History, Discipline, and Shorter Real Estate Cycles

Of all the lessons learned since 2008, there is one that LPs fervently hope GPs have taken to heart: that it is better to hand back capital than to invest when opportunities have gone beyond them. It was something that few managers showed a talent for in the run-up to the financial crisis. Little more than six years on, with asset prices climbing and cap rates declining closer to, and sometimes below, pre-crisis levels, investors are starting to quietly wonder if history will repeat itself. Such contemplation is being driven by the thought that real estate investment cycles could be getting shorter. PrivcapRE can’t profess to back this with algebraic equations forecasting real estate’s new phases. However, many investors, consultants, and managers are surprised at the speed and scale of the recovery in key parts of the global property market. And there is concern that prices are racing ahead of fundamentals. Much of the attention has focused on the U.S., not least its gateway cities. The Moody’s/RCA Commercial Property Price Indices, which track price changes based on repeat sales, show apartments and central-business-district office assets surpassing their 2007 peaks by as much as 11 percent. European managers are also worried that the sheer weight of capital in the region is driving pricing in certain markets, for some assets, well beyond the realms of rational rent growth assumptions. So do tighter cycles really matter? They do when set against the context of investing through a closed-ended private equity real estate fund, which has a typical seven-to-10-year life. As the cycle gets shorter, investment periods will increasingly span the life cycle of the market, the highs and the lows. And as one investor commented, if GPs are not reaching the level needed to get their carried interest, the industry is “either completely fooling [itself] as to what [it] expects to get or it’s the [closed-ended fund] structure that’s an issue.” One potential response to shorter cycles could be to reduce the investment period of a fund, and even the fund life. The option was raised by LPs in the immediate wake of the crisis as they sought greater control over investment strategy, and it has once again become moot. However, unless LPs want to see their manager constantly on the road trying to raise their next closed-ended vehicle, shorter investment periods and shorter fund lives could work against their best interests. LPs should also be conscious of the impact shorter hold periods have on their own portfolios. A recent study by Joseph Pagliari and PREA showed that the drag effect of asset management, acquisition and dissolution fees, and various fund-level fees and costs on net levered returns fades the longer an investment is held. So while shorter investment periods and funds could mitigate deals from spanning the entire life cycle of new, tighter real estate cycles, it would do so at the expense of an investor’s net returns. There seems only one answer left: for GPs to hand back capital when markets move too far and too fast. Investors can only hope that GPs have learned from history and now have the discipline to turn off the deal spigot when the markets become fully priced. ■