Threadmark on navigating a ‘red hot’ market

This article is sponsored by Threadmark

When Anne Gales took on her first real estate secondaries client in 2006, most of her time was spent educating investors on what the strategy is, let alone why it would be a good fit for their portfolios. Eighteen years and several multi-billion-dollar funds later, the appeal of real estate secondaries is broadly understood and becoming more evident by the day. Gales is the London-based co-founder of capital advisory group Threadmark, working with John Scott, a New York-based managing director for the firm. They note that secondaries funds are having a critical moment today – not only for raising capital, but also for deploying it.

Many have been predicting a major buying opportunity for secondaries funds since the onset of the covid pandemic. Has that moment arrived, or is it still on the horizon?

Anne Gales: It is red-hot right now, secondaries funds are committing capital and most of these groups started to invest at the end of last year. In general, the fewer financing and liquidity solutions available, the better for secondaries, so the opportunity set is exceptional right now. It is very different from the primary market, where people are still waiting to see where the bottom is on pricing.

John Scott: There is a lot of GP-led activity going on in the US right now. Continuation funds are a similar strategy we are seeing a number of managers use as we speak.

What strategies and property types are driving this activity?

JS: Certain real estate sectors are poised to outperform. Data centers and general digital strategies are prime examples, and industrial continues to perform solidly. Multifamily is going through a big repricing, but the long-term fundamentals remain intact. The office sector, however, is one that has fallen off in desirability; it will likely take some time to work through the issues in that sector.

Secondary funds are unfortunately not a silver bullet for the US office sector. There is very limited liquidity in the office sector now and I do not believe there is going to be much trading in the sector anytime soon. Very few institutional investors are looking to take on additional exposure to the office market, not at any discount.

 

 

 

 

 

 

 

“We expect things to remain red hot in 2024 and stay hot into 2025”

Anne Gales
Threadmark

AG: Secondary funds are not just looking for the most beaten-up situations where they can get the biggest discounts. Managers go through the same filtering of risk-adjusted returns that happens on the primary side to build a diversified portfolio. Sometimes these managers go through hundreds of opportunities to find one they like. We see investors that want to commit to the current vintage, with lower valuations, after sitting out the past year or two, but they are struggling to form a view on where to invest. They are generally focused on investing and discounts, downside protections and relatively short durations, so secondary funds fit well at this point in the cycle.

What does a secondary fund bring to the table that opportunity and credit funds do not?

JS: Flexibility across the capital stack, for one. Often, there is not the immediate need to agree on a valuation today for secondaries transactions. It is more of a case of setting promoted interest and earning your respective share of returns, if it all goes according to plan.

“In many ways, secondary funds are seen to be more flexible and more creative than the other strategies”

John Scott
Threadmark

A dominant theme in the market today is that we have moved to this new higher interest rate environment, which means a lot of property owners and their portfolios need to be refinanced. Secondary funds compete against opportunity funds and real estate credit funds to address this opportunity. In many ways, secondary funds are seen to be more flexible and more creative than the other strategies when it comes to offering solutions to GPs in these situations.

AG: An opportunistic fund manager wants to have control across the board, over all the assets; they do not necessarily play well in the sandbox with other parties. Secondary groups do not want to give away all the control, but they will gladly allow GPs to handle the day-to-day business.

A critical component within these transactions is the diligence that a secondary manager will do on the GP, and whether or not they believe in that group’s ability to execute. Because an opportunity fund is, more than likely, looking for total control, it is a very different decision. That is why secondary funds are playing so well right now, because GPs want these kinds of warmer solution-oriented partnerships to sort out the funding gap versus outright sales at low valuations.

Does this dynamic make sourcing deals more challenging for secondary platforms attached to firms that are also active on the primary side?

AG: Many factors should be considered. However, it can be a little bit harder for platforms that also have value-add and opportunistic funds, as they could be perceived as competitors. It is a consideration when you bring in a secondary group – do you want one that is not active in the primary side at all, or are you more focused on a group’s expertise regardless of whether it has a primary business? It is a partnership with two sides that really need to work together on a transaction. The group that is perceived as more co-operative and creative usually ends up being the preferred partner. It is not just the group, either, it is also the people within that group.

Have LP-led secondaries transactions seen an uptick in activity?

JS: We have seen some pickup in LP-led secondary activity, but there remains a bid-ask spread between buyers and sellers. There is a lot of uncertainty about where the cost of debt and corresponding cap rates will be in three to five years’ time. Also, there has been an acceleration in determining which sectors are desirable and will outperform, and which sectors are going to underperform or are no longer desirable.

AG: Good deals can be done on the LP side, but the GP side is more attractive right now, and that is a market where it is typically much harder to be active. When the markets are going up, GPs can easily tap into a liquid debt market or other sources of capital, which makes things tougher on secondary funds. In a market where everything stops and financing is not available, that is when the GP recaps become crucial.

Why have so many primary fund managers expanded into the secondary space recently?

AG: Every down market doubles the number of players in the secondary space. In the early 2000s there were two, and then the down market in 2009 pushed it to four or five. Another down market happened and now we are at around 10 key groups. Over time, we will probably have 20 or 25 respectable players in the real estate secondaries market, each one serving a particular opportunity set.

There have been quite a few acquisitions in this space in recent years, because it has become more interesting across the board to have real estate secondary activity in their business. And that is true for even the larger players. These platforms would not enter the market if they thought this was just a temporary product, one that is in demand for two years then goes away. They are seeing it as a valuable commodity.

For now, there are still just a handful of groups that are very active in real estate secondaries, which is very different from the value-add market where there are several hundred in the US and between 50 and 100 in Europe that are continuously looking for deals. There is a competitive advantage in having to compete with fewer groups that makes secondaries attractive across the board. Once we get over 25 significant secondary groups, that dynamic might change a little.

What are your expectations for the secondaries market through the rest of 2024 and beyond?

AG: We expect things to remain red hot in 2024 and stay hot into 2025. Then, depending on how the rest of the world looks, the opportunity set might become a bit more neutral. Even then, I expect the secondaries space to remain active, but with more of a focus on identifying groups that have strong business plans but cannot raise capital for whatever reason.

While the opportunity set now might be working with big managers with big problems, perhaps in the future the market shifts to focusing on the mid-market players or going back to operators. The target market might be slightly different in some of these vintages, but I do not expect it to drop off. There will continue to be a need for flexible capital after 2025.

JS: Also, the LP-led secondaries market should normalize over time as interest rates trend down and buyers’ and sellers’ expectations further align. There is some uncertainty about how quickly, and to what extent, that neutralization occurs, but it seems to be trending in that direction.