When it comes to private real estate investment activity, depictions of the market today are sounding bleak.
“Right now, we’re in no man’s land, where there’s just bid-ask spreads, and nothing much is trading,” says Jeff Giller, head of StepStone Real Estate, the real estate arm of New York-based private markets firm StepStone Group. Because of the higher financing costs that need to be underwritten, “when we’re on the sell side, we’re often being re-traded. We’ve pulled from deals, and we’ve had deals pulled from us on the buy side.”
One high-profile re-trade was London-based manager MARK’s sale of an industrial real estate portfolio spanning 128 buildings, six developments and seven European countries to logistics specialist Prologis for €1.59 million.
Between Prologis’s initial bid in February and the close of the transaction in September, the portfolio re-traded two times. “When we first talked about this deal, the bid-ask was pretty far apart,” Dan Letter, the firm’s global head of capital deployment, recalled during the firm’s Q3 2022 earnings call in October. But after negotiating two price reductions, “we were actually able to win that deal at a very favorable price.”
Against this backdrop, the number of active sellers in Europe has fallen to its lowest level since 2013, reflecting in part the regional economy’s greater vulnerability to energy price shocks, according to Tom Leahy, head of EMEA real assets research at New York-based index provider MSCI. “There’s a sense that property owners are not bringing assets to market unless they have to, and if they do, they’re having to take a haircut on the price.”
Meanwhile, global real estate transaction volumes fell 30 percent year-on-year during the third quarter in the wake of rising financing costs driven by rapid interest rate hikes and macroeconomic concerns, according to MSCI’s Q3 2022 Global Capital Trends report.
Global real estate performance is also slipping, with returns down 2.9 percent quarter-on-quarter in local-currency terms at end of the third quarter, according to the MSCI Global Quarterly Property Index. This marked the second consecutive period of slowing returns after the index reached a record-high quarterly return of 5 percent at the end of 2021.
“There’s generally going to be a reluctance to sell now,” Giller says. “Nobody wants to sell into a downward trending or depressed market.”
But while there is a freeze in many parts of the private real estate market, some property owners, however, are under pressure to sell during this period of uncertainty, sparking the beginnings of a sell-off of direct and indirect real estate holdings. PERE spoke with a dozen managers, investors and advisers on what is motivating a growing number of parties to sell.
“Generally, anyone who is really a seller right now is doing it because they need liquidity for some reason or another,” Giller says. He adds that leverage issues are “absolutely the main driver right now, but it’s coupled with more conservative underwriting assumptions.” These include increasing exit cap rates, reduced rental growth rates, higher interest rates and lower loan-to-value ratios.
“Anyone with refinancing dates coming up in the next six months is going to have far less favorable financing terms and may be seriously feeling a real pressure to sell,” concurs Steven Cowins, co-chair of law firm Greenberg Traurig’s global real estate practice. In his view, the most pressured parties will be open-ended funds. “If you look for who is going to be pushed to sell now, they’re going to be the start of it. And obviously, once those assets reprice, then it causes a ripple through the rest of the market.”
Cowins says he has heard estimates of more than £2 billion ($2.4 billion; €2.3 billion) in redemption queues for the UK open-end real estate funds. Those queues will result in either direct asset sales or secondary trades from the open-ended funds, he says.
His observation is echoed by Doug Weill, co-founder of New York-based capital advisory firm Hodes Weill: “We have seen redemption queues build up in open-end funds globally. That’s in part driven by some investors looking for liquidity.”
“This feels to me to be the early innings of another dislocation,” remarks Sarah Schwarzschild, co-head of BGO Strategic Capital Partners, the global multi-manager platform of BentallGreenOak. “The level of activity in the secondary market is shifting from those sellers that choose to sell to perhaps need to sell. I think it could be a generational opportunity in the real estate secondary market.”
“I think the more forward-looking managers will look to get assets on the market quickly, before the market really reprices”
Sales of limited partner stakes began picking up significantly in 2021. But those transactions were primarily for the purposes of portfolio management, such as an investor consolidating its manager relationships, she points out. “What has changed as of late – and I would say this is around the middle part of this year – is that the nature of the motivations is more related to wanting to raise liquidity, wanting to shore up balance sheets,” Schwarzschild says.
For LP stake sales, “the discounts have widened out quite dramatically,” somewhere in the range of 25 to 35 percent, if not more. “There is a price discovery that’s naturally happening,” she explains.
Schwarzschild expects to see significantly more dealflow in closed-end funds, whose investors lack other means of getting liquidity. However, investors in open-end funds could also put stakes up for sale if they are faced with liquidity issues and find themselves stuck in a queue or with the fund gated.
At the same time, she anticipates manager-led recapitalization activity will remain robust. “If you’re a manager with a good asset, and you don’t want to sell it and it doesn’t make sense to sell it, but you have to refinance, then potentially there’s a place there to do some sort of GP-recap, because you will need to fill in a place in the capital stack,” Schwarzschild says.
