Although real estate secondaries transaction volume has continued to rise over the past several years, the drivers of that activity are no longer the same, according to a new report released today.
During the recession, the primary groups of investors seeking early exits from real estate investments were endowments, foundations and other institutional investors that were overcommitted or in distress after placing disproportionate amounts of capital in alternative investments.
In fact, the overwhelming majority of sellers on the secondary market in 2009 were endowments and foundations, representing 82 percent of parties that were shedding real estate interests, according to a Partners Group report published today. Meanwhile, other distressed institutional investors – including individuals, family offices, funds of funds and hedge funds – made up an additional 10 percent.
However, “ongoing shifts in portfolio management and regulatory pressures on financial institutions are not only the primary drivers of deal flow in the current environment, but are also expected to drive future deal flow,” co-authors Marc Weiss and Fabian Neuenschwander wrote in the report.
Indeed, banks and other financial services firms and pension funds represented the largest groups of sellers in 2012, accounting for 35 and 30 percent, respectively, of the overall seller pool, the report said. This was a dramatic shift from 2009, when financial institutions made up only 5 percent and pension funds just 2 percent of sellers. A far more stark contrast, however, was in the sharp decline in foundations and endowments’ participation in the seller pool, shrinking to just 5 percent last year.
Meanwhile, secondaries trading volume has been steadily rising since 2007, reaching $2 billion in 2011, the most recent year with available data, according to the report. While few transactions closed in the aftermath of financial crisis because buyers required a high discount to net asset value that often exceeded 50 percent, that discount today has moderated for non-core real estate portfolios to a range of 10 to 25 percent, the report said.
Much of the surge in activity from public pension plans has been in reaction to recent market volatility, with those investors moving more capital to core investments and selling non-core investments in an effort to lower portfolio risk. Additionally, more market-specific concerns, such as overheating in parts of China or the future of the euro zone, have led some investors to sell real estate interests targeting certain regions.
Also, “many investors now recognize the opportunity cost of being saddled with legacy assets or commitments to managers with whom they do not plan to invest in the future,” Weiss and Neuenschwander wrote. “Combined with investor fatigue for assets of poorly performing vintage years (and their slow pace of distributions), this has led some to pursue large-scale liquidations.”
The largest driver of real estate secondaries deal flow last year, however, was regulations such as Solvency II and Basel III in Europe and the Volcker Rule in the US, which have and will continue to put pressure on financial institutions and insurance companies to unload private market investments. In fact, regulatory and liquidity requirements was the key motivation for 50 percent of sellers on the secondary market last year, according to the report.
However, while less prevalent than before, distress still remains a factor behind some sales on the secondary market. Many family offices and foundations still are carrying legacy investments that have become a financial strain to those organizations. “While some hope to recover values, many no longer have the choice to do so and must use the secondary market to create liquidity,” Weiss and Neuenschwander noted. Also, the longer investors avoid addressing issues such as excessive leverage, poorly timed investments or regulatory pressures, the more likely they will become distressed in the future, they said.