Private equity real estate funds have been enjoying robust fundraising in recent years that has resulted in record high levels of assets under management. Yet fund managers are bracing for more challenges ahead that could cause them to lower target yields.
Globally, the private equity real estate industry reached $900 billion in assets under management as of June 2018, with a record number of funds actively raising capital, according to London-based research firm Preqin. The latest industry outlook from the firm also highlights some big obstacles ahead for fund managers that include high asset pricing and a potential market correction in the coming months that could negatively impact fund performance.
Property values have surpassed 2007 highs, and gateway markets in particular have experienced significant cap rate compression. Fundamentals have not fallen off a cliff by any means, but growth is slowing, notes Tammy Jones, CEO of Basis Investment Group LLC, a multi-strategy commercial real estate investment platform. “Most of the fund managers at this point of the cycle recognize that we are at a stage where the yellow lights are flashing and it is definitely a time for caution.”
Many funds were able to ride the market recovery up. Today, it’s harder because managers can’t underwrite the same rent growth assumptions and value appreciation that they did a few years ago. Most agree that opportunities still exist, even if it takes more work and creativity to find them. For example, funds that have been shifting their attention to secondary and the middle market are still finding ample risk-adjusted returns in cities such as Austin, Denver and Salt Lake City, where there is employment and population growth along with other demand generators, notes Jones. Basis closed on a $400 million diversified debt and structured equity fund, Big Real Estate Fund I, earlier this month.
Data on rolling IRR performance shows a slight decline with rolling IRRs that dropped from 12.2 percent in December 2017 to 10.1 percent in September 2018, according to Preqin. A December 2018 Preqin survey also revealed that two-thirds of fund managers bringing funds to the market have lowered their targeted returns as a result of concerns about high valuations and their effect on future performance.
“Given the long lifecycle of the industry, it may be some time before we see overall performance drop significantly, but the general consensus seems to be that funds raised today will not be able to match the returns of funds that are coming towards the end of their lifespan,” says Tom Carr, head of real estate at Preqin.
Funds leverage flexibility
To an extent, lower returns are a natural phenomenon at this stage of the market, when values are near peak levels and growth is slowing. However, some fund managers are adapting strategies to the current climate in order to meet or even exceed yield expectations. “Property prices are high, and underwriting is tightening, but we’re still seeing a lot of good opportunities across asset classes,” says Robert Lindner, co-founder with investment advisor Integrated Capital Management (ICM). ICM closed its debut real estate private equity fund in December with capital commitments of $30 million.
“I think we’re a little bit insulated from some of the problems that other funds are having,” adds fellow ICM Co-founder John Carrick. Specifically, the ICM fund is structured as a co-GP fund, which allows it share in some of the sponsor’s compensation in a deal. The fund was also structured with a broad investment mandate and is asset class-agnostic for commercial real estate, which gives it more flexibility to invest in different property types and geographic markets. The projects ICM is investing in are typically delivering IRRs between 17 and 20 percent over a three- to five-year period.
Such diversified strategies may give some fund managers an edge, because they do have more room to maneuver and can pick investments with the best risk-adjusted returns. For U.S. investors specifically, the rise of Opportunity Zones also creates an opportunity to pass tax relief on to investors. Managers can offer the same ultimate net gain to their backers without chasing higher up-front returns, notes Carr.
Investor satisfaction remains high
Certainly, not all fund managers are decreasing their targeted returns, and the pressure on future performance does not fall equally across the industry. “Core assets are facing the highest asset pricing, while more opportunistic strategies and more niche markets or approaches are likely to be somewhat sheltered,” says Carr.
In addition, investor satisfaction levels with real estate, especially relative to other investment alternatives, is holding up very well. According to a Preqin survey from December 2018, only 10 percent of institutional investors said that their real estate portfolio performance in the past 12 months had fallen short of expectations. Sixty-four percent said portfolios have met expectations and 26 percent said portfolios have exceeded expectations.
One of the things that is going to be a key differentiator for whether fund managers are successful or not in the going forward paradigm is underwriting discipline and protecting the basis, notes Jones. “Fund managers are really starting to focus on downside protection, while investors are more focused on defensive positioning,” says Jones. Investors are also looking for target returns that are sustainable, which for many fund managers means projecting returns that can be achieved over a three-year horizon.
“Investors want you to deliver what you say you’re going to deliver,” she adds.