Colin Hill, senior vice-president at investment consulting firm Meketa, believes that loan maturities will spur more transactions that would involve bringing in another investor to plug the financing gap, rather than doing a full asset trade at a potential loss.
“I think there’s going to be a lot of recapitalizations opportunities without the property selling outright, and I’d expect to see more and more of that in 2023,” he says. “There’s a lot of dry powder on the sidelines, waiting to find a good entry point. And I think those entry points are going to be in these recapitalizations rather than outright sales.”
Better today than tomorrow
Liquidity is not the only main driver of sales activity, however. For Taylor Mammen, chief executive of real estate consulting firm RCLCO Fund Advisors, there are two other primary drivers for his clients – which include the Government Pension Investment Fund of Japan, California State Teachers’ Retirement System and Alaska Permanent Fund Corporation – to sell at the current time.
“The first would be because you believe that private market values haven’t been sufficiently impacted by whatever’s going on within the market,” he explains.
He points out the current disconnect between public REITs, which are trading at more than 30 percent below peak, and private market values, which remain positive. “Something’s got to give here, and it’s probably private market values.”
Even in deals where both parties have come to an agreement on price, the lack of debt availability remains a challenge in getting the deal over the finish line.
New York-based alternative asset manager KKR has circumvented these financing challenges in its European business by focusing on selling smaller assets of less than €200 million in value to core, unlevered or low-levered buyers.
“In this environment, I think size is not your friend generally, because of financing, because people are worried about making outsized bets,” says Guillaume Cassou, the firm’s head of European real estate. “It’s the €50 million to €150 million lot size rather than the €300 million or €500 million or a €1 billion-plus portfolios, which are going to be harder to finance and where the equity might be hard to find as well.”
As a seller, KKR is looking not only to unlevered buyers, but also buyers using lower levels of leverage. “Full equity constrains the size of what can be done, and you’re losing a bit on the optionality,” Cassou explains. A lower-levered transaction, similar to an all-cash deal, can be refinanced one to three years down the road when the financing markets have become active again.
Ben Sanderson, managing director of real estate at Aviva Investors, the global asset management business of UK insurer Aviva, agrees: “I think the more forward-looking managers will look to get assets on the market quickly, before the market really reprices, because you’re better taking a discount today off current valuations than taking a discount off a more heavily reduced capital value later.”
He adds that a mistake many people made during the global financial crisis was “they didn’t take their pain early enough,” whether from a valuation or a sales perspective.
This anticipated repricing is the primary reason why open-ended fund redemption queues have grown over the past couple of quarters, according to Mammen. “It’s going to take a little time to get any of that capital back, so better get in the front of the queue rather than the back,” he explains.
A related driver is the belief that a certain asset or portfolio of assets is at peak value today. This includes assets in favored and fairly liquid sectors, such as multifamily and self-storage, as well as assets in more challenged sectors such as office, where values are only expected to be lower in the future. “Better today than tomorrow,” Mammen says. “Even if your values are lower than what they were earlier this year, you’re still doing pretty well. You can sell that and free up some capital to have dry powder for better opportunities going forward.”
Hill adds that even if an asset – particularly one that is new and well-leased – trades at a lower price than it would have a year ago, that does not necessarily mean the property is sold at a loss: “There’s still the ability to put wins on the board without taking much of a markdown, because they were slow to mark up the properties. And things were happening so fast with value increases, those write ups were behind what was actually happening with trades.”
For StepStone Real Estate, this year’s planned sales were for properties whose business plans had been completed and were ready to be liquidated. Giller estimates roughly half were re-traded and ultimately were terminated; approximately a quarter maintained the firm’s desired pricing; while the remaining quarter were re-traded but still offered attractive returns to proceed with a deal. On the latter, he uses the baseball analogy of hitting a triple when one was expecting to hit a grand slam out of the park, but “even though it’s not a home run, it’s still pretty good.”
One of the most widely discussed drivers of selling activity has been the denominator effect. “Everybody’s overallocated because of declines in their public equity portfolio value,” Giller observes. “So they either have to stop investing or hit the sell button for balance.”
In its October 26 board meeting materials, the New York State Teachers’ Retirement System said it “was actively working to manage the overweight equity allocation down closer to its 11 percent target allocation.” In its bid to move back to target, NYSTRS disclosed plans to sell part of its $1.1 billion real estate portfolio of open-end funds, as well as selling relatively weaker performing or non-strategic properties, which it said were “overvalued compared to their public market peers.” The sales are intended to free up capital for net new investment of $495 million to $900 million in real estate equity in its fiscal year 2023, according to the meeting materials.
Not everyone views an overallocation to real estate as a reason to sell, however. Indeed, 21 percent of participants in PERE’s Perspectives 2023 study said they were overallocated to real estate – a significant increase from 9 percent in last year’s survey and the highest percentage since 2018. However, of those overallocated respondents, 44 percent said they planned to remain overallocated.
