Investors in private real estate funds have a problem: Even as office buildings and other commercial property prices tumble, their holdings may be locked in for years.
Wall Street has the answer. They’re called secondary funds, and they exist to buy private equity that might otherwise be hard to sell — but at a significant discount. Recently, real estate-focused secondaries have become a hot ticket.
Goldman Sachs said in June it had raised a record $3.4 billion for its third real estate secondary fund, Vintage Real Estate Partners III — the largest fund in Wall Street history. (For the fund’s predecessor, which closed in 2020, Goldman Sachs raised $2.8 billion.) Another firm, Stepstone, is raising money for its fifth fund and says it surpassed the $1.4 billion it raised for its last fund in 2020.
The new funds follow the $3.3 billion that Ares raised for its landmark real estate fund IX, which closed in December, and the $2.6 billion that Blackstone completed in November for its strategic partners real estate VIII fund.
The concept of a secondary market embodies Wall Street’s drive for profit that changes regardless of whether asset values are rising or falling. Financiers will package and sell anything that has economic value to investors. If those assets fall in value or investors need to cash in and are willing to take a haircut to do so, the same financier will buy the discounted assets on behalf of others.
In the private equity and venture capital industries, Secondary markets is a long established fixture. They give people with shares in start-ups or private funds a way to cash out early by flipping their holdings to other buyers, who gain access to investments otherwise unavailable for purchase.
So is investing in commercial real estate funds Hard to sell: Private real estate investment trusts (known as REITs) and other funds that own properties such as apartment buildings, warehouses, and shopping centers are typically held by their patrons — usually pensions, endowments, or wealthy individuals — for five years or more. Lock keeps. And even when the investor is allowed to withdraw funds, That withdrawal size may be limited.
But investors want to exit as office and retail buildings, in particular, face rising vacancies, declining valuations and high interest rates that have reduced the ability of homeowners to cover their debt.
That, and the fact that private real estate funds grew so large before the recession, means there are plenty of opportunities for bargain hunters.
“The size of that total addressable market has grown tremendously,” said Michelle Creed, partner at Ares. “There is definitely a lot of interest from investors to invest in this space.”
The private real estate funds from which these secondary funds can buy now have an estimated $393 billion in “net asset value,” according to MSCI, a company that tracks private investments. That figure, which has risen more than 70 percent in the past five years, measures the value of buildings or other investments, after deducting debt and fixed costs.
It’s a buyer’s market: In the first half of 2024, the average real estate secondary deal had a 26 percent markdown on net asset value, Analysis by Jeffrey.
There are other reasons for investors to turn to secondary funds, Ms Creed said.
Compared to REITs and other more general investment vehicles that are typically focused on a specific sector, such as apartment buildings or data centers, secondary can provide investors with broader diversification across regions and property types. A typical secondary fund has stakes in hundreds or even thousands of buildings.
Another advantage to secondary funds is that investors can essentially skip the riskiest phase of real estate development, the early years when fund sponsors are buying and building, said Jeffrey Giller, Stepstone’s head of real estate.
“You’re coming in at a discount, and you’re getting a portfolio of more stable assets, maybe with cash flow,” he said.
The coronavirus pandemic has changed parts of the commercial real estate market, wiping out investors’ expected profits on some projects such as office buildings and retail complexes. However, secondary fund managers insist that the increased capital flowing into their sector is not driven by vulture investors.
“One of the misconceptions about the secondary strategy is that it is more of a distress play. Not so,” said Mark Burton, who heads Blackstone’s real estate secondary business. “In most cases, we provide investors with liquidity for assets that are doing really well.”
Even perfectly healthy properties can face a funding gap – a common consequence of high interest rates. When low-interest loans expire and property owners are forced to pay more to refinance, a subordinated fund can step in with the cash and cut the deal.
But the effects of higher interest rates and the pandemic on the industry have changed the dynamics of the secondary market. Sponsor-led deals — those done directly with property developers and with general partners of private funds, which manage real estate portfolios on behalf of their investors — have increased. But direct transactions with passive investors (“limited partners,” in industry parlance) have been sluggish, as fund managers have been reluctant to reduce the value of their assets.
That gives investors who hold stakes in those funds less incentive to sell, if they can afford to wait for a recovery. That could start when interest rates begin to fall, which is expected to happen later this year.
Publicly traded REITs quickly reflected the sinking value of their office and retail property holdings, but “private real estate managers were reluctant to start writing down those valuations as the super, correction loomed,” said Juliet Clemens, fund strategy research analyst at PitchBook.
Total transaction volume in the real estate secondary market was $9.8 billion last year. Data collected by Ares. That’s a sliver of the more than $100 billion that traded in the more established private equity secondary market last year.
Fund managers expect their transaction volumes to pick up this year, due to industry woes. Even if the Federal Reserve begins Rates drop this monthAs Fed watchers expect, many borrowers with commercial real estate loans reaching maturity will face steeper borrowing costs than most borrowing costs of the past 15 years.
And many squeezed real estate funds have cut their distributions and limited withdrawals — forcing investors in need of cash to consider selling their stakes. For suitable discounts, secondary funds are ready for entry.
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