Real estate secondary transaction volume in 2023 declined following a record high the previous year, but this will likely be recorded in history as a temporary phenomenon in its evolution.Against the backdrop of a prolonged period of high interest rates and a broad correction in real estate prices, both investors and managers are increasingly in need of generating liquidity.
Market participants generally say there are signs of accelerated growth in the secondary market for private real estate fund shares over the next few years.
New York-based private-market investment and advisory firm StepStone Group is particularly optimistic, betting that a bull market in real estate secondaries will emerge from the overall real-estate turmoil. “Right now is a great time to be investing in secondaries,” Jeff Giller, the firm’s head of real estate, said on a podcast in February.
“Unlike after the global financial crisis, there are no operational issues with the assets.”
But liquidity in 2023 is as low as it was during the 2008-2009 global financial crisis, according to Achal Gandhi, chief investment officer of indirect real estate strategies at CBRE Investment Management. What's more, valuations have hit rock bottom.
“This makes it a very attractive vintage for us, given that we are able to enter closer to the bottom of the valuation cycle and negotiate a more discounted entry basis through the secondary market due to reduced liquidity across various structures and a broader closure of capital markets,” Gandhi noted.
Supply has never been greater, according to data from global alternative investment manager Ares Management. The US-based firm estimates that there is more than $970 billion in net asset value (NAV) held in closed-end real estate funds, of which $180 billion is held in funds that are more than eight years old. Outside of funds, there is more than $1 trillion in NAV held in non-fund structures such as joint ventures and separate accounts.
“Converging debt maturities within legacy vehicles, coupled with portfolios that require more time and capital to complete their business plans, are reducing distributions from funds and creating liquidity issues for some investors. This scenario, combined with a denominator effect, is already causing increased sales in traditional investor-led secondary markets,” said Kieran Farrelly, head of global real estate solutions at global private markets asset manager Schroders Capital.
“There have been significant redemptions in the UK, particularly from defined benefit funds, and there are very real opportunities to buy those interests at attractive discounts,” Farrelly explains. “We will see this activity spreading across Europe.”
Investor-led revival
During the global financial crisis, secondaries' stake acquisitions were primarily limited to purchasing investor interests in funds. Over time, real estate secondaries have followed private equity secondaries in not only taking up a larger portion of the overall transaction market, but also expanding from investors looking to sell their stakes to managers fulfilling other liquidity needs, such as recapitalizations, fund continuation vehicles and platform expansions. According to data from Evercore, a global independent investment bank, manager-led transactions have become the norm since 2020.
“You're going to find a lot of structures that don't meet the needs of future-proofing assets. There are going to be very specific needs in that regard.”
Kiernan Farrelly
Schroders Capital
Investor-led transactions are expected to bounce back in 2023, up 26% year-over-year, while manager-led transactions are down 35%. Still, Michelle Creed, partner and co-head of real estate secondaries at Ares, sees manager-led sales returning to an upward trend over the next few years.
“The last 12 months have seen an increase in the real estate secondaries pipeline from both managers and investors, but a look at the numbers shows the market drivers are on the manager-led side,” Creed says.
Investor-led secondaries funds are generally less transparent than manager-led funds, and they have the power to reshape the fund's governance structure. Plus, the secondary fund market today is much larger and more traded than it was a decade ago, so investors feel comfortable with the option as a legitimate avenue, says James Jacobs, managing director at financial services advisory and asset management firm Lazard.
“Access to secondary liquidity has become a standard tool in the portfolio management arsenal alongside direct markets,” Jacobs notes. “We focus on the quality of the underlying asset and whether it is sustainable and fit for purpose now and in the future. The market is huge; there are a lot of great assets, portfolios and platforms out there that need additional capital to maximise their potential.”
In contrast to the post-financial crisis period, real estate secondaries transactions are no longer necessarily synonymous with distress. CBRE IM focuses on stressed capital stacks rather than stressed assets, says Gandhi. “In this environment, the stressed capital stack allows us to acquire positions at discounted prices that provide exposure to preferred segments with stable, high-quality assets.”
