When the upside is limited, there is value in downside protection

Long-term viability trumps short-term returns in a mature market as New Mountain Capital Partners’ oversubscribed first-time real estate fund demonstrates.

Facing the prospect of a near-term downturn, some real estate investors are taking their long-game approaches to new, lower risk-return levels.

A common theme during last week’s PERE Investor Forum in Los Angeles was how to invest in a mature market, one which is camping out on a cycle high plateau for an extended period. The current growth cycle shows no sign of faltering, but its continued protraction is providing little solace to those investors that feel a slowdown is inevitable. That cohort of institutions is seeking investments that can weather a turbulent market and emerge profitable, even if it means longer hold periods and modest returns.

“You have to have legs on the other side,” one investor said during the conference. “If I have to hold something during a downturn, I want to know we’re going to be OK because it’ll come back up on the other side.”

An example of this approach in action – and its evident appeal to investors – is New Mountain Capital Partners’ debut real estate fund. Despite being a new strategy for the New York-based private equity and private credit specialist, New Mountain Net Lease Partners $533 million and was over subscribed by more than $180 million, more than 50 percent.

PERE understands few investors had committed to the firm’s previous vehicles. Without a track record to fall back on, NMNLP secured capital by promising two things investors now crave: stability and longevity.

The fund will be used to acquire ‘operationally critical’ industrial properties from private equity-backed businesses. Those companies will remain as tenants on 15- to 20-year triple-net leases. New Mountain will cover few, if any, capital improvements, and though the firm says there will be opportunities for rent growth, the notion here is that, too, will be minimal. This type of sale-and-leaseback is essentially a bond play with the bonus of owning the underlying asset, which is what made it a fit for New Mountain in the first place. With the firm projecting the core-plus strategy to net value-add-like returns, it is easy to see why investors like it too.

Broader economic concerns aside, investors are still drawn to real estate. Many, in fact, are looking to increase their exposure to it. The problem lies in finding assets that will produce enough – and, in these days, the right – returns.

Prices continue to rise, albeit at a slower rate than recent years. Real Capital Analytics found that property values ticked up 5.8 percent year-on-year in the first quarter of 2019, the most modest growth since 2011 and tepid compared with the heady years of 2014 and 2015 when double-digit increases were common. Total transactions fell by 22 percent year-on-year last quarter as buyers and sellers failed to find common ground.

Real estate fundraising, however, remains robust, even if capital is diversifying more by vehicle type than ever before. Managers for traditional closed-end funds have actually closed on $39 billion thus far in 2019, according to PERE data, the most secured in a first quarter since 2015. Capital, however, has favored mega managers targeting multi-regional strategies at an unprecedented level – but the hunger for property is certainly alive and well.

Sweetheart deals are hard to come by in today’s real estate market, but that does not mean investors desire the asset class any less. While returns are king, managers should be alive to the benefits of downside protection in a limited-upside world.

To contact the author, email kyle.c@peimedia.com.