portfolio!!!

Good Investing

Photo: Stuart Heath

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About Author

Michael Zuber is an active buy-and-hold real estate investor who still has a full-time job. Michael is not an agent or broker, and simply uses the internet and agent relationships to drive his business. He currently averages at least one deal a month and has developed laser focus on his 5 step process.

10 Comments

  1. Be sure to keep the forums informed on the progress of kicking their behinds and how well your properties are appreciating with their help!

    Dale

    • Dale

      Will do. At this point 2012 will be my best year yet for aquisitions, yield and cash flow creation.

      Good Investing

      • Hi Mike do you mind telling me where you find most of your properties. REO, auction etc?
        This is my biggest problem right now. Thanks.

  2. Michael,

    Loved your article, for both its information and its spirit!

    There’s a method to their madness when it comes to geography. Ratings services are already signalling that securities based on single family rentals in markets with the best recorded margins will win better ratings. (see The Rush to Securitize Single Family Rentals: The Fitch Report Changes the Rules.)

    Steve

    • Steve

      Thanks for the note. I read all your articles and use them as one of my many guide posts. Kepp up the great work I really appreciate all the help

      Good Investing

    • Jeff

      Thank you! But remember I am rubber and you are glue and what you say bounces off me and sticks to you …

      Thanks again

      Good Investing

  3. Great article, like the previous one, I completely agree. Hedge funds, like banks, invest in “sure thangs” – new, up market, central districts, etc – as a result, they always go for the lower yielding, higher appreciation potential properties. I focus my efforts on anything that isn’t (mainly older, higher yields, out of the top locations)- no direct competition, and the indirect competition, as you said, brings nothing but benefits.
    Top tips, keep it up :)

  4. So I’m a young teacher (26) relatively new on the investment scene. I finished paying off loans and just bought a modest house in the Phoenix area. I started a Roth, but not being particularly optimistic about Wall Street and the market in general (I’ve got a small portfolio with American Funds) is there a good way to invest in some funds that have large real estate holdings (or any area where I can ‘buy low’)? Any advice? Thanks!

  5. I like the post and for the most part agree, although the hedge funds actually having much of an impact on long term holdings is probably a stretch. In the short term Id agree. Once they see less value in an area they will move on and the market for that area will realize its natural position bringing down the prices again. Id say sell very soon and rebuy again a little while after the markets stabilize. Of course thats speculation

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