Before reading further, I want to make it clear that the term “Hedge Fund” is a very “broad term” and that I am not writing this to stir up a bunch of anti-Hedge Fund comments. The fact is, the introduction of big buyers into the market has both helped and hurt and probably will continue to do both for a while. I am writing this article because just like every other business out there, some companies will succeed and some will fail. Single-family rental investments are not different and some Hedge Funds will do well and some will fail! And they will fail for some of the same reasons other companies fail and for one BIG reason. Failure to understand the Hedgehog Concept. Want more articles like this? Create an account today to get BiggerPocket's best blog articles delivered to your inbox Sign up for free Simply put, the Hedgehog concept comes from the book “Good To Great” by Jim Collins and is all about knowing what you do better than anyone, how that drives your company and then getting passionate about it. Hedge Funds were created for one purpose…to be a hedge. They were originally created to be great at protecting the participants capital. A safety net against riskier investments. Unfortunately, many in real estate investing are wondering just what in the world some hedge funds entering the single-family rental market are thinking and doing because the strategy seems less like knowing what you do best and more about flushing dollars down the toilet…and neighborhoods with them. Not exactly following the Hedgehog concept or the original intention of a Hedge Fund. Hedge Fund or Institutional Buyer…Is There A Difference? Definition of Hedge Fund: An aggressively managed portfolio of investments that uses advanced investment strategies such as leveraged, long, short and derivative positions in both domestic and international markets with the goal of generating high returns (either in an absolute sense or over a specified market benchmark). Legally, hedge funds are most often set up as private investment partnerships that are open to a limited number of investors and require a very large initial minimum investment. Investments in hedge funds are illiquid as they often require investors keep their money in the fund for at least one year. Definition of Institutional Buyer: A corporate entity that falls within the “accredited investor” category, defined in SEC Rule 501 of Regulation D. A Qualified Institutional Buyer (QIB) is one that owns and invests, on a discretionary basis, at least $100 million in securities; for a broker-dealer the threshold is $10 million. QIBs encompass a wide range of entities, including banks, savings and loans associations, insurance companies, investment companies, employee benefit plans or entities owned entirely by accredited investors. Banks and S&L associations must also have a net worth of at least $25 million to satisfy the QIB criteria. I found both definitions on Investopedia.com and thought they were perfect for this article because the definitions do a really good job of illustrating the difference between the two. In many cities around the country, there are institutional buyers doing much of the investing and they are buying millions of dollars of real estate. They have been for years. I met with a family operation that is considered an institutional buyer back in 2009 and they had an excellent plan and purpose for investing in single-family homes. They were very clear on the properties they wanted to purchase, where they wanted to purchase them and why. The plan they shared with me made perfect sense and what was so brilliant about it is that no one really knew they even existed. They were purchasing properties in designated areas with a small group of people making decisions and with very good companies providing the expert services they needed. Yes, they were purchasing properties in two parts of the country, hundreds of miles from where they lived and were having success. They spend their time cautiously buying the properties they want in the areas they want them and then building and funding the teams they need in each area. Juxtapose that with what many investors today recognize as Hedge Fund buyers. They are not nimble nor are they quiet. Some of the ramifications of their entry have been escalating prices with some winning bids at nearly twice the list price and double the next highest bid. A quite common explanation is that they have an algorithm that tells them exactly what to buy, where to buy it and how much return on investment they will get. Of course, any experienced real estate investor knows that money can be lost quickly in real estate and trying to spend your way out of a bad property can get expensive quick. When properties are bought with no regard to price and even less regard with how to make them operate as an asset, trouble is quick to follow. Some Hedge Funds do not appear to have the patience of an institutional investor. They are set up to act quickly – not even “ready, fire, aim”. They are set up for “fire, fire, fire…now let’s see where we were shooting”! Real Life Example Of Crazy Real Estate Thinking… Before this becomes some gab fest where we all jump on Hedge Funds, let’s be real clear about a few points. There are good and bad in every business. I think the same goes here. What I have found is that there are a handful of Hedge Funds that know what they are doing and are going to be fine. There is a real sense that in the end, they will buy up much of what the institutional investors have been acquiring over the last few years. That could happen and you will see the big boys and the small operations both win. What is left…and who I think could fail…is the muddy middle. The muddy middles are those funds that have found themselves buying anything and everything and hiring anyone off the street who will take their low-ball offer for services. I have seen both good hires and bad hires by the Funds, but I have yet to see a deal where the funds bought expert companies for true market value and brought them in to do what they do best. Instead, I have seen talent gobbled up by Funds only to have their hands tied on a local level with lack of funding for the basics like staff! While Hedge Funds have completely changed some markets around the country, in some areas they have left gaping holes in the normal services like proper repair, great management for tenant satisfaction and a poor understanding of what awaits them in 12-36 months. Experienced investors know that returns do not get better over time. In fact, they will decline at some point as