Private real estate has seen a surge in manager-led sales of existing ownership interests in funds or portfolios in recent years, a trend that only deepened in 2022. Manager-led transaction volumes hit a record $9.5 billion – reaching an all-time high for the third year in a row, according to Ares Secondaries Group, the secondaries business of Los Angeles-based Ares Management. This represented a 35 percent increase from the $7 billion in deals that closed or were under contract in 2021, and a 46 percent annualized growth rate over the past five years.
Recapitalizations, moreover, accounted for 77 percent of 2022’s total real estate secondaries transaction volume, which itself reached an all-time high of $12.4 billion, up 17 percent from 2021. Transaction volumes were bolstered by several large-scale manager-led recapitalizations, including two valued at more than $1 billion.
One significant change occurring with recaps, however, is that a growing number of investors are now opting out of staying in.
“Oftentimes, these recapped assets or portfolios or companies are assets that the managers want to continue to manage and think have long-term value,” says Bill Thompson, co-head of the real estate capital advisory business at investment bank Evercore. “The thought is that the manager will stay involved, and a number of existing investors will elect the option to stay involved. What’s actually happening in this market is a number of investors are electing to take the liquidity option. Investors are saying, ‘I’ll take cash versus staying involved in this investment,’ even though they are quality investments with long-term growth potential.”
The percentage of investors opting for liquidity on asset deals increased from 64 percent in 2021 to 78 percent in 2022 across private markets, according to Evercore’s 2022 Secondary Market Synopsis. However, Thompson estimates that sell rates were even higher in real estate, hitting the 90 percent range. “The second half [of 2022] was higher than we’ve ever seen,” he says.
Thompson attributes the increase in overall sell rates partly to the lack of liquidity in the broader market. As to the fact that sell rates are even higher in real estate, he says there are more significant liquidity issues at play. “I think real estate transaction flow slowed down more precipitously than on the private equity side,” he explains. “So that would suggest that LPs in their real estate portfolios have received fewer distributions and therefore they’re viewing this liquidity mechanism as an alternative to a sale. So, fewer sales in real estate, hence more interest in selling in a recap situation.”
Thompson expects LP sell rates will decline after transactions start to pick up again and investors receive liquidity through traditional sales. Investors “don’t want to necessarily trade out of these assets, particularly if they’re high quality and have tremendous performance potential and [are] difficult to reproduce. So I think that will change. The sell rates are a function of the current dislocation in the market.”
‘The challenge is valuation’
In a capital-starved environment, “usually what you find is people will try to raise liquidity from anything that is liquid first,” says Marc Weiss, chairman of Swiss investment firm Partners Group’s private real estate business. However, “the challenge is if you tried to recap a portfolio today, I query if you’re recapping it off of a stale value or not. The challenge is valuation at the end of the day.”
Partners has not closed on any recaps recently because of current dynamics around valuation, adds Weiss. “We think that there [are] a lot of sponsors trying to hold on to higher marks,” he says. “And I suspect appraisers are going to force that through adjusting discount rates to reflect higher borrowing costs.”
He expects that most sponsors will wait to see what year-end values look like before deciding whether to go out to market with a recap opportunity: “They themselves want to have something to try to hang their hat on to for valuation purposes. So I do think there is going to be a lot of transaction activity, probably starting in the middle of this year.” Another significant change in recap transaction activity this year is expected to be driven by sponsors needing to refinance assets, rather than a fund coming to the end of its investment life, according to Weiss.
Until interest rates began to spike in mid-2022, virtually all recapitalizations were end-of-life situations. “Today, what you see is not only end of life, but you see imminent refinancings triggering the need for a recap,” he notes. “If I have a big loan coming due on a portfolio of assets at a super low borrowing rate, I know I’m going to replace that with higher cost of debt. That is indeed a trigger point to start discussions around these types of transactions.”
Flip to refinancing
Pre-interest rate spike, Weiss estimates that nearly 80 percent of recaps were tail-end transactions. Now, he expects that percentage to flip to refinancings by year-end.
He adds: “This is what I think is going to greatly turbocharge the business in the latter half of this year, and it’s going to continue. You went from 3-4 percent borrowing to 5, 6, 7 percent borrowing. That’s a big change. And that’s all going to reset values, that’s going to require more equity, depending upon your gearing level. So I do think that catalyst for transaction volume is going to continue until interest rates start coming back down.”
Even as recent as early 2022, property owners were acquiring assets with low-cost debt that likely had a five-year term. If the asset has a growth trajectory backed by strong tailwinds, the borrower could potentially refinance at the same cost level in five years’ time. If not, “you could see these types of opportunities still existing as far out as 2027,” says Weiss. “But the peak of it is probably going to be in the next couple of years.”