In this third extract from The Secondaries Market, published in early December, James Sunday and Min Zhou of Landmark Partners look at pricing and outlook.
Real estate secondaries pricing
Pricing levels have generally improved over the past five years
Landmark has built an extensive database of secondaries pricing across 781 funds (including non-discretes) between 2010 and 2015. Overall, pricing levels have improved since the global financial crisis, although the observed pricing ranges are wide. The overall improvement in pricing levels is a result of improved real estate fundamentals, deleveraging, acceleration of fund distributions, as well as the ‘appraisal lag’, a phenomenon discussed in more detail below.
Dissected by geographic exposure, US-focused funds have priced better than Europe- and Asia-focused funds over the past three years (2013, 2014 and 2015). The stronger pricing of US-focused funds relative to Europe- and Asia-focused funds is consistent with the relative strength of underlying real estate market fundamentals in those regions and, more recently, the negative impact of currency movements in funds with non-US exposure.
As detailed in the previous section, there has been a notable increase in large transactions with at least $200 million of NAV. Some of these large transactions utilised deferred payment transaction structures. In 2015, portfolio pricing for larger diverse portfolios utilising deferred structures ranged from 85 percent to 100 percent of NAV (see Figure 12.8).
Appraisal lag has contributed to improving secondaries pricing and increasing transaction volume
In December 2015, Landmark published a white paper titled Valuation Trends and the Pricing of Real Estate Secondaries, which details our finding of the appraisal lag experienced by private equity real estate funds relative to both public real estate investment trusts and the direct transaction market, utilising three years of data between 2012 and 2015.
In the analysis, three indices, FTSE NAREIT All Equities, Burgiss US Real Estate and Landmark Adjusted CoStar Repeated Sales Total Return Index, are used as proxies for public real estate, private equity real estate fund and direct transaction market values, respectively.
As illustrated in Figure 12.9, private equity real estate funds have experienced valuation lag relative to both public real estate and direct transaction market values since 2009.
Because the adjusted CoStar Repeated Sales Total Return Index is constructed to measure actual property sales, and the FTSE NAREIT Equity REITs index is actively priced based on the underlying trades of its underlying securities, Landmark believes the appraisal-based nature of private fund valuations accounts for this lag.
The period since 2009 coincides with an unprecedented increase in transaction volume in the real estate secondaries market. As previously noted, appraisal lag (or the lack of) is one of the determining factors in secondaries pricing. When market evidence exists indicating that properties are being liquidated at prices that exceed their prior quarter valuations, secondaries buyers may be more willing to underwrite value growth, which leads to improved pricing. Improved pricing enhances the likelihood of successful completion of a transaction which, in turn, encourages more potential sellers to come to the market, therefore driving secondaries transaction volumes.
Robust transaction volumes are expected over the next three years, driven by broad seller motivations
The secondaries market has experienced a significant amount of transaction volume growth over the past seven years with 2015 seeing a 70 percent increase in volumes from the prior year. Coming off such a great stretch and blockbuster year leads to the question: here does the market go from here?
Taking an academic approach and applying normalised NAV turnover rates to the current base of outstanding NAV yields approximately $15 billion to $25 billion of aggregate transaction volume over the next three years. This is considered a healthy level of transaction volume, but the high end of the range implies annual transaction volumes in line with 2015. That said, this range may prove to be somewhat conservative, based on the current market trends and themes discussed below.
Seller motivations have and continue to be very broad-based. The following are a few current themes that Landmark anticipates may drive significant transaction volumes:
- Public pension funds: Over the past four years only six US public pension funds have transacted in the real estate secondaries market, leaving a large number of pensions with substantial legacy portfolios which have yet to be rebalanced. Last year’s two mega transactions are anticipated to act as strong catalysts for other public pensions to sell.
- GP/sponsor-led transactions: Fund recapitalisations and other GP-led transactions represented only 5 percent of 2015 volume versus 20 percent seen in private equity, but this has the potential to materially increase in the future. There is over $170 billion of NAV held in funds that have reached, or are close to reaching, their legal term. Investors are becoming fatigued and frustrated in dealing with these funds.
- Portfolio management: The real estate secondaries market historically has lagged the private equity secondaries market in terms of overall market acceptance as a portfolio management tool. Over the past few years, however, the real estate secondaries market gained a lot of visibility and validation. This, coupled with LPs’ increasing desire to more actively manage denominator issues, rebalance between different sectors and strategies, and reduce the number of GP relationships, should lead to significant transaction volumes looking forward.
As discussed throughout this chapter, the real estate secondaries market has experienced an unprecedented level of growth over the past few years. Below is a recap of six key trends:
- Growth in the secondaries market over the past few years has been very broad-based with a significant number of first-time sellers.
- US pension funds have led the growth of secondaries dollar volumes and are fertile ground for future market growth.
- There has been a notable increase in larger transactions and structured transactions.
- Recapitalisation and other GP-led liquidity solutions are still in the infant stage of development, but are poised to experience substantial growth given the large base of NAV held in expired funds and increasing LP fatigue.
- A few leading dedicated secondaries buyers drove a significant amount of transaction volume over the past few years given the increase in large portfolio transactions, which have required well capitalised and resourced buyers to successfully execute these transactions.
- Secondaries pricing continues to be wide ranged but generally improving thanks to a number of factors, including appraisal lag.
In conclusion, the real estate secondaries market has come of age and is generating a significant amount of annual transaction volume. Going forward, transaction volumes are anticipated to remain very robust with strong prospects for continued growth as more public pension funds look to manage their portfolios and GPs look to restructure mature funds.
Benchmarks are provided for illustrative purposes only. Comparisons to benchmarks have limitations because benchmarks have volatility and other material characteristics that may differ from the portfolio. Also, performance results for benchmarks do not reflect payment of investment management/incentive fees and other fund expenses. Because of these differences, benchmarks should not be relied upon as an accurate measure of comparison.
The NAREIT Equity REITs index is composed of securities that are actively priced in a liquid stock market. Total returns are therefore comprised of (i) an income return and (ii) market price return based on a daily closing price.
Burgiss’ Private iQ database provides return information on over 900 closed-end private real estate funds across vintages ranging from 1980 to 2015.
Burgiss US Real Estate is a benchmark constructed by Landmark using data from Burgiss to represent returns of private-market US real estate funds. Includes all vintages, industries, fund sizes and currencies.
The CoStar Commercial Repeat Sales Index (CCRSI) is constructed using a repeat sales methodology, widely considered the most accurate measure of price changes for real estate. This methodology measures the movement in the prices of commercial properties by collecting data on actual transaction prices. When a property is sold more than one time, a sales pair is created. The prices from the first and second sales are then used to calculate price movement for the property. The aggregated price changes from all of the sales pairs are used to create a price index.
The Landmark Adjusted CCRSI Total Return is an adjustment made to compare the CCRSI on a “like-to-like” basis with total return indices. Landmark levered the index 40 percent at its 2007 peak and held the loan balance constant thereafter. Landmark then appended a public-REIT income return so that the resultant index is a CCRSI “Total Return” leveraged equities index.