In 2013, US real estate investment manager NorthStar entered the secondaries scene by landing portfolios with TIAA-CREF and the New Jersey Division of Investment in deals totaling nearly $2 billion. Its merger with Colony Capital to form Colony NorthStar last year has done nothing to abate its appetite in the space. Managing director and co-head of investments Robert Gatenio and senior vice president Bill Bowman say that, in fact, Colony’s experience as a primary investor has given the secondaries platform an added advantage in the marketplace.
PERE: Why did Colony NorthStar enter the real estate secondaries business?
Robert Gatenio: NorthStar executed two large transactions in 2012-13, at which time we thought the risk-return profile made sense due to valuation levels and the fact there were a lot more sellers than buyers in the market. It was a big bet, but we have done more than 15 deals and built a track record in the sector since then.
Bill Bowman: NorthStar’s balance sheet made those investments for the same reasons that any investor would. Buying into a secondaries pool provides diversity of geography, property type, investment style and manager. A secondaries investment generally occurs after fund investments have been made; therefore, the money tends to come back faster, so you can achieve attractive returns with less risk. The real estate secondaries market has been growing over the last 10 years or so but there are still a limited number of players. Firms like Colony NorthStar, a large publicly-traded REIT with an embedded investment management business, can invest on behalf of its own balance sheet as a public REIT as well as managing vehicles for institutional and individual investors.
PERE: What are the benefits of being a primary real estate fund manager and investor for operating a successful secondaries platform?
BB: Institutional investors have several different reasons why they might sell secondary positions: they might be looking for liquidity, to shed non-core managers or adjust their portfolio allocations. The use of secondaries has become an accepted portfolio management tool. The bulk of the secondary transactions that have been done are pre-financial crisis funds that are getting near the end of their life. In the future, we will see more fund restructurings where existing investors combine with new outside capital to buy out other investors, buy assets out of the fund, or set up a structure to hold assets in the fund for longer. Those transactions will be more asset-focused than some previous secondaries deals, so having experience as a direct real estate investor should be valuable.
RG: The leading contenders in the market are secondaries specialists, and most have real estate as a sleeve within the bigger secondaries bucket. As a commercial real estate-focused firm, that is our only focus when it comes to secondaries. Seeing commercial real estate through the lens of a lender, a borrower, an equity owner and an operator allows you to understand and underwrite the assets better. A large primary investor like Colony NorthStar looking at a specific asset in a particular market may have made a loan in that market or own an asset in it already, so it is able to leverage the associated infrastructure and knowledge base. Such an investor could bid on a property that is competing with that asset, so you will have an insight on how the asset is viewed in the market from your investment and management teams, outside brokers and networks.
For example, we were just looking at a pool with an investment in an office building in Ohio. We happened to own a subordinate debt on a property competing with it within one mile of that asset. We were able to call our asset manager up and get his view of the market. He put us in touch with two brokers and we got a sense of what the rents and rent-free periods are in that market. It gave us a boots-on-the-ground direct insight into how the property performs.
BB: Also, if you invest in commercial mortgage-backed securities, then in CMBS there is a wealth of information that you can get about property transactions, cashflows and rental rates. If you operate internationally, you have the knowledge and resources to look at a broader range of funds, whereas perhaps bidders with a domestic focus may only look at assets in one particular territory, precluding them from providing a total solution for the seller.
PERE: Thematically, what is the major difference between primary and secondaries investing?
BB: One of the key differences between primary and secondaries investing is that when you are an institutional investor investing in a primary fund you are making a bet on that manager’s ability to execute within a market through a specific strategy on a go-forward basis. It is a blind pool. However, when you buy into a secondaries transaction you are almost always past the underlying fund’s investment period, so you are underwriting identified assets. You are looking at the value of the assets today and what you think the value of the assets will be upon realization. The manager’s ability to execute the strategy is less important than on the primary side, except for the assets that have not yet reached stabilization.
Because you are investing in identified assets, the ability to underwrite those assets becomes more important. You are underwriting a cashflow stream based on less than perfect information, and the ability to do that accurately and well is the most important skill in these transactions. When you look at a secondaries investment, the information you are given is generally the quarterly and annual reports of the manager, and the range of detail and transparency you get across managers varies greatly. Some of that is a function of style or scale and the types of assets they may have. These limited partnership positions are illiquid, and it takes a fair amount of work to determine value in order to trade them. Having a greater depth of information is extremely helpful in wading through the range of detail you get in those reports.