The Scale Trap
Why Bigger Real Estate Funds Deliver Smaller Returns
Why Scale is the Enemy of Returns in Real Estate
Most investors dream of scale. But what if scale is quietly killing your returns?
More importantly, it raises critical questions for LPs thinking about where to deploy capital. After all, there are countless places to invest. The framework should be simple:
What’s my real return potential?
What’s the true risk I'm taking to get it?
Can I get my money back when I need it?
Many LPs answer these questions by defaulting to brand names.
After all - people think that if you’re investing with Goldman Sachs, there must be some “special sauce.”
But big Firm mega-funds are often where returns get strangulated.
Consider this - mega funds launched by major firms like Blackstone, Starwood, KKR, and Goldman tend to struggle in terms of performance compared to their smaller competitors. And there's a straightforward reason why.
They're too big. Size is the problem.
Look at it this way: If you need to invest $1 million, you have lots of options. But if you need to invest $1 billion? Totally different ballgame. What are you going to do with that much money?
Someone brings you a delicious 25-unit apartment complex. Great! You've knocked $3 million off your total. You still have $997 million to deploy.
And here's the kicker—in a private fund, you typically get paid management fees when the money actually gets deployed. So picking off $3 million at a time doesn't solve anything, wastes massive time, and doesn't move the needle.
To prove this point, we conducted research that's pretty telling. I asked a simple question: How many deals exist in the United States valued at $100 million or more - roughly the minimum size that large funds need to pursue to make deployment meaningful?
The answer reveals why scale becomes a straightjacket. And the correlation between size and diminished returns isn't just real estate - it's demonstrable across investment classes. It's just particularly pronounced in real estate.
Here's what the data shows.
The Academic Evidence is Brutal
The numbers don't lie. Small real estate funds consistently destroy their larger competitors.
Preqin data analyzing 2017 performance showed small funds (under $200 million) achieved average net IRRs of 11.2% compared to just 5.7% for large funds (over $1 billion). That's not a rounding error. That's a 96% relative increase in performance.
But it gets worse for the big guys. Li and Riddiough's 2023 study analyzing 2,738 liquidated private equity funds found that real estate funds generated mean size-weighted IRRs of only 7.0% compared to 14.5% for buyout funds. They explicitly identified "diseconomies of fund scale, with no skill-based persistence to offset the negative scale effects."
Translation: Being big in real estate isn't just unhelpful - it's actively destructive.
The pattern is so consistent it's almost mathematical.
Cambridge Associates data from 1986-2014 shows that while small and large buyout funds achieve similar median gross IRRs of around 10%, the distribution tells the real story. Small funds demonstrate higher upside potential, with top quartile performance exceeding 35% gross IRR, while large funds peak at 30.2%.
Even during the 2008-2009 financial crisis, small funds from 2005-2006 vintages posted positive returns while large and medium funds lost value. Think about that. When the world was ending, the little guys were still making money.
The Math Problem Nobody Talks About
Here's where things get really interesting. Let's look at what large funds are actually competing for.
The US multifamily market contains roughly 140,000-160,000 properties with 50+ units. Sounds like a lot, right? Wrong. Only 4,000-7,000 properties are valued above $100 million nationally. That's less than 5% of all institutional-grade assets.
Meanwhile, there's approximately $1.5-2.0 trillion in institutional capital actively targeting US multifamily investments. About 50-75 institutional players capable of $100M+ acquisitions are competing for just 200-300 mega-deals annually.
It's like 50 people fighting over 200 pieces of pizza, while 25,000 people are sitting at an empty table next door with 25,000 sandwiches that nobody wants because they're "too small."
The mid-market segment ($25-75M) contains an estimated 25,000-35,000 properties with significantly less competition. That's 10x more inventory than the mega-deal market.
When Blackstone Pays Stupid Money
Let me give you a recent example that perfectly illustrates this problem.
Blackstone's $10 billion acquisition of AIR Communities in 2024 wasn't just a big deal—it was a desperate deal. They paid a 25% premium to market price because they literally had no choice. When you need to deploy billions, and there are only a handful of assets that can absorb that kind of capital, you pay whatever it takes.
This isn't isolated. KKR's $2.1 billion Quarterra portfolio acquisition priced at approximately $404,000 per unit for Class A coastal properties - a massive premium to comparable mid-market transactions.
Why do they do this? Because they have to. Blackstone alone manages over $520 billion - approximately 12.7% of the global real estate market. They can't buy 25-unit apartment complexes all day. They'd be there forever.
The Geographic Reality Check
Here's another brutal fact: 60-70% of $100M+ multifamily transactions occur in just six gateway markets: New York, Los Angeles, San Francisco, Washington DC, Boston, and Chicago. New York City alone accounts for 25-30% of mega-deal volume.
If you're a $5 billion fund, you're basically forced to compete in the most expensive markets in the country for the most expensive assets with the most competition. It's like being forced to shop only at the most expensive stores in the most expensive neighborhoods.
Meanwhile, mid-market deals ($25-75M) occur across three to four times more metropolitan areas. Markets like Nashville, Austin, Phoenix, and Denver see robust mid-market activity but limited mega-deal opportunities.
