COMMENT Private equity real estate has matured from an inflation hedge to a mainstream investment strategy over the past decade. Institutional investment into alternative asset classes such as real estate is now part of active portfolio allocations.
The past three years have broken historical records in the amount of money allocated to PERE both in terms of the volume and allocation. According to data released earlier in the year by Prequin, PERE fundraising hit a new high in 2019, with $151bn (£116bn) being raised by 295 PERE funds. By the end of 2019, 60% of raised capital had been deployed and 40% remained as dry-powder for execution in 2020.
In contrast, $148bn was raised by 486 funds in 2018. Fewer funds are now managing larger pools of money and they need to make this money work within the next three years.
The challenge of capital deployment was keeping the industry on its toes ahead of 2020. There was already a lot of capital chasing very few deals, resulting in cap rate compression. In 2019, $410bn of real estate transacted in the market. The transactional price paid increased by 6% as more capital chased real estate assets.
Then Covid shut the world down.
Changing risk profile
Valuations in 2019 were peaking. A dip in the cycle would represent an opportunity to finally make investments which could leverage off some distress and inefficiencies in the market due to the shock of the pandemic. But unlike a financial recession, the pandemic has been a double-edged sword as it has changed the risk profile of asset types and investment strategies.
In 2018, office assets represented the greatest share of PERE activity. The funds raised in 2019 are structured around trends of a pre-Covid built environment. Suddenly, no one knows how to value a core office asset anymore. The fiscal policy of most governments has propped up the markets despite the recessionary changes in the labour markets. The uncoupling of the labour markets from the financial health of an economy is being fuelled by government spending and debt. Interest rates are at a record low to help support most economies. The shock to the system has come from the new uncertainty of asset classes. There is no distress. There is no activity. There is just a standstill.
Valuation challenge
To add to the problems of PERE, $80bn of real estate assets are now approaching their eight-year exit mark from older investment vehicles. The income approach to valuation has been the standard for underwriting, but how does the industry value assets when that income is no longer guaranteed? Is replacement value as a tool of valuation a new normal for certain asset classes? And if so, what is the investment strategy that needs to be built around it?
Most of the funds raised in PERE in 2019 came from pension funds and insurance companies. A change in the risk profile of an asset class may require a change in the risk and return allocation within the balanced portfolio of the institutional limited partners of the funds.
Most PERE funds raise money for a specific strategy. They can’t change that strategy overnight and deploy the cash in an opportunistic way. They also need to deploy the dry-powder in a very short period and produce returns within the lifecycle of the fund. They do not have the luxury of waiting for markets to normalise.
Historically, private equity creates value by reinventing the operational model. The two asset classes which are trending investment favourites include multifamily and industrial. Both these classes provide ample value-add opportunity through improved service offerings. This would involve aggregating assets while creating an operating platform that builds scalability and competitive advantage. The only way to do this is by creating platforms that put technology first. The PERE mandates may not allow investing in tech companies directly, but they do allow for building operational models that marry domain knowledge with breakthrough technology.
Tripty Arya is founder and chief executive of Travtus