Normalize NAV
Secondary interests in private real estate funds trade at a discount of around 10% under normal circumstances, but significantly higher haircuts are available today: according to data from Ares Management, portfolio prices for 2023 ranged from 15% to 85% discounts to NAV on an all-cash basis.
“Through much of 2023, GPs are still right-sizing their NAVs to reflect current values, which has resulted in large visual discounts and large bid-ask spreads,” Creed says. “As NAVs normalize, we believe bid-ask spreads will normalize as well.”
26%
Investor-led deals increased last year compared to the previous year
There's also room for significant growth. Historically, 1% of real estate NAV has traded in the secondary market, while private equity secondaries have averaged about 2%. Even assuming a 1.5% trading rate, that would translate to annual real estate secondaries volume of $14.25 billion. Creed expects at least a 45% year-over-year increase from 2023 onwards, and believes that figure could even double. “The combination of frozen capital markets and challenging fundraising markets has created a perfect storm for real estate secondaries,” she says.
U.S.-focused partnerships have traditionally led real estate secondaries transactions, accounting for 62% of total volume in 2023, compared with 32% in Europe and just 6% in Asia. Farrelly says Europe is certainly poised to catch up in the coming years, given the growing demand for special situations capital.
“With debt rising by roughly $250 billion over the next four years in key European markets alone, we expect to see a funding gap of $50 billion to more than $100 billion over this period,” Farrelly noted. “A secondary program would help address this gap from a recapitalization perspective. There are so many moving parts, but even at the low end of the range, it's a very large opportunity to address.”
One urgent capital need that is often overlooked is green capital investment, he explains: “In the European context, I think you'll find a lot of structures that are lacking what they need to future-proof their assets. There will be very specific needs in that regard.”
“Beds and huts” continue to be a trend this year in both primary and secondary markets, along with data centers and healthcare facilities, but Lazard is neutral on the sector type. “We target large, deep, liquid market and sector situations that are experiencing growth or positive tailwinds, typically based on favorable demographics and/or positive supply-demand imbalances,” James says. “We try not to generalize. I wouldn't say there's nothing to do in office or retail. I love office and it's not dead. But you really need to understand the asset, the submarket and the business plan.”
“If you have the right type of office in the right market, configured in the right way, with the right ESG credentials that can attract the right tenants, it can be a really good investment strategy. The same is true for retail.”
Summary in Action
Smaller large US investment firms such as Ares, Brookfield, Blackstone and StepStone continue to dominate the global real estate secondaries market. In Europe, Partners Group stands out as a specialist firm, while Aquilias Investment Partners is one of the few real estate secondaries investors with capital dedicated to opportunities in the Asia-Pacific region.
While both Europe and Asia are poised for growth, the U.S. dominance is unlikely to change anytime soon, Farrelly said.
“Any multi-manager group with a strong European focus will do secondaries as part of their day-to-day operations,” he said. “Some have dedicated programs for secondaries, others don't, but at the end of the day it's part of the overall indirect investment opportunity set, whether that's a primary fund, a co-investment or a JV. This has been the case for many years.”
Still, Farrelly sees opportunities for more specialised European players to enter the space: “We're entering a one- or two-year vintage of fantastic acquisition opportunities, many of which I think will revolve around recapitalisation opportunities, which I think will become a more permanent feature of the European market. We're already seeing a wider range of special situations funds and value-add/opportunistic vehicles doing these and the grey areas where groups run into each other will be very real in today's market.”
In a clear sign of investor appetite, two of the largest fundraising deals in 2023 took place in the secondary sector of the market. Though 2023 was the worst fundraising year for private equity real estate in the past 11 years, according to PERE data, real estate secondary funds saw a significant increase in the amount raised, with the percentage committed to the strategy rising from 0% in 2022 to 6% in 2023. Ares' Landmark Real Estate Fund IX closed on $3.3 billion in December, and Blackstone's Strategic Partners Real Estate VIII closed on $2.6 billion in November.
“This reflects a need and an opportunity given the current market environment,” Jacobs said, “although there are many more secondaries funds in the overall private equity market. In that respect, the real estate secondaries market remains challenging.”