And here's the kicker: cap rates in mid-market deals typically trade 25-50 basis points wider than institutional mega-deals in the same markets. You get better yields for taking less competition risk.
The Deployment Death Spiral
The math becomes impossible pretty quickly. A $5 billion fund targeting 20% annual deployment needs to invest $1 billion per year. With average equity requirements of 30-40%, this translates to $2.5-3.3 billion in total transaction volume annually.
But there simply aren't enough $100M+ opportunities to absorb this capital without accepting suboptimal investments. So what happens? Fund managers start compromising. They pay higher prices. They accept lower cap rates. They chase markets they don't understand.
It's a death spiral of forced mediocrity.
The Little Guys Are Laughing
While the mega-funds are fighting over scraps in gateway cities, smaller operators are quietly cleaning up in middle America.
First-time North American real estate funds achieved median net IRRs of 18% according to 2023 data - five times the performance of established value-added funds. Five times!
Why? Because they can be picky. They can wait for the right deal. They can walk away when pricing gets stupid. They can invest in markets where a $50 million building is considered large rather than tiny.
Most importantly, they can focus on execution rather than deployment. When you don't have $50 billion burning a hole in your pocket, you can actually underwrite deals properly.
The Institutional Recognition
The really interesting part?
Institutions are starting to figure this out.
CalPERS committed $1 billion specifically to emerging and diverse managers in 2023, recognizing this performance advantage. New York City pension systems report their emerging real estate managers achieved a 5.5% PME spread since 2015.
Even the big institutional money is realizing that small is beautiful when it comes to real estate returns.
It’s just that even for them - to access it - they have to structure Fund-of-Fund structures. And so the fees upon fees issue starts to crop up.
A Personal Story
As many of you likely know, I worked at Goldman Sachs for years. And in that role I was privileged to meet and connect with some incredible people.
Two things.
It’s almost like a law of nature - as you become more successful as an investor, your fund size grows. After all - that’s how you become super wealthy. If you are reading this, and you’re a sponsor, I challenge you to challenge this law.
I know I don’t want to! More AUM is good, all else being equal, for me and my family. Wherever incentives flow is where we go.
But I will tell you this - the two most successful venture capitalists I met while in San Francisco have consistently produced outstanding returns. Like absolutely crushed it. They make lists of top 5 VCs, etc etc.
And the factor I attribute most?
They grow in skill, but refuse to raise more than $100 million for their funds.
Now VC is intriguing because you can deploy $100 million and return like $2 billion, and make a mint on carried interest. Most real estate funds can’t do this. So it’s not exactly an apples-to-apples comparison - the management fee revenue to a fund for real estate is more important than in other vehicles.
But it’s an extraordinary story. I always like sharing it. Wish I could share their names, but they’re both private guys and don’t want to be paraded around here for my enjoyment.
Why This Matters for Your Portfolio
If you're an LP trying to figure out where to deploy capital, this data should fundamentally change how you think about manager selection.
The traditional approach of allocating to brand-name mega-funds because they're "safe" is actually the riskiest strategy. You're guaranteed to get mediocre returns because the math doesn't work for large funds.
Instead - I’d think about it like this.
First off - get educated
Second off - appropriately vet and analyze the managers you’re investing with
Third off - never invest in private assets more than you can afford to lose
I’m going to harp on this until the day I die. I’m not a typical real estate guy. You should maintain appropriate exposure to the stock market and liquid assets. You should not put 100% of your capital into real estate (if you are an LP). It’s a mistake. Don’t do it.
Consider that smaller funds have wider return dispersion. The worst small funds perform much worse than the worst large funds. But the best small funds absolutely destroy the best large funds. And if you do your homework on operator selection, you can tilt the odds heavily in your favor.
The Bottom Line
Scale is the enemy of returns in real estate investing. The data proves it. The academic research confirms it. The recent transaction evidence demonstrates it.
While everyone else is chasing the safety of big names and big funds, the smart money is going small. They're finding better deals, paying better prices, and generating superior returns.
The question isn't whether this pattern will continue. It's whether you're going to take advantage of it or keep throwing money at mega-funds that are mathematically destined to underperform.
As institutional capital continues flooding into real estate and concentrating among fewer mega-managers, the opportunities for nimble, focused operators to generate superior returns will only get better.
Heck - as I was writing this, somebody shared this WSJ piece about how Wall Street is preparing to raise several massive funds. Do you want in on that? I don’t.
The big guys can have their $10 billion deals and 4% cap rates.
I'll take the small operators buying great assets at 7% cap rates all day long.
PS - if you haven’t checked out our podcast show yet (The Timeless Investor Show) make sure you don’t miss it here.
By the way - added thought - look at Softbank and tell me that mega-funds actually work.
We literally had a term for this - the Softbank Effect. Whenever Softbank invested in a company, it usually fell apart shortly thereafter.
Why? It was cursed with the particularly nefarious curse of "too much money". As a result, it a) lost its way, b) had to grow in weird and uncomfortable ways because it had SO MUCH MONEY to deploy, and c) I don't know - it just didn't work.
Rappi. WeWork. So many examples.