The Rise of Secondary Funds in Private Real Estate: A Solution for Locked-In Investors

Investors in private real estate funds are facing a significant dilemma. As the prices of office buildings and other commercial properties continue to decline, many of their holdings remain locked up, potentially for years. This situation has created a pressing need for liquidity among investors who are eager to exit their investments. Fortunately, Wall Street has stepped in with a solution: secondary funds. These funds are designed to buy out private stakes that might otherwise be difficult to sell, albeit at a substantial discount. Recently, secondary funds focused on real estate have gained considerable traction, becoming a hot ticket in the investment landscape.

The Surge of Secondary Funds

In June, Goldman Sachs announced that it had raised a record $3.4 billion for its third real estate secondary fund, Vintage Real Estate Partners III, marking the largest such fund in Wall Street’s history. This impressive figure surpasses the $2.8 billion raised for its predecessor fund, which closed in 2020. Other firms are also following suit; StepStone is currently raising money for its fifth fund and has already exceeded the $1.4 billion raised for its last fund in 2020. Additionally, Ares raised $3.3 billion for its Landmark Real Estate Fund IX, while Blackstone completed $2.6 billion for its Strategic Partners Real Estate VIII fund.

The concept of a secondary market reflects Wall Street’s inherent drive to capitalize on shifting asset values, regardless of whether they are rising or falling. Financiers are adept at packaging and selling anything with economic value. When asset values decline, or when investors need to cash out and are willing to accept a loss, these financiers are quick to seize the opportunity, purchasing discounted assets on behalf of other investors.

The Need for Liquidity in Real Estate Investments

Investments in commercial real estate funds are notoriously challenging to liquidate. Private real estate investment trusts (REITs) and other funds that own properties such as apartment buildings, warehouses, and shopping centers typically lock in their investors—often pensions, endowments, or wealthy individuals—for five years or more. Even when investors are permitted to withdraw funds, the size of those withdrawals can be limited.

As office and retail buildings face increasing vacancies, declining valuations, and high interest rates that strain building owners’ ability to manage debt, many investors are looking for ways to exit their investments. The substantial growth of private real estate funds prior to the market downturn has created numerous opportunities for bargain hunters.

Michelle Creed, a partner at Ares and leader of its real estate secondaries group, notes, “That total addressable market size has grown tremendously. There definitely is a heightened interest from investors to invest in this space.” According to MSCI, private real estate funds currently hold an estimated $393 billion in net asset value, a figure that has surged more than 70% over the past five years.

The Dynamics of the Secondary Market

The first half of 2024 has seen a buyer’s market emerge, with the average real estate secondary deal carrying a 26% markdown on the asset’s net value, according to an analysis by Jefferies. This environment presents an attractive opportunity for investors looking to enter the market at a discount.

Secondary funds offer several advantages over traditional investment vehicles like REITs, which often focus on specific sectors such as apartment buildings or data centers. Secondary funds provide broader diversification across regions and property types, with a typical fund holding stakes in hundreds or even thousands of buildings. Additionally, investors can bypass the riskiest stages of real estate development—the early years when fund sponsors are acquiring and developing properties. Jeffrey Giller, head of real estate at StepStone, emphasizes, “You’re coming in at a discount, and you’re getting a portfolio of more stabilized assets, probably with cash flow.”

The Impact of the Pandemic and Interest Rates

The COVID-19 pandemic has significantly transformed parts of the commercial real estate market, leading to diminished profits for investors in sectors like office buildings and retail complexes. However, secondary fund managers assert that the influx of capital into their sector is not merely a result of opportunistic investors seeking distressed assets. Mark Burton, who leads Blackstone’s real estate secondaries business, clarifies, “One of the misperceptions of the secondary strategy is that it is more of a distress play. It is not. In most instances, we’re providing liquidity to investors for assets that are actually doing pretty good.”

Even healthy properties can encounter funding gaps, particularly due to rising interest rates. As low-interest loans mature and property owners face higher refinancing costs, secondary funds can step in with cash and negotiate favorable deals.

Challenges and Future Outlook

Despite the growing interest in secondary funds, the dynamics of the market have shifted due to the effects of higher interest rates and the pandemic. Sponsor-led deals—those conducted directly with property developers and general partners—have become more prevalent, while transactions with passive investors (known as limited partners) have slowed. This slowdown is partly attributed to fund managers’ reluctance to reduce the stated value of their assets, which diminishes the incentive for investors to sell if they can afford to wait for a recovery.

The total transaction volume in the real estate secondary market reached $9.8 billion last year, a small fraction of the over $100 billion traded in the more established private equity secondary market. However, fund managers anticipate an increase in transaction volume this year, driven by the industry’s distress. Even if the Federal Reserve begins cutting rates, many borrowers with commercial real estate loans maturing will face significantly higher financing costs than they have experienced over the past 15 years.

As many real estate funds reduce distributions and limit withdrawals, investors in need of cash may find themselves compelled to consider selling their stakes. For the right discount, secondary funds are poised to swoop in, providing liquidity in a challenging market.

Conclusion

The emergence of secondary funds in the private real estate sector represents a crucial development for investors grappling with illiquid holdings amid a turbulent market. As these funds gain popularity, they offer a viable solution for those seeking to exit their investments while also presenting opportunities for savvy investors looking to capitalize on discounted assets. With the landscape continually evolving, secondary funds are likely to play an increasingly prominent role in the future of real estate investment.