Secondaries Investing Is an Underutilized Risk Mitigation Tool for Real Estate Investors

Interested in real estate secondaries investment? Click here for more secondary market insights.

A conversation with Kilian Toms, Managing Director—CBRE Investment Management, Real Estate Partners strategy, and Michael Yang, Senior Managing Director—CBRE Investment Banking, Head of Secondaries and Liquidity Solutions

1. Participants on both sides of the real estate secondaries market agree that the market has been growing in recent years but that it’s hard to measure. Why is that the case, how do you attempt to measure it and how big do you think the market is?

KT: The market is difficult to measure because a lot of transactions never hit the open market. The trades are completed between private buyers and sellers and don’t even get reported in the press.

The definition of a secondary transaction is evolving as the market itself evolves. We consider secondaries to be any transaction where equity is exchanged within the ownership structure of a real estate asset, which includes recapitalizations.

When we consider all the various kinds of transactions and add in our market knowledge of transactions that never go public, we estimate that real estate secondaries transaction volume is probably two to three times the 2023 $9-$10 billion reported range.

MY: Another way to estimate real estate secondaries transaction volume is to think of it as a growing portion of the over $400 billion direct real estate transaction activity. Historically, once an owner/operator achieved its goal with a real estate asset, it was sold. Now, liquidity does not need to come from an outright sale; instead, it can come from a recapitalization of the equity capital stack.

Owners are making strategic decisions to hold onto assets longer. Secondary transactions allow investors to tap into a portion of the direct market. The market itself is dynamic and evolving to meet the needs of buyers and sellers.

KT: We are training AI to identify secondary transaction reports from multiple news sources and then merge and structure the information into a deal list. We combine that list with the private transaction list our team maintains, which is critical because so many transactions don’t get publicly reported. In 2023, our team conducted detailed reviews of the full output list and are continuing to conduct sample tests. We are excited at the prospect of being able to more systematically measure and maintain a database of secondary transactions.

2. What’s been driving the increasing interest in real estate secondaries?

MY: The interest in real estate secondaries is being driven by the ability to create liquidity under different market conditions while also providing access to great assets that otherwise would not be available for sale in the direct market.

There’s been a perfect storm of macro and market factors driving the need for liquidity in real estate. Rapidly rising inflation led to swift interest rate hikes that led to lower valuations across all real estate sectors. Public market valuations adjusted faster than private markets, leaving many investors suddenly overweight in private assets—the denominator effect.

Whether investors need to rebalance portfolios or simply need liquidity outright, it’s created strong demand for secondary transactions. The only way to generate liquidity for private investments in closed-end vehicles is through secondaries.

KT: Picking up on Mike’s comment about access, secondaries are increasingly viewed as a way to access prime assets, some of which many never trade on the primary market again.

The appeal of secondaries, however, goes beyond accessing the highest quality assets and operators. Secondaries have several attractive characteristics that differentiate them from primary transactions and make them a valuable complement to a traditional real estate allocation.

3. What are some of those differentiated characteristics that make secondaries complementary to primary real estate investments?

KT: Secondaries offer investors a later entry point into an investment, resulting in advantages.... A portfolio of more mature assets that are already generating cash flow mitigates the J curve typical of private investments. Investors also know the actual assets and can underwrite them with greater conviction.

MY: The most underappreciated benefit of secondaries is their risk management capabilities, especially in an uncertain environment. In secondary transactions, investors partner with an existing owner, who has perfect information. Full transparency into operations, allows for pro forma underwriting versus using estimations. Combined with less J-curve risk, better visibility on cash flows and a shorter duration of the investment, secondaries can provide downside protection and help mitigate risk in a portfolio’s real estate allocation.

KT: Secondaries also provide other financial benefits. Assets are typically purchased at a discount and get marked to market value on day one, providing an immediate uplift to a portfolio. Secondaries may come with historical financing. In an environment where real estate prices are still adjusting down, the combination of the price discount and lower financing costs means secondaries investors may be able to purchase assets today at tomorrow’s prices with yesterday’s financing rates.

4. Interest in secondaries has increased while primary market valuations have been adjusting down. Where are we now in the real estate cycle? Looking ahead, is it still a good time to invest in secondaries?

MY: Pinpointing where we are in the real estate cycle is difficult. We can use the NCREIF Fund Index—Open End Diversified Core Equity Index (NFI-ODCE) as an indication. The NFI-ODCE first turned negative in Q3 2022. Since then, valuations have declined 19% through Q1 2024 but with wide variation between sectors—office declined approximately 38%, while industrial declined only around 10%.

