A variety of seller motivations and increasing deal flow is helping to develop the secondaries market in real estate. Marc Weiss explains
Real estate secondary transactions represent the purchase of partial interests in property portfolios or individual assets from existing investors. These transactions are often consummated at a discount to net asset value (NAV) and therefore provide investors with some unique advantages.
Whereas a typical real estate portfolio consists of several assets, a real estate secondary investment strategy generally provides investors with broader diversification through owning hundreds of assets through multiple portfolio transactions. In contrast to a blind pool investment programme, secondary transactions are typically made at a later stage in the investment life cycle. This lowers duration risk because capital and gains will be returned sooner than an investment made in a blind pool at inception.
Furthermore, buying into existing portfolios at a discount to NAV allows investors to both deploy their capital faster and to substantially mitigate the J-curve. Finally, the value creation endeavours of the sponsor are largely complete when buying mature portfolios. If investors are able to acquire such portfolios at a discount to NAV, it is possible to generate significant cash-on-cash returns and a return profile akin to a value-added strategy, but with core-like property risk.
Motivated sellers are necessary for a robust real estate secondary market. As depicted opposite, the nature of the sellers and their motivations continue to evolve over time.
Despite the lack of distress in the current market environment, there are many other factors steering sellers towards the real estate secondary market to seek exits.
Immediately after the financial crisis, endowments and foundations with significant exposure to alternatives were most acutely affected. Many of these organisations depended on the profits from their investments to fund their operating budgets and were, therefore, faced with immediate cash requirements. Furthermore, these organisations had large outstanding obligations from past commitments that would have increased their portfolio concentration to alternatives if fully funded. In contrast, today’s market has a much deeper pool of sellers, albeit with different drivers, as described below.
Over-commitment and investor distress during the recent recession served as the catalyst to institutionalise the real estate secondary market and promote industry awareness.
Ongoing shifts in portfolio management and regulatory pressures on financial institutions are primary drivers of deal flow in the current environment, and are expected to drive future deal flow.
Shifts in portfolio management
Many public pension plans reacted to recent market volatility by shifting capital to core investments in an attempt to de-risk their portfolios, selling non-core investments, and stimulating secondary deal flow in the process. In addition, market-specific concerns, such as overheating in parts of China, have caused investors to selectively rebalance their portfolios.
Many investors now recognise the cost of holding legacy assets or wish to exit commitments to managers with whom they do not plan to invest in the future. Combined with investor fatigue for programmes in poorly performing vintage years (and slow distributions), this has led some institutions to pursue large-scale liquidations. Investing in only a subset of positions with a high likelihood of value recovery makes these portfolios attractive. The key to successful asset selection is the understanding of the portfolios and underlying property markets in order to identify investable inflection points.
Regulatory enforcement on insurance companies and banks (Solvency II and Basel III in Europe as well as the Volcker Rule in the US) has placed pressure on financial institutions to shed private market investments. Certain institutions have been proactive in selling private market investments and provided a significant source of secondary opportunities over the past year. As the various reforms are implemented over the coming years, more financial institutions are expected to utilise the secondary market to exit portfolios.
Pockets of distress still remain
The longer investors avoid dealing with problems of excessive leverage, poorly timed investments or regulatory pressures, the more they are likely to become distressed. In particular, Partners Group has observed many family offices and foundations still struggling with legacy investments that strain financial resources.
While some hope to recover values, many must use the secondary market to create liquidity. Partners Group believes that the real estate secondary market is evolving in a manner that benefits both buyers and sellers. Ongoing portfolio management activities coupled with increasing regulatory pressures create a sustainable supply of real estate secondary opportunities for buyers. This, in turn, creates a robust secondary market, attracting further sellers. As a consequence, and contrary to popular belief based on the lack of apparent investor distress, secondary investment opportunities are proliferating and the amount of transactions executed are increasing.
Although the real estate secondary market continues to lag the private-equity secondary market in terms of the number of participants and the sophistication of the market, the trajectory is clearly upwards.
Marc Weiss is head of private real estate secondaries at Partners Group