Secondaries Come into Focus

With the real estate recovery in the U.S. reaching a more mature stage, deal flow for secondary interests in commingled RE funds has picked up as limited partners seek to better manage their holdings. Domestic foundations and endowments were active sellers last year, and those players are expected to continue to stay active, along with select U.S. pension plans, market participants say.

Indeed, the market has grown rapidly since 2008, witnessing a compounded annual growth rate of more than 30 percent that culminated in more than $5B of real estate deal volume in 2014, according to data from placement agent Park Hill Group. Secondaries advisory firm Setter Capital puts last year’s deal volume even higher, at roughly $6B.

At the same time, the quality of secondaries in the market has improved. What was once a minefield of non-performing and distressed funds has evolved into a serious portfolio-management tool through which investors are paring back exposures to individual managers, regions, and even property types. Moreover, those interests are now backed by stronger managers, better underlying assets, and funds that are largely or fully invested, thereby providing buyers with a clearer view of values and underwriting issues, market players say.

Consequently, bids for secondary interests have been on the rise, with a number of recent deals struck at or close to par. Despite paying par pricing, buyers contend that the underlying assets are still cheap relative to current valuations or have a better risk profile relative to when they were acquired. “Generally speaking, net asset values lag the market, as do reference dates for deals,” says Sarah Schwarzschild, a principal at Metropolitan Real Estate. “As a result, many assets are marked conservatively, so it is important to understand the true value of the underlying assets.”

In addition, many large portfolio transactions are structured to allow the buyer to defer payment or pay for the interest in stages over time, thereby creating artificial leverage that can boost returns and, in certain instances, reduce risk, says Josh Cleveland, a partner at StepStone Real Estate. The seller, meanwhile, is receiving par value for its investment, so there is no need to book a loss on the transaction. “Such structures are useful in bridging a bid-ask spread,” Schwarzschild adds.

For buyers, acquiring real estate secondaries has become more competitive, thanks to nearly $5B in new dedicated capital raised over the past year or so. Still, that is not so much capital, considering that these funds will be invested over the course of the next three to four years and that $5B traded last year alone, market players point out.

In terms of focus, much of the capital to be put to work is in the hands of a few large fund managers who are more likely to target larger stakes and portfolios, including what is likely to be the premier offering this year—a rumored $1.8B sale by the endowment Harvard Management. For most players, however, success will be found in working existing GP relationships, striking off-market deals for small and midsized fund interests, and solving liquidity needs in unique—if not more complicated—situations.

“In general, more than half of the annual volume comes through an auction process, and less than half is off-market,” says Cleveland. “While the off-market portion is the greater driver of returns for buyers, those smaller deals and more complicated situations can take as long or longer to complete and can have higher execution risk. We are seeing several opportunities for secondary investment with less competition by focusing on recapitalizing fund and non-fund portfolios.”