By Scott Koenig
We believe slowing activity in direct property markets will increasingly push real estate funds LPs and GPs to seek liquidity in the secondary market.
The sharp rise in interest rates and macroeconomic uncertainty over the past year has given commercial real estate (CRE) buyers a pause and substantially slowed the pace of CRE transactions. In the first two months of 2023, CRE transaction volume in the US fell to its lowest level since 20141while in Europe volumes in 1Q23 slid to an 11-year low.2
With market conditions not forecast to change meaningfully anytime soon, investors in CRE funds hope that asset sales will facilitate distributions or redemptions may be waiting for some time. And as rates remain higher and some lenders stay on the sidelines, we believe cash-out refinancing is likely to be few and far between.
Given this environment, we expect investors in CRE funds will increasingly turn to the secondary market for the liquidity that direct property markets are currently unable to generate. Factor in record-high AUM within closed-end CRE funds3as well as investors’ full allocation to real estate generally4and the potential for significant growth in the supply of secondary real estate opportunities appears high.
Of course, there may be a material gap between what secondary buyers are willing to pay and what investors are willing to accept; recent bids of 20-30% (or more) below par have not been uncommon, even for good assets5. Over time, however, we hope several factors will help bridge this gap:
- The longer investors go without seeing meaningful realizations from their existing CRE exposures, the more pressure some may face for liquidity. At some point, a specific cash need or other event may force some people’s hands.
- To the extent CRE funds mark down asset valuations, secondary bid-ask spreads should shrink, freeing those sellers who may have balked at large optical discounts. From the perspective of the secondaries market, the small average write-down among value-add and opportunistic CRE funds at year-end6 is a step in the right direction.
- As the Fed eventually ends its hiking cycle, market participants should gain more certainty over borrowing costs, cap rates and valuations, giving everyone more confidence to make investment decisions.
How long these factors will take to play out is uncertain, but, in our view, one thing remains clear: Investors’ desire to get liquidity from CRE funds is not abating, presenting providers of liquidity – ie secondary buyers – with an exciting opportunity in coming years.
Sources: (1) Green Street transaction data, as of 5/1/23; (2) PERE News, April 28, 2023; (3) Preqin, as of 5/1/23; (4) Hodes Well & Associates, November 2022; (5) Based on NBAA market observations and analysis as of 5/12/23; (6) Burgiss, as of 5/1/23.
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