Consulting firm Ernst & Young recently published its Global Market Outlook 2016 report, which highlights key trends in private equity real estate. NREI talked with Mark Grinis, global real estate fund services leader at Ernst & Young to get more insight into the top 10 issues to watch in the coming year.
1. The China effect
Despite a positive outlook overall for the real estate fund industry, slowing growth in China is the big wild card in the global economy. There is a definite “real estate story” that comes into play in terms of supply and demand fundamentals. As evidence of this, China has been building the infrastructure and real estate equivalent of New York and London for each of the past five years. Ernst & Young rates a “hard landing” for the Chinese economy as the number one downside risk for private equity real estate funds in the coming year.
2. Reforms Open Doors to Foreign Investors
Proposed reforms to the U.S. Foreign Investment in Real Property Tax Act (FIRPTA) could allow for more foreign capital to flow into U.S.-based private equity funds. These reforms are still taking shape and private equity firms are waiting for greater clarity on what the final outcome and impact might be. However, the big picture is that the reforms will lift some of the traditional restrictions on the amount of dollars that foreign pension funds could invest in U.S. real estate, which had previously been capped at 5 percent.
The rule change would allow foreign pension funds to take larger positions, including positions of up to 100 percent, in joint ventures, properties and shares of real estate companies. It may not necessarily open the flood gates of foreign capital, but without question, the change in FIRPTA will allow for more capital to invest in U.S. real estate.
3. Growing Liquidity in Secondaries
In 2015, there was notable activity that occurred in buying existing limited partner positions in private equity funds. Some very sizable funds have been raised, which coupled with some investors’ desire to consolidate or streamline the number of managers they have, has led to more buying and selling of existing interests in limited partner positions. Those types of transactions are expected to continue in 2016. That activity is a positive for the broader private equity market as it brings more liquidity to a segment of the market that has typically been considered a niche business.
4. Privatization Deals to Continue
There were eight or nine transactions that occurred in 2015 that involved some type of public vehicle being taken private by real estate private equity. Ernst & Young expects 2016 to be as big or bigger in terms of such deals. That activity is being fueled by a number of factors, including real estate funds that have plenty of “dry powder” to finance these deals and attractive pricing within the REIT sector. In 2015, five funds raised 35 percent of the total capital raised throughout the year. These mega-funds will look for scale in their investment targets, and certain REITs in targeted sectors with a discount to NAV will be prime targets.
5. M&As Will be a Hot Topic
Real estate funds are not seeing a large volume of mergers and acquisition. But when they do occur, they are important transactions for the marketplace. That is something that we are going to see more of in 2016, and it is important for certain platforms that believe now is a good time to acquire some or all of a registered manager. The M&A activity could involve existing fund managers that are looking for a larger scale to their existing real estate platform; the opportunity to tap new markets or investors; or even make a first step into the real estate space. These deals can also come in the form of a strategic partner buying a portion of the manager.
6. More Access to European Capital
First drafted in the aftermath of the financial crisis, the Alternative Investment Fund Managers Directive (AIFMD) has been a work in process. However, it will likely receive more attention this year as have a clearer picture of how to access capital sources in Europe. From a regulatory standpoint, AIFMD provides a road map that enables funds to more effectively tap those capital sources and stay in regulatory compliance.
Preparing for a Dip in Foreign Fundraising
Some of the global dynamics, including lower oil prices and slower growth coming out of China, could create some softening in the total volume of foreign capital flowing to U.S. real estate in 2016. Domestic and foreign pension funds and endowments make up the bulk of capital commitments, and there is a lot of international money that will continue to seek the diversity and safe haven offered by the U.S. real estate market. So any decline in foreign capital flows will result in a drop in 2016 commitments, but not by more than 10 percent.
8. Rising Interest Rates
The Fed’s decision to raise interest rates by 0.25 percent in December has been widely anticipated in the marketplace. Grinis does not expect aggressive rate hikes to occur this year, given the backdrop of China and other indications that 2016 won’t be as strong as expected. The likelihood that interest rates won’t ratchet up quickly is good for the overall real estate market.
9. SEC Inspections on the Docket
SEC regulators will continue to take a closer look at the private equity real estate fund space. Given some of the high-profile fines that have occurred, it is not a particularly pleasant topic for the industry. However, regulators are working to better understand real estate as an asset class and the sensitivity among investors. The SEC has a large number of inspections on the docket for 2016, and as such, funds’ chief compliance officers should have a keen interest in gaining more insight into the areas that are a priority for regulatory professionals.
10. Outsourcing Comes of Age
This will likely be the year that more private equity real estate funds pull the trigger on outsourcing back office operations. Ernst & Young predicts that there will be a number of announcements in 2016 that are going to define the role of outsourcing within real estate private equity. In some cases, that shift is validating the idea that it makes sense from a cost and efficiency perspective for certain parts of the operation, such as fund administration, accounting or valuation, to be conducted by third parties.