Second to none

With the market dislocation ringing in the ears of general partners and the denominator effect impacting investors, the real estate secondaries market is set to expand five-fold over the next two years, with up to $5bn of trades expected each year. Experts argue it could eventually be half the size of the $15bn private equity secondaries market. By Zoe Hughes

The stars are lining up for the private equity real estate secondaries market, according to industry professionals. In just a few years, what was once deemed an unpredictable, and unsustainable, marketplace is turning into the darling of the private equity real estate world. As the world's capital markets run for cover and real estate valuations are reassessed, players in the secondaries field are suddenly in demand. Lots of demand.

Since last summer's credit dislocation, industry professionals have seen a significant increase in interest in their activities. Last year, there was an estimated $1 billion (€644 million) of trades in the real estate secondary market. Over the next 18 months to two years, experts predict that it could be as much as $5 billion.

“What we are seeing in the market is a significant need or increased perception for liquidity. More and more investors are concerned about the liquidity of their holdings in private equity real estate vehicles. The secondaries market is a financial alternative for them.”

There are many reasons why the secondaries market has suddenly increased in importance. From the need for financial institutions to re-evaluate their assets to institutional investors feeling the impact of the denominator effect, the secondaries market is now needed like it has never been before. Robert Dombi, partner of secondaries firm Landmark Partners, predicted at a recent New York real estate conference, “the stars are lining up” for the industry.

The US private equity real estate secondaries market, in particular, can trace its origins back to the real estate crisis of the late 1980s and early 1990s, when 26 of the country's largest investment managers, consulting firms and pension funds decided to form the Institutional Real Estate Clearinghouse. Formally launched in 1994, the IREC was intended to stem the bleeding of the real estate fund industry by establishing a secondary marketplace where investors could obtain detailed information on existing private real estate funds and trade fund interests.

Its online electronic trading platform, in the early days of internet accessibility, however proved ultimately unworkable for the industry and within five years of being established the IREC was dissolved. Its failure was in part owing to the reluctance of investment managers to provide information for dissemination, but also because a rising market discouraged sellers from ever learning how to use the online system. In the three years before it closed its doors for good, the IREC – together with Cantor Fitzgerald, the broker-dealer hired by IREC – completed just $300 million of deals. All, however, were executed privately and without the assistance of the IREC's screen based system. What the IREC drew attention to though was the ultimate viability of a secondary market in the private real estate world. It wasn't until the late 1990s that trading in private equity-style real estate funds started to take hold, although by all accounts trades came in “fits and starts” and by no means presented a sustainable living.

Across the Atlantic, the same slow start was being experienced in Europe, namely the UK where the majority of secondary real estate trades take place. The industry had followed in the footsteps of secondary trades in open-ended funds during the early 1990s, and by the end of the decade the transfer of interests in closed-ended real estate funds had begun to take off so that a viable, albeit small, industry had established itself by the turn of the millennium.

Value-added and opportunistic private equity and real estate funds compared

Private equity Real estate
Cumulative amount committed to funds since 1990 $1.6 trillion $384 billion
Number of fund managers Approx 3,000 Approx 400
Number of dedicated secondary market buyers More than 40 5
Secondary transaction volume since 1990 Approx $54 billion Approx $5 billion

The right price?
The key issue for limited partners and secondary market investors though has to be price. In the UK alone, the weakening market fundamentals and the credit crunch have had a dramatic impact on the pricing of real estate secondary interests. According to Clarke, it depends on the information available on the underlying assets. With regular reporting of net asset values (NAV), firms entering the secondaries arena in the 2001-02 era saw interests trading at a one to two percent premium to NAV. During the rising market of 2004 to 2006, premiums were up to 12 percent of NAV. Today, however, discounts are the norm. In fact some fund interests are being offered with as much as a 25 percent discount to NAV.

Uncertainty is the factor behind discounting. When a secondaries fund is unable to ascertain the true value of the underlying asset, or as in the current market, future returns are seen as less predictable, fund interests may be sold at discounts. In real estate markets in the US and Europe though, Clarke says, the level of transparency to secondary buyers is relatively poor. In more transparent markets such as the UK investors have access to quarterly and monthly reports, cash-flows, NAVs and comparables. Core real estate assets are, by their nature, easier to price than value-add and opportunistic assets, where an element of subjectivity can be at play.

Of course, current market conditions, Clarke says, have also created a “mismatch” between the number of sellers, the supply-side of the secondaries market, and the number of firms able to buy the interest, the demand-side. It is prompting many to make “cheeky bids,” Clarke says, “to see how desperate the sellers are.”

“As more capital flows into emerging markets, so too will emerging market secondaries grow. At the end of the day, the secondary markets mirror the primary markets they serve.”

That dislocate between supply and demand though is one of the factors the industry is set for a rapid expansion. As the private equity industry sees the growing opportunities to be had in real estate, so the number of general private equity secondary firms and fund of funds entering the space will grow.

Gerardo Lietz says she expects “many more entrants” in the field over the coming months and years, something Stevens says he also expects to happen. Although secondary firms argue the barriers to entry are higher for real estate secondaries than their private equity cousins, not least the need for a firm grasp of real estate economics, the growth of the industry is inevitable.

A liquid future
And one guaranteed area of growth is that of Europe and the emerging markets. Simsbury, Connecticut-based Landmark last month announced their plans to expand their European secondaries activities with the appointment of former DTZ Investment Management executive Paul Parker. Parker, who led DTZ's multi-manager and fund of funds business, argued at the time of the announcement that pricing adjustments on the Continent and in the UK would present the secondaries industry with “valuable opportunities.”

As the overall secondaries real estate market grows, so will the number of trades taking place in the UK, and across much of Western Europe. One factor, he argues, is that a lot of European investors have been traditionally focused on investments in their domestic markets. The emergence of investment markets such as China, Brazil and India, particularly over the past 12 months, has seen an increasing number of Europeans look to diversify their portfolios by reallocating funds into markets that didn't previously exist.

“It's almost a case that investors in unlisted vehicles hadn't contemplated any liquidity in the market place, but as portfolio managers re-evaluate their strategies and realize the need and desire to manage and trade their investments, as now they are being motivated to do, it's really going to drive the market.”

But it is the speed with which the real estate secondaries market is expected to catch up with the private equity secondaries market (it is generally believed to lag about five to seven years behind), that Parker says will be most interesting to watch. “We are some distance behind private equity but the speed with which real estate catch's up will, I believe, surprise us all. The current market is small but when you look at how much investors are holding and how much volume is in the secondaries real estate market relative to that universe, its minimal. In that way the future is going to be very exciting because the opportunities for both existing and future investors are there.”

For Landress and Giller, emerging markets such as Mexico present even more exciting possibilities. The firm recently closed two investments targeting the country's growing middle class and its need for new real estate. “Whenever we enter new markets we spent a lot of time upfront assessing the economic, demographic, political and real estate market risk. We are looking at these first two investments as a beach head into the Mexican market,” says Giller.

The majority of Liquid's equity is currently committed to funds and partnerships operating outside the US, according to the duo. And although primary real estate funds have only just started targeting emerging markets, such as Mexico, Landress argues emerging markets will be a big topic of conversation for secondaries over the next five years. “As more capital flows into emerging markets, so too will emerging market secondaries grow. At the end of the day, the secondary markets mirror the primary markets they serve.”

And when PERE data shows the top 30 private equity real estate firms raising an aggregate of $190 billion in the primary market over the past five years alone, the secondaries market can expect to witness a rapidly changing future.