When asked about the survey findings, Hill notes they are consistent with many of the conversations Meketa is having with clients. “It’s ‘don’t overreact, but be patient,’” he says, adding that some institutions have considered expanding their target allocation range in real estate to avoid rebalancing out of a well-performing asset class. Many clients also expect private real estate values to moderate or fall in response to rising interest rates.
Meanwhile, Mammen says liquidity issues and the belief that today’s values are at their peak are more dominant drivers among RCLCO’s clients than the denominator effect. “With those two other motivators, there will be enough of those opportunities to bring the allocation within line,” he says. “So, you’re cutting the fat and not the bone in order to take care of the denominator issue.”
Also, chief investment officers do not necessarily want to make decisions based on what might be a temporary situation, Mammen adds: “The long history of the stock market suggests that after a year like this one, there’s probably going to be a rebound next year, or if not next year, the year after that, and then that’s automatically going to bring a lot of things back into compliance.”
While one large group of investors is opting to be patient, another large group is taking what Hill calls “soft actions.” These actions include slowing down the pace of new commitments and putting in redemption requests to open-end core funds, with investors expecting they can only receive 5 or 10 percent of that redemption amount in the next couple of quarters and that they can rescind that request if the markets rebalance on their own.
Who is buying?
But for sellers under various pressures to sell, the question remains the same: who is buying?
And just as certain parties are under pressure to sell, others are also under pressure to buy. One such group are buyers that need to find assets to purchase to fulfill a 1031 exchange, in which a seller can defer paying capital gains taxes on a real estate sale if the proceeds are reinvested in a similar property shortly after the sale. “They’re very much incentivized to find assets to buy,” says Matt Jackson, co-portfolio manager of US real estate at New York-based alternative investment manager Angelo Gordon. “We’re in situations like that in a few cases across the portfolio. It’s a more targeted approach to selling.”
“There are owners of assets that are under significant pressure, where we’re seeing discounts of, say, 30 percent off valuations”
In Europe, another group of so-called ‘forced buyers’ are French and German retail funds that raised record amounts of money in the first half of the year, observes Tristam Larder, head of European capital markets at London-based real estate services firm Savills. “They have to spend the equity raised because the longer it takes to spend, the bigger the drag on returns,” he says. “In this respect, they are motivated buyers because they need to get the money out into the market.” These retail funds typically look for relatively modern assets with good income profiles in logistics, hotels and offices and are seeking a mid-4 to 5 percent net yield on investments.
Other groups have different motivations to buy assets at the present time. Angelo Gordon has received particular interest in its real estate assets from unlevered buyers, which currently are benefiting from significantly reduced competition from levered buyers. “We’ve seen those buyers who don’t have to underwrite debt be much more competitive on pricing,” Jackson says. “It’s not just a pricing discussion. It’s also certainty of execution because debt markets continue to move around quite a bit. The benefit of unlevered buyers is they’re not subject to the whim of financing markets.”
Buyers seeking distressed opportunities are also becoming more active. Debt maturities that cannot be extended are already leading to more acute stress and distress sales, Jackson observes. “We’ve been in this world of ‘extend and pretend’ for so long, and it’s been easy to do that because rates have been so low,” he says. “Now it feels like it’s finally stopped. If you look at the cost of financing on loans maturing, it’s more than doubling.”
In fact, Angelo Gordon recently purchased its first property out of foreclosure since the GFC, a multifamily asset in Texas. “We would expect more of that stress in 2023 and beyond,” Jackson says.
Meanwhile, Singapore-based manager CapitaLand Investment acquired Borui Plaza, a prime office building in Beijing’s East Third Ring Road for 2 billion yuan ($280 million; €270 million) in a court auction in October. The asset was purchased at a 30 percent discount to market valuation.
“Absolutely, there are owners of assets that are under significant pressure, where we’re seeing discounts of, say, 30 percent off valuations in some instances, depending on the seller, depending on the pressure,” says Simon Treacy, chief executive of private equity real estate, real assets at CLI. “Clearly we have a full pipeline of opportunities that we’re seeing where the developers are under pressure, or there’s a loan-to-own situation from the banks or the music’s just stopped and they’ve got to sell it.”
In China, “it’s a multi-billion-dollar distressed equity opportunity” that began to emerge during the second quarter, Treacy observes. “Then in Q3, the wheels started to come off a little bit.”
He expects the opportunity to continue to unfold for some time to come: “That’s the thing on sellers’ minds – how long will this last? How bad will it get for them? Where do they pull the trigger? It might be through to the end of next year possibly, given the [country’s] ongoing stance on covid. There’s not much mercy for developers. So this window could be open longer than people think.”
Private real estate transaction activity is at an inflection point. Many buyers and sellers remain at an impasse over repricing in a rising rate environment, but some sellers are beginning to capitulate. With pressures mounting, more concessions are expected to come, along with an easing of the freeze that has gripped much of the market.