July 25, 2018
By Tim Bodner, US Real Estate Deals Leader
With the rise in secondary market transactions1 over the last decade, one industry is challenging the conventional view that such deals aim solely to “cut your losses.” Real estate secondary market transactions represent the purchase of investment positions in property portfolios and/or single assets from existing investors, primarily fund interests. Until recently, market opinion held that a secondary trade indicated the seller’s error in underwriting the original investment. That belief likely formed in the wake of the 2008-2009 financial crisis, when institutional and other investors used secondary transactions to exit their illiquid real estate holdings and suffered losses. But as the market continues to mature, the view that secondary transactions are reserved for distressed assets is changing, and some of the world’s leading financial institutions and investors are taking notice.
Real estate secondary transactions are often consummated at a discount to the net asset value (NAV) of underlying assets. Secondary markets, or “secondaries,” first developed in the 1980s2, but activity didn’t pick up until the years leading up to the financial crisis3. And the sentiment around secondaries typically wasn’t favorable.
That feeling is shifting as activity increases. The real estate secondary market saw a record 108 transactions in 2017 – up 10% from 2016 – with deal value totaling more than $6 billion, according to Landmark Partners, a private equity and real estate investment company specializing in secondary funds4. Secondaries deal value in the current decade has consistently trended upwards (see graphic below), increasing from an average of $2.8 billion in 2011-2013 to more than $6 billion in 2014-20175. Even more notably, the last three years saw transactions from some of the premier real estate institutions, including The Blackstone Group, CalPERS, Harvard Management Company and the Government of Singapore Investment Corporation (GIC), which further signaled the legitimacy of the secondaries market6.
What’s driving this surge? Portfolio management strategy, not distress selling. Current sellers are mostly focused on three things:
- Reducing the number of general partner relationships and, in turn, fees paid to fund managers.
- Redeploying capital into direct holdings that allow for more decision-making power.
- Alleviating regulatory pressures by reducing the number of private market investments.
The opportunities to achieve these objectives through the secondaries market have drawn deal flow from a number of pension funds and sovereign wealth funds seeking to simplify their real estate portfolios, consolidate relationships with managers and reduce management fees. The increased volume from institutional investors has now brought market makers into the secondaries space, and all participants are seeing greater liquidity and a more narrow spread.
Benefits for buyers and sellers, but also unique challenges
The secondaries market offers unique advantages to both sellers and buyers hoping to capitalize on the current real estate environment. Many of the fund interests being brought to the secondaries market in recent years have a common vintage: Funds that originated between 2005 and 2007 and typically hold a diversified portfolio of real estate assets across core subsectors, such as office, retail and hospitality, in primary markets10. The secondaries market allows investors with holdings in these funds to exit part of their portfolio so they can reallocate capital to other opportunities, such as direct investment in real estate assets, including assets in emerging markets and niche subsectors (e.g., student housing, data centers and single-family housing.)
The growth of the real estate secondaries market has also been a boon to buyers, particularly those who historically haven’t had a significant real estate footprint. For these investors, the ability to buy interests in commingled funds with a focus on core property types and markets presents an opportunity to invest in stable, cash-flowing real estate properties in gateway cities at reasonable prices. This can be particularly attractive when considering the cap rate compression over the past 4-5 years for assets in primary locations, combined with the discounts to NAV that are still common in the real estate secondaries market.
The market also presents unique challenges. For example, while many secondary transactions still close at a discount to NAV, these discounts aren’t as high as when the market first emerged. Further, investment vehicles coming to the secondaries market are typically past the initial investment period and may have only a few years left in their life cycle, which results in less time for the buyer to realize the desired return on investment. Given the fact that a secondaries transaction results in an investment in an established portfolio of real estate assets, combined with a potentially shorter investment horizon, both buyers and sellers need a more granular understanding of real estate fundamentals. That includes information on the microeconomics of individual markets and asset-specific characteristics. This understanding can ensure that a particular transaction aligns with the entity’s overall portfolio management strategy.
Opportunities beyond direct investors
The secondaries market also is growing in prominence and impact on indirect participants. For example, institutional investors’ use of secondaries to trim the number of fund manager relationships – reducing management fees – may present opportunities for future consolidation within the fund management industry. In addition, investors’ need for more detailed local market and asset information creates a strategic advantage from building relationships with individual managers to capitalize on their skill and expertise. On the other hand, fund managers are using the secondaries markets to provide more options for their investors. For instance, some fund managers are trading assets from a fund near the end of its term – thereby providing liquidity to investors who wish to exit the portfolio – into a new fund, which creates the prospect of holding assets beyond the original investment horizon.
As the popularity of the real estate secondaries market continues to grow, market participants should keep in mind that these transactions present a unique set of considerations with respect to tax structuring, valuation and accounting. Given the relative opacity of this market compared to primary real estate markets, investors need a thorough diligence process to assess a prospective transaction in light of their overall portfolio management strategy and return on investment requirements. In addition, secondaries market players should understand the income tax implications of buying or selling a real estate fund interest within a particular fund structure; the existing structure may be optimized for the original fund investors and could carry unforeseen consequences as a result of the tax status of the secondaries buyer.
With the right level of preparation, real estate investors can capitalize on the opportunities arising in the secondaries market and successfully navigate the expanding landscape of real asset investment options. To find out more, visit PwC’s Private Company Liquidity web page.
Lauren Furlan and Olga Vasilieva, Capital Markets and Accounting Advisory Directors, contributed to this post.
1 PwC’s Deals Publications. July 2017. http://www.pwc.com/us/en/deals/publications/private-company-liquidity.html.
2 Le, Adam. Secondaries Investor Si30. PEI Alternative Insight, September 2016.
3 Moylan, Andrew. “Historical Fundraising by Private Equity Real Estate Funds”. Preqin, March 2010, https://www.preqin.com/blog/0/2253/private-equity-real-estate-fundraising-0310.
4 Morris, Meghan. “Landmark: RE secondaries up 20% on heels of Harvard transaction”. PERE, January 2018, https://www.perenews.com/landmark-re-secondaries-20-heels-harvard-transaction/.
5 Chong, Florence. “Record number of real estate secondaries tracked in 2016”. IPE Real Estate, January 2017, https://realestate.ipe.com/news/markets-and-sectors/record-number-of-real-estate-secondaries-tracked-in-2016-corrected/10017367.article. PwC calculations.
6 Chong, Florence. “Motivational shift: Institutional investors are selling LP stakes more for strategic than distress reasons, points out Strategic Partners’ Mark Burton”. PERE Secondaries Report 2015, December 2015 / January 2016.
7 (Chart) “Funds in market. Growing in popularity: timeline of top 10 fund closes.” PERE Secondaries Report 2016, December 2016 / January 2017.
8 (Chart) Witkowsky, Chris. “Landmark closes eighth real estate secondaries fund on $3.3 bln”. PE Hub Network, April 2018, https://www.pehub.com/2018/04/landmark-closes-eighth-real-estate-secondaries-fund-3-3-bln/.
9 (Chart) “Strategic Partners Closes Second Infrastructure Secondaries Fund at $1.75 Billion”. April 2018, https://www.blackstone.com/media/press-releases/article/strategic-partners-closes-second-infrastructure-secondaries-fund-at-$1.75-billion.
10 Chong, Florence. Refer to footnote 6 above.