maintenance comes due. When you do shoddy work on the front end because of lack of funding, the bill comes due on the back-end and returns drop even harder than anticipated because of high and quick turnover and a constant stream of maintenance. Some funds get these types of challenges and some don’t. Allow me to illustrate: This property was recently purchased by an investor with my company. No big deal – take a quick look for comparison. Nothing more than a nice ranch home that fits the typical model of a 3/2 ranch in the suburbs ringing Memphis. Who owns it and what portfolio it goes into does not matter. What matters is that the house itself and the way it is presented to a renter are designed to attract high quality. The work done on the property is also at a level to minimize maintenance. Prior to us purchasing the property, we had tried to buy another property a couple of doors down. There were two bids on it so it went to highest and best. We raised ours only a small amount. The winning bid went over the list price by 50%…they really wanted the house! But why? Because it was a Hedge Fund buyer with a local operator who has been tasked with buying as much property as possible. What makes this even more peculiar is that we bought the house a few doors down for listing price! A Hedge Fund – with a smart, local strategy – could have purchased both properties for only slightly more than the price paid for one. So what about a rental strategy? One of the big reasons that there has not been much of an impact on my market from the Hedge Funds so far is that the quality of work being done on the rental properties is so poor. It appears from all indications that there is no limit on purchase price, but there is a huge limit on dollars allocated for renovations and curb appeal. As you can see from the pictures, it really looks like a “rent ready” mentality. Spend as few dollars today with as little work possible, to get someone in the property! The property is listed lower than our rent range and still sits vacant to this day. Why? The pictures show a property with overgrown grass, 4-foot tall weeds, a missing A/C unit, no kitchen sink, dirty carpet and a rusty water heater in an outdoor closet with no handle or lock on the door. Yup…that just about sums it up! It does not look like anyone has even been by the property in weeks and this is acceptable how? Local Reps For Hedge Funds: Lazy or Just Underpaid At first glance I know a lot of readers may put equal blame on local providers as they do on the Hedge Funds. I agree that in some respects that is true. In this case, I removed the rental signs on the property because the local company does not matter. Readers from every corner of the country will have a similar story to this one from their city. The question becomes, as a local provider, should you not have some responsibility to your own business and the neighborhoods where you are operating? Unfortunately, when the ink from a deal is dried, it becomes apparent that there is not enough money to go around. This is where the real criticism of some Hedge Funds (or Hedge Funds in general) really comes in. More and more investors see this happening in their communities. During a recent conversation I had with a HUGE fund, they explained the term “warehousing” to me. It is the practice of some mid-size funds going around and buying up everything they can without regard to the performance of the property. They simply want to buy, hold, maybe renovate and rent when they can get to it, but hope that a bigger fund will come in and buy their portfolio. Hence – the name. They are literally warehousing empty houses like any other shelf stable commodity. As a business owner who has built multiple businesses at this point, I know a thing or two about properly staffing a company and the trajectory of growth that tells you when to hire and train new staff. That includes every position including buying, renovating, renting, managing and then leading each of those departments. When Hedge Funds come into markets and hire companies like these, they are not walking in with a suitcase of money saying “here you go – go build your team”. They are walking in expecting big numbers on all fronts and they want it done on a budget and on-time. Many funds offer what amounts to a few percentage points of purchase price for the local company they hire to run the business. A few percentage points on a low dollar average purchase price does not create enough overhead for proper staffing. In some cases we are talking about $1,500 to $3,000 per property. That sounds awesome when the fund wants to buy 500 properties in a year! That is a cool $1 million+ dollars… But that is a gross revenue number and any decent company worth their salt can make 5 times that on a property and deliver something they can be proud of and happy to tell others in the city that a property represents their work. With pictures like the ones above, what is the point? Most any good business person would be ashamed to put their name on work like that. When there is not enough revenue to cover the overhead of proper staffing, oversight and operation of a company that has to buy and renovate 10 properties a week, something has to give and it is going to be the quality of the properties. You can probably tell at this point that I do not blame the local company for the pictures above. Should they do a better job? Absolutely. Unfortunately, they run an ad every Sunday in the real estate section and the ad with what is presumed to be every vacant address grows every weekend. This past week the list of vacancies was over 300 properties! I can only speak for the two cities that I operate in and I can tell you that I have been impressed with some Hedge Funds that I have had the pleasure of meeting with one on one. Most seem to have their act together, but this is a pretty good example of the down side to the heavy buying volume of institutions and funds. I have seen what a poorly executed plan can look like and the damage that can be wrought on neighborhoods and I have not left one meeting without bringing up the damage that some Hedge Funds are doing. I can guarantee you that no Hedge Fund has an algorithm with 15%+ vacancy rates and houses that look as bad and sit vacant as long as the one above. You simply cannot calculate how quickly the safety underlying a Hedge Fund is wiped away! For me, this is exactly why some Hedge Funds will absolutely fail at Single-Family rental investing. I just hope the local companies that signed up for the ride can find a way to weather the storm.