Capital raising numbers for value-add strategies are close to 2007 highs. Should investors treat this as a signal to stop?
Tristan Capital said it broke a company record this year, raising €1.5bn for its latest value-added real estate strategy in just four months. It is the latest sign that the fundraising market has finally gone into overdrive.
Blackstone also revealed it had raised $18.3bn (€16.8bn) in six months across its range of real estate-related strategies. Preqin recently reported that fund managers are sitting on record $250bn of ‘dry powder’, and INREV said capital raised for European non-listed real estate last year reached levels “only comparable with 2007”.
Should these developments serve as a portent to investors?
“The environment does feel more 2007-like”
“The environment does feel more 2007-like,” said Paul Jayasingha, senior investment consultant.
“We are seeing double-digit returns, transaction volumes at multi-year highs, yields reaching multi-year lows, debt costs at ever lower levels on higher loan-to-value terms, regional, non-gateway locations seeing increased investor interest, speculative development starting to re-emerge and fundraising breaking records in terms of speed and size.”
Towers Watson’s approach to value-added and other higher-return strategies has become more “cautious”, he said. “Unlike 2007, the property yield spread relative to long-term government bonds shows a healthy spread, which provides some investor comfort. Further, a lot of continental Europe has missed much of the rally seen in other developed markets in recent years and appears some way from peak-cycle behaviours.”
But Jayasingha is concerned by an increasingly aggressive value-added fund sector. “We are starting to see some evidence of funds overstretching to meet high expected return targets rather than keeping risk levels constant and accepting that expected returns are likely to be lower,” he said. “For example, we have seen some funds increasing their planned use of leverage or drifting into riskier markets and strategies to maintain high expected returns.”
This happens every time at this point in the cycle
Christopher Macke, managing director of research and strategy at American Realty Advisors, said: “This happens every time at this point in the cycle… investors start to stretch for returns.”
Core property in the US has delivered double-digit returns over the past year (13.38%), three years (12.07%) and five years (13.33%), according to the National Council of Real Estate Investment Fiduciaries’ open-ended core fund index. Macke argues that such strong returns invariably encourage investors to look to real estate for “alpha generation” when they should be using it for portfolio stabilisation.
“They start to confuse the role of commercial real estate,” he said. “They look at fixed income and see there is not much yield. They look at equities and they see that the returns have not been consistent… and so they say, let’s go to commercial real estate – it’s been getting really good returns.”
But to continue to achieve these returns investors are either taking on more risk in the core strategies or committing capital to value-add strategies. “What they do is start to engage in style drift in the core funds [or] start to go more into value-add funds, which in and of itself isn’t a bad thing,” Macke said. “The question is: why are they going into value-add funds?”
He added: “Part of the way people are engaging in style drift in core funds is, not only are they taking on more leasing risk, they are going into smaller and smaller markets. And these are markets that have lower long-term income growth and take significantly longer to recover after a downturn. We believe it is the exact wrong time to be doing that.”