Investment Perspectives
Real Estate Secondaries are Transforming the Market
April 11, 2024 5 Minute Read Time
The cyclical tailwind of rising interest rates has been a catalyst for the increase in real estate secondary transactions, but other factors internal to the asset class are also powering secular growth. These structural factors are expanding and evolving the secondary market in ways that will drive long-term growth and transform the broader real estate market—even when interest rates eventually start to fall.
For buyers, real estate secondaries offer an attractive entry basis vs. primary real estate investments and can often be purchased at a further discount to intrinsic value. Equally important, real estate secondaries tend to be less risky because buyers are often entering an investment during the harvesting period; this mitigates the J curve, offers income from day one and limits blind pool risk.
Sellers include both limited partners (LPs) and general partners (GPs). LP sellers have come to the secondary markets over the past few years to meet liquidity requirements, implement a change in strategy or rebalance portfolios that are overweight to private market assets due to declines in public market valuations. GPs have used real estate secondaries to meet shortfalls during disruption in the debt and equity capital markets and provide term extensions when delayed business plans become misaligned with the existing capital structure and/or expectations of equity investors.
Increasingly, however, GPs have become savvier about using the secondary market to maintain control of their best assets through recapitalizations. GP-led transactions have driven significant increases in annual transaction volume over the past five years, which was previously dominated by LP transactions.
Reflecting this shift over the past decade, CBRE IM uses a purposefully broad definition for real estate secondaries that includes any transaction where equity is exchanged in the capital stack, but the operator or sponsor stays in place and maintains control over the real estate.
Classifying more types of transactions as secondaries offers a more realistic picture of the breadth and depth of the real estate secondary market. Accurately estimating the market’s size, however, is challenging since there is no comprehensive data set and many transactions are off market. While some sources estimate annual global transaction volume at $10-$15 billion, we think the market is two to three times that the size, considering the volume of recapitalizations that are not captured.
The secondary market transaction volume range could increase if the path is like private equity where secondary market activity increased with the growth of the primary market and now has a turnover rate of about 2%-3% of global private equity assets under management. Real estate secondary transaction volume—which we estimate at 1%-2% of the market—could realistically grow to 2%-3% of the $1,026 billion in unrealized value in private real estate funds and the more than $816 billion in non-fund structures.1
The secondary market is not just expanding, it’s also changing the entire real estate market. In addition to being used for liquidity, portfolio management and risk management, real estate secondaries are becoming an important way to access high-quality assets. As GPs realize they can continue to create value in some of their best assets by holding onto them and recapitalizing, investors cannot ignore the secondary markets when looking for opportunities in their preferred sectors. In fact, some prime assets may never trade in the primary market again.
Q&A on the real estate secondaries opportunity
Why are secondaries investments attractive now?
The current evolution in the real estate secondaries market coincides with the highest interest rates in a decade across many regions. CBRE IM forecasts suggest that although interest rates may have peaked, they may not come down as quickly as they rose or return to near-zero levels—a supportive backdrop for the secondary market. Given more reasons for secondaries investing and greater acceptance, secondary transactions may be less impacted by falling interest rates than in previous cycles.
Which assets are likely to transact in the secondary market?
At present, the fall-off in transaction volume has limited price discovery resulting in private real estate valuations still adjusting downward to reflect the current high interest rate. At this point in the cycle, only the higher-quality assets in more liquid markets, such as logistics, storage and residential, will transact—and typically at meaningful discounts. In this environment, underwriting is more challenging, benefiting experienced operators that can access preferred assets.
What are the historical returns like for secondaries investments?
Valuations are likely to further support real estate secondaries. As the real estate market bottoms, close to the peak of interest rates, secondary investments look increasingly attractive. Current discounts on prime investments enable secondary investors to get today’s real estate at tomorrow’s prices. Historically, secondary vintages when valuations are approaching a trough, have produced strong returns.
Investing in real estate secondaries around an inflection point requires two competitive advantages: access to high-quality assets through strong relationships with experienced operators in local markets and a deep understanding of the fundamentals and complex nuances of the real estate market. Investors need to be able to evaluate the price discount to real intrinsic value—not just the current valuation. Investors also need to ensure that the transaction aligns with their strategy, determine an eventual exit strategy and in some cases, take advantage of the ability to recast the governance. Opportunities often have a short execution window, requiring a local team that can mobilize quickly.
The secondary market is increasingly providing access to some of the highest-quality assets in the broader real estate market at discounted prices with less risk. Investors will want to pay careful attention to this growing area of the market at all points in the cycle.
1 National Council of Real Estate Investment Fiduciaries (NCREIF), as of March 2024.