Call it the stars aligning or a perfect storm, but a confluence of factors in the commercial real estate investment and private equity markets has many seeing a silver lining for the secondary real estate market.
These factors include macroeconomic trends such as runaway inflation and rising interest rates, declining valuations of real estate assets causing denominator effects in mature portfolios, wide bid-ask spreads that prevent buyers and sellers from matching deals, etc. Differential performance across sectors and regions also contributes, calling for more rigorous due diligence to identify future value of real estate amidst changing ESG requirements and occupier needs.
According to data from international alternative investment manager Ares Management, although there has been a slight decline in completed real estate secondary transactions in 2023, supply is greater than ever before and capital demand remains very high. As a result, the real estate secondary market is expected to accelerate over the next few years, with a broad pipeline of transactions emerging.
According to data from Lazard's Private Capital Advisory Group, a global financial services advisory and asset management firm, the majority of investor-led real estate secondaries portfolios were sold in North America, where prices remain strongest. Meanwhile, pension funds and financial institutions were the most active sellers in the secondaries market as they sought to realign their investment portfolio allocations for 2023, along with an increasing number of family offices looking to sell in the secondaries to meet their liquidity needs.
Investors and managers alike are seeking liquidity in today's market, resulting in an increase in manager- and investor-driven trading across asset classes. While manager-driven trading continues to dominate the market, investor-driven trading has increased significantly over the past year.
Continuation funds are also growing in popularity among managers and investors willing to navigate their complexities. While the US accounts for the majority of completed secondaries transactions, specialists in fragmented markets in Europe and Asia see growth opportunities, particularly as significant debt maturities create opportunities for recapitalization.
Funding for secondary strategies also continues to grow: According to data from Secondaries Investor, funds with final closes in secondaries across all asset classes will reach $117.92 billion in 2023, more than double the prior year's total of $53.28 billion.
Real estate-focused secondaries funds also saw an increased proportion of capital raised, accounting for 7% of last year's total, up from 2% in 2022. After raising $8.37 billion last year, approximately $940 million was raised in the real estate asset class for private closed-end vehicles in 2022. Overall, the real estate secondaries market is poised for significant growth due to increased capital demand, attractive discounts to net asset value and an expansion in deal types.
Beyond the big picture, several other important trends are emerging as investors see opportunities to provide much-needed liquidity to a traditionally illiquid real estate market.
1. Entering the Asian market
Asia's real estate secondary market is developing, but lags behind more established markets in terms of development. Traditionally, Asian investors have preferred direct investments and traditional real estate funds over secondary market opportunities. However, this attitude is gradually changing as investors face challenges such as delayed distributions and the need to rebalance their portfolios, leading to increased interest in secondary transactions.
The emergence of continuation funds has played a key role in facilitating this transition. These funds offer existing investors the option to exit or roll over their investments into new funds, providing flexibility and liquidity. For managers, continuation funds offer the opportunity to preserve capital and optimize asset performance over a longer period.
Navigating Asia's secondary real estate markets presents unique challenges, with transactions often being bilateral and navigating different local markets requiring a deep understanding of the needs and motivations of both investors and managers. That said, the momentum in the region is undeniable, driven by a growing number of investors and managers in the sector.
2. Continuity of the Strategic Solution
Continuation funds have become popular in the real estate secondaries market, providing a strategic vehicle for both investors and managers. These funds allow investors to maintain existing exposure or allow new entry into a portfolio of mature, high quality assets, while also addressing the liquidity needs of investors wishing to exit funds approaching the end of their life cycle.
A win-win situation gives managers the opportunity to optimise asset performance and align it with investors’ objectives and business plans over a longer time horizon.
Continuation funds offer stability and flexibility in uncertain markets, allowing investors to hedge volatility and manage risk. By extending their investment horizon, these funds enable strategic initiatives such as asset redeployment and capital improvements, enhancing value for investors.
However, the successful introduction of a continuation fund requires clear communication, transparency and alignment of interests between all parties. Furthermore, careful consideration of the fund's terms and conditions is essential to ensure a mutually beneficial outcome for all stakeholders, as is a strong understanding of the individual assets and local markets that new investors will be accessing.
3. Sector Selection and Performance
Sector preferences play a key role in shaping investment strategies and driving performance in the secondary real estate market. Sectors such as data centers, digital strategies and industrial real estate have emerged as major drivers of activity, driven by strong demand fundamentals and robust revenue streams.
In contrast, the office sector faces challenges due to remote working trends and changing workplace environments. While value creation opportunities may emerge in certain submarkets, the overall outlook for the office sector remains subdued compared to other property types. Meanwhile, retail is becoming more popular among investors who have exited the sector in recent years.
Navigating sector preferences requires a disciplined approach that focuses on sectors with strong demand fundamentals and favorable supply-demand dynamics. Diversification across sectors and regions can help mitigate risk and make a portfolio more resilient, but strategic asset selection is essential to capture value in a competitive market environment.
4. Pricing and Risk Management
Pricing remains a key consideration in the secondary real estate market, with mismatched bid-ask spreads and valuations posing challenges for investors across real estate sectors. Preferred sectors may demand premium prices, while other sectors may face downward pressure on valuations.
Mitigating the risk of real estate secondaries across the risk spectrum requires rigorous due diligence and a proactive risk management strategy. Investors must thoroughly evaluate each individual asset, including property-level cash flow and market data analysis. Understanding the capital structure and performance of the underlying assets is essential to assess risk and evaluate potential returns.
In addition, investors should evaluate macroeconomic factors and geopolitical risks that may affect real estate markets around the world. By maintaining a diversified portfolio and keeping a close eye on market trends, investors can effectively navigate pricing challenges and mitigate downside risks. Of particular importance is evaluating the discounts offered by providing liquidity and determining the extent to which the offered discount represents true value compared to future pricing.
5. Changing dynamics and opportunities
The secondary real estate market is transitioning from investor-led transactions to manager-led transactions due to changing investor preferences and market conditions. Manager-led transactions offer several advantages, including improved asset selection and better alignment of interests between managers and investors.
Additionally, the current market creates unique opportunities for private equity investors to take advantage of liquidity constraints and inefficiencies in the primary market. Demand for real estate secondaries funds is growing, creating value-focused investment opportunities.
Looking ahead, the secondary real estate market is expected to continue to grow and innovate. As the market matures, investors must remain vigilant and adaptable, seeking out opportunities that offer attractive risk-adjusted returns and align with their investment objectives.
Navigating the secondary real estate market requires a strategic approach based on sector insight, price trends and risk management strategies that allow investors to unlock value in a changing market.