This article is sponsored by Landmark Partners, an Ares company
As recently as 2005, real estate secondaries was a tiny, niche market with only $300 million traded worldwide. But in less than two decades, its increasing popularity as a portfolio management tool has driven enormous growth in the sector, particularly in recent years.
“If you look back over the past decade, in 2012-16, the average annual volume traded was $4.9 billion. In the five years since then it has averaged $7.5 billion,” notes Michelle Creed, a partner at Landmark Partners, part of the Ares Secondary Solutions Group since its acquisition by Ares Management Corporation last year. Creed, and her fellow partner James Sunday, tell PERE about the drivers for expansion of the sector and gauge the likely effect of the pandemic on future dealflow.
What is the trajectory of growth in the real estate secondaries market?
Michelle Creed: Growth started to take off after the global financial crisis, but it really hit its stride in the last few years. In 2021 we saw $10.6 billion in total global transaction volume. That was a banner year for the market and a 24 percent increase over 2020, which was also a record year at $8.5 billion.
The number of transactions has also increased. In 2021, 153 deals were completed, the highest number on record. There were 114 in 2020, and prior to that the highest year was 127 in 2019, so those annual records are all clustered within the last several years.
The GP-led side has certainly been a big contributor to that growth. Two-thirds of the total volume in 2020 and 2021 came from the manager-led space. GP deals have grown by 38 percent on an annualized basis over the past five years.
Despite a pause in LP-led transactions during the pandemic, the LP side has continued to mature and expand. Increased activity in both segments has now coupled together to produce excellent prospects for growth.
What will provide the impetus for future growth?
James Sunday: The underlying drivers for growth in secondaries transactions are the base of outstanding net asset value held across real estate funds, and the overall utilization of the secondary market by both LPs and GPs. At the end of last year, the outstanding base of NAV across closed-end real estate funds was over $800 billion, $90 billion of which was held in more mature funds that are over eight years old. On top of the $800 billion of NAV there is an additional $400 billion of uncalled capital available which will add to that NAV base over time.
Five years ago, the outstanding NAV base was $550 billion, so there has been a 45 percent growth over that period. This growth is due to increased capital flows into real estate funds and capital appreciation that has taken place in sectors such as logistics and multifamily. It should be noted that the NAV figure does not include the trillion-plus dollars held in non-fund vehicles such as separate accounts, co-investment vehicles, joint ventures and private REITs, which also contribute to transaction volume.
As for measuring the overall utilization of the secondary market, we compare the total annual transaction volume with the base of outstanding NAV every year to calculate the real estate secondary turnover ratio. In real estate, the turnover ratio has averaged about 1 percent over the past 10 years. In private equity secondaries, which is a much larger, more mature marketplace, the turnover rate has averaged about 2 percent. This tells us that private equity LPs generally have been more proactive in utilizing the secondary market to manage their fund portfolios, and GPs have been more active with fund recapitalizations and continuation vehicles to manage their legacy funds and investments than real estate has been.
However, in the real estate secondary market last year, the turnover rate increased to 1.3 percent, so it is trending in the direction of private equity. There is still a gap, but we believe that gap will close over the next few years.
What has been the impact of the pandemic on real estate secondaries?
MC: While investors utilize the secondary market as a portfolio management tool throughout all cycles, macro events generally create an additional catalyst for secondary market transaction volumes, albeit with a lag. Investors reassessing their portfolios in the wake of these events can employ secondary solutions to address problems that arise. At the height of the pandemic, LP portfolio sales were essentially halted, simply because it was too difficult to gauge pricing. As the market stabilizes, managers are adjusting NAVs to reflect current market values, so transaction volume on the LP side should ramp up.
In 2021 many of the recapitalizations were in pandemic-resistant asset classes like multifamily, life sciences and industrial. About 74 percent of recaps were in those in-favor sectors. The buy side could really lean into the underwriting of those sectors with conviction.
JS: On the other side of the equation are the funds that have exposure to covid-impacted property sectors such as office, retail and hotels. As we come out of the pandemic, more mature funds that have exposure to these sectors likely now need more time to stabilize their assets and reach a point where they can maximize value.
We are already seeing an increase in recapitalization opportunities with funds that have some exposure to covid-impacted property sectors. In these situations, the GP is looking to proactively provide a liquidity option to LPs that may have been in the fund for eight, nine or 10 years and would like the opportunity to exit. In most cases, the LPs that decide to ‘roll’ and stay in the fund usually also agree to a multi-year term extension in order to provide the fund sponsor with enough time to finish the business plans.
Do GP-led transactions retain the characteristics that typically attract capital providers to secondaries investing?
MC: Yes. It is possible to construct a portfolio including GP-led deals in which the cashflow has the characteristics of J-curve mitigation that investors in secondaries have typically enjoyed. The investor still has the opportunity to get a quick payback, whether that is through income or asset sales.
Even GP-led deals that require growth capital can have some level of seasoned exposure, providing potential distributions to investors in the early stages of a continuation vehicle. Given the seasoned nature of these portfolios, they are substantially de-risked and provide for a shorter-duration strategy than one might see in the direct market.
JS: Whether it is an LP portfolio or a GP-led recapitalization, we seek to acquire exposure to more seasoned real estate assets at some discount to intrinsic value. In GP-led transactions where the LPs are making the decision to either sell or roll, oftentimes there are non-economic factors driving an LP’s decision to sell. In addition, it is not uncommon for the key decision maker at the pension fund or endowment to be different than the decision maker who makes the original commitment to the fund. Therefore, these factors can lead the ‘sale’ decision by the LPs to be less about price and more driven by administrative and/or portfolio management objectives.
In GP-led transactions involving the sale of a portfolio or property from a fund to a continuation vehicle, a fund sponsor’s motivation oftentimes is to generate liquidity to their legacy fund vehicle while continuing to manage and operate the assets on a go-forward basis. It could take months to hire a broker and market a multi-property portfolio for direct market sale, and transaction costs can be high. A recapitalization transaction can be more time efficient and less costly than a direct market sale. Therefore, a GP-led transaction involving a direct sale of a portfolio to a continuation vehicle can offer an attractive investment opportunity to secondary buyers, but can also offer a good outcome for the LPs in the underlying fund.
What are the main risks facing real estate secondaries investors?
MC: The devil is in the detail in terms of assessing the risk of the underlying real estate. Secondary buyers must have a team that is fluent in real estate from a technical standpoint. Applying a broad-brush approach to underwriting may lead to missing something that could impact cashflows in a detrimental way. Equally important is underwriting the manager. The manager will be in place for the long run and must have the proper ability and incentives in place to achieve the objectives of the business plan.
JS: A common mistake that we have seen in the past is for investors to feel good about a large ‘optical’ discount, to the extent that it becomes the driver for their investment decision. Fund NAVs are backward looking, and property values can be inflated, so you need to underwrite each of the assets in the portfolio from the ground up to determine future cashflows and the appropriate price. That can be tricky with traditional LP stake sales because information quality can be variable. You really need a deep team that has direct real estate experience and the relationships in the property markets to fill in the information gaps.