We are still in a price discovery phase—assets may unfreeze and trade depending on expectations of where the borrowing rate will land. On the transaction side, investors are not willing to take on negative leverage. For most sectors going through repricing,... entry capitalization rates need to readjust to a 6% cap environment, which requires time to filter through the asset base. We see some investors pacing their investments prudently through the cycle with dollar cost averaging.

KT: Going back to Mike’s comment about the differences in price adjustments between sectors, we see a continued bifurcation of asset-based occupier preference. Even in our preferred sectors—for example, logistics—we see the difference between modern and legacy assets magnified in asset underwriting. We think this bifurcation will characterize the next cycle and that investors will have to drill down to the individual real estate asset level when making decisions.

This is an extraordinary time to be investing and unique to what we have seen over the past 10 years, at scale. The current pipeline of deals looks similar to what we saw after the 2008-2009 Global Financial Crisis—we can buy real estate with core-like attributes at pricing that generates enhanced returns without having to bet on the direction of cap rates. The potential exists for above-average returns with further upside potential, given where cap rates could go. The assets are ones we want to own; not distressed assets. Historically, these environments have been great vintage opportunities.

5. How would you describe the current market activity in real estate secondaries? What kinds of transactions are you seeing?

KT: A year ago, the bid-ask spread was extremely wide and the direction and magnitude of valuation adjustments were unknown. The recent documentation of some valuations has helped unlock transactions. Whether the bid is the same or slightly lower, buyers and sellers are striking deals.

Uncertainty is fueling innovation spurring conversations with sponsors around a variety of creative, collaborative solutions. The market is different from earlier days when deals may have been viewed as special situations with a more opportunistic angle. Today,... we are able to position ourselves as a thought partner with an operating mindset—given our CBRE DNA—and work to solve liquidity needs with investors.

One example of a solution is where the seller provides financing at a rate that is better than what can otherwise be achieved through open market financing. We’ve also been able to help an operator plan for the future by selling some assets that were concentrated on its balance sheet. We expect that as investors increasingly understand the potential of the secondaries market in solving a wide range of liquidity and strategic needs, we will see even more of these types of transactions.

MY: One important barometer is that $8.5 billion of capital dedicated for real estate secondaries was raised in 2023. Investors are becoming more aware that it is an opportune time or vintage to deploy capital in a market that requires liquidity.

We are using secondaries to create dynamic solutions that are structured to help investors obtain some liquidity in an uncertain environment with a level of protection. A preferred equity structured solution can create a partial liquidity event for the existing asset holder, which may be enough to get through the current market environment while ensuring a reasonable return.

The private equity (PE) secondaries market has grown significantly and generated a lot of investor interest. Is this a playbook for real estate secondaries?

MY: The growth of secondaries is a derivative of the growth in private market assets, which now exceed $10 trillion. Real estate is about 10% of that total, or roughly $1 trillion. A portion of that market has the potential to trade in the direct or secondaries market.

The PE secondaries market is a decade or two ahead of the real estate secondaries market; it’s more mature and transaction volume is ten times larger. PE is a great sector to learn from because a lot of the innovative tools we are now using for real estate came from the PE secondaries market. Currently, continuation funds are a focus in real estate, but they have been long-established in PE.

KT: The PE market has been innovative and a good leading indicator. However,... to be successful in real estate secondaries, investors must focus on the actual assets. PE investors can take a more top-down approach. In real estate secondaries, thematic investments must be combined with bottom-up analysis. Performance is driven by operations that cascades down to the asset level. Understanding the intrinsic value of assets is critical to underwriting.

MY: Real estate is also becoming a more complicated asset class—transactions are taking place not just at the property level but at the entity level. Many more opportunities now have both a propco and opco element, making transactions more complex.

KT: This is especially true in some of the key sectors—data centers, self storage and single-family rentals—they have gotten more operationally intensive and complex. Managers of secondaries need expertise and more sophisticated tools to manage these opportunities.

7. In a few summary words, how do you see the real estate secondaries market continuing to evolve?

MY: Investors and asset owners are becoming more informed about the potential for real estate secondaries to generate liquidity and returns. While the tremendous amount of capital invested over past cycle will continue to fuel growth in transaction volumes, secondaries are also increasingly being viewed as an essential tool for managing risk. This shift in investor mentality will drive continued innovation that drives further growth as existing asset owners recognize additional paths to exiting investments.

KT: We think the growth of real estate secondary transaction volume is at an inflection point. Increased utilization means that a larger share of assets is trading in the secondary market. That growth, combined with increasing complexity, is going to require a higher level of expertise and customized solutions. Investors in secondaries need to conduct due diligence down to the asset level. Good operating partners will be absolutely critical. We see an increasing role for thought partners,... who can provide liquidity solutions with sponsors/operators that are specialists in their markets.