Are Private Equity Real Estate Funds Losing Their Edge?

Are Private Equity Real Estate Funds Losing Their Edge?

Real estate private equity funds have been enjoying tremendous success in recent years. Part of that success is clearly coming from stellar returns related to alternative investments. Yet intense competition and a maturing market may prompt both fund managers and investors alike to adjust expectations going forward.

Private equity funds have posted impressive performance results in recent years. According to London-based research firm Preqin, annualized private real estate fund returns over a three-year period stood at 16.1 percent as of September 2014. Going forward, the story could certainly take a different turn. One question is how much those returns owe to simply riding the upswing on a very strong real estate market, while a second question is whether value-add and opportunistic funds in particular will continue to be able to source what have so far been great opportunities.

“I think the general consensus is that returns should be declining for the real estate market in general going forward, and certainly for the opportunistic funds and the value-add funds in the closed-end space,” says Greg MacKinnon, Ph.D., director of research for the Pension Real Estate Association (PREA) in Hartford, Conn. No one expects a precipitous drop, but returns are likely to slide lower as the cycle matures and property prices continue to rise. “The low hanging fruit has been picked at this point in many ways,” MacKinnon notes.

Findings from PREA’s Q1 2015 PREA Consensus Forecast indicate that investor expectations are for real estate returns to slow over the next two to three years. On average returns for direct, unlevered real estate investments are forecast to be 10.6 percent this year, falling to 8.6 percent in 2016 and 7.7 percent in 2017. “I think that is entirely realistic. But then again, the market continues to surprise the upside,” says MacKinnon.

Opportunistic fund managers are adjusting target returns to slightly lower figures. Some fund managers who had been going on the road to raise funds predicting target returns of 20 percent are now lowering those projections to perhaps 15 percent, notes MacKinnon. “What I’m hearing from investors is that they appreciate that honesty,” he adds.

According to Preqin, the target net IRR for opportunistic closed-end real estate funds targeting U.S. investments has dropped slightly in the past two years. New funds launched in 2014 and 2015 have average target IRRs of 16.5 percent for both years compared to 18.0 percent in 2013 and 17.9 percent in 2012.

“In the private equity, opportunistic world, I think returns are generally holding up because of leverage,” says Brian Ward, president, capital markets and investment services for the Americas at real estate services firm Colliers International. Cap rates are continuing to compress. So yields are falling, but fund managers have also been able to bolster returns by deploying leverage.

Opportunistic investments are really being driven by an arbitrage play, which is the spread between cap rates and the cost of capital. Many of the more opportunistic funds are using short-term, floating rate debt and buying some kind of hedge or cap protection for a three- or five-year term. The difference between the short-term rate and the cap rate is pure cash flow. “So that is how the game is being played right now,” says Ward.

It is also important to note that private equity funds are typically a long-term vehicle. Given their seven to 10-year life, it takes several years before they start harvesting investments and distributing capital to investors, notes Peter Ciganik, a managing partner at GTIS Partners, a global real estate investment firm based in New York City.

In that respect, long-term private equity rates continue to beat alternatives such as the Russell 3000 and S&P 500 indexes based on 10-year returns. According to the latest Performance Update Report from the Private Equity Growth Capital Council, private equity funds invested by large U.S. pensions outperformed the public markets by 5.2 percentage points annually over a 10-year period. The median private equity benchmark return (excluding venture capital) was 12.8 percent, net of fees, over a 10-year period.

Reduced return expectations will likely be fairly easy to swallow for today’s investors who are well aware of market conditions, competition and the returns in alternative investment assets.

“While return expectations for every asset class come down towards the end of an economic cycle, we expect that real estate will continue to attract strong investor interest,” says Ciganik. “Investors will also turn to new markets, some of which have suffered in recent years, but have strong long-term fundamentals,” he says.

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