Stars Align for CRE Secondary Funds

High interest rates, slumped property valuations and maturing debts across commercial real estate have weakened investors’ appetites. Altus Group reports that as of the third quarter of this year, transaction volumes were at their lowest point since 2013, while the total square footage that traded was at a nearly 15-year trough.

In contrast, general partner-led secondaries funds are feasting on the opportunity to acquire equity interests in real estate assets and funds from existing investors. Blackstone, Goldman Sachs and Lexington Partners are some of the bigger names forming secondary vehicles, but institutional investors, pension funds, family offices and sovereign wealth funds across the globe are also partaking as fund managers or fund investors.

PJT Partners, an asset advisory and fundraising services firm, reports that real estate secondaries funds have raised nearly $12 billion in capital over the past seven quarters. In the first half of 2024 alone, $3.4 billion was raised, accounting for 6 percent of all capital raised for closed-end real estate funds, the highest portion of total fund closures since 2019.

Secondaries enable investors to gain a stake in premium assets at a discount while fund managers get the liquidity and stability that’s hard to come by today.

The perfect storm

With limited partners not realizing expected distributions from funds, which on average are down 70 percent since their peak, investments from secondaries have an irresistible appeal for fund managers. “When (transaction) volumes are slow, it means investors are not getting the normal distributions, which puts them in an illiquid position,” said Jeff Giller, partner & head of real estate at StepStone Group, which recently closed on a $7.4 billion secondaries program focused on the private equity sector.

This is happening while real estate owners are having to service higher interest rate debt or refinance existing properties with less proceeds than their existing loan payoff amounts. S&P estimates that more than $950 billion worth of commercial mortgages are set to mature this year, increasing by more than $300 billion by 2027. It’s a perfect storm.

“Managers are unable to raise capital by selling their assets, (some) loan levels are down and some lenders are out of the market entirely,” observed Giller.

And these difficulties don’t account for other worrisome macroeconomic trends or sector-specific struggles, such as hybrid work for office and supply-chain slowdowns for industrial.

“Because of the pandemic, a number of managers across all asset classes decided to extend their funds’ lives because it wasn’t the right time to sell,” according to Achal Gandhi, CIO & head of indirect real estate strategies at CBRE Investment Management. “After that, we had an inflationary spike and an interest rate cycle, where managers said the same thing.” 

How investors stand to benefit

But what’s in it for the secondary investors? For starters, secondaries allow them to purchase otherwise inaccessible assets on a discounted basis. A February 2024 study from Neuberger Berman found that real estate secondaries reported a sub-75 percent discount to net asset value from 2022 and 2023.

In the longer term, this means higher gains. “It’s a good J-curve mitigant,” said Elizabeth Bell, managing director & co-head of real estate at Hamilton Lane. “You can immediately step into a fund and get access to mature assets at a discount, and that’s a great entry point.”

This even goes up to the portfolio level, where an LP’s need for liquidity may cause them to sell off entire collections of assets.

GP-led secondaries typically allow the investor to conduct more due diligence on the assets in the funds they’re investing in. “You’re not buying out the GP, because you depend on their knowledge and expertise to manage the assets, but you are getting access to the assets at somewhat of a discount by infusing new capital to help the GP create opportunities and solve problems,” Giller explained.

What’s more, secondaries by nature gain an equity stake in existing assets, sidestepping contentious development and debt structuring processes.

In turn, you “can expect a shorter time horizon to reach stabilization, quicker liquidity and less exposure to market volatility vs. traditional funds,” according to Brian Di Salvo, partner of capital advisory at Park Madison Partners.

Areas of interest

The preferred investments are “those that have continuing economic and upside potential,” said Ron Dickerman, CEO of Madison International Realty, which is in the process of raising capital for its ninth secondaries fund. On the flip side, risks such as low vacancy, expiring debt or a large lease maturity would disqualify a potential secondaries investment, according to Dickerman. Therefore, office properties take a back seat to other property types.

The potential lies almost entirely in assets benefiting from growing demand for consumer goods ranging from groceries to electronics, services and computing power. In the industrial sector, which has posted some of the largest payouts of all asset classes, Madison and other firms focus on cold and outdoor storage, intermodal, single-tenant and small-bay facilities. Dickerman is motivated by demand for delivered groceries, which is expected to grow nearly tenfold by the end of the decade.

Other promising areas are medical office facilities, which benefit from a growing health-care and pharmaceutical industry and an aging population. Data centers, for similar reasons, are “built for GP-led secondaries,” according to Di Salvo. “Surging data needs due to the rapid expansion of AI and cloud computing create significant capital requirements for these assets.”

Another winner to emerge on the retail front are convenience-oriented retail centers, which Gandhi says are posting high yields and relying on non-discretionary spend. In Di Salvo’s model, any asset where “you expect to see several legs of growth in the underlying business plans over the next five to 10 years is a compelling one,” said Di Salvo.

Higher for longer—a good thing?

Experts expect higher-for-longer interest rates will be a net benefit for secondaries investors since the appeal of acquiring cash-producing assets at a discount supersedes any market cycle.

“This is not a point-of-time opportunity,” predicted Cherine Aboulzelof, co-head of BGO Strategic Capital Partners, which is currently capitalizing its third secondaries fund. “With the wall of maturities coming due, a lot of these triggers will continue for the next few years.”

“While high interest rates are depressing transaction activity in the current market environment, once cap rates adjust to reflect the reality of the new, higher rate environment, the markets will reset and we will return to a more normalized transaction environment,” predicted Giller.

That said, the next 18 to 24 months seems like the best time for getting into secondaries. But that doesn’t mean the opportunity will disappear, noted Kilian Toms, managing director of CBRE Investment Management’s Real Estate Partners strategy. “Term extension will continue to be a catalyst for why fund managers and GPs will continue to use the space, specifically in markets where business plans are delayed in periods of dislocation.”

With this in mind, Toms believes managers’ focus has changed and may affect why secondaries funds are capitalized in the future. “The market has shifted from more of a carried interest, compensation-oriented market to more of a long-term, growth-oriented market,” he concluded.

Read the January 2025 issue of CPE.