Real estate private equity funds appear to be riding high on a wave of returning capital. Not only is money pouring back into those investments, but fund managers are anticipating even more demand in the coming months as institutions continue to raise target allocations for 2014.
“We have seen a lot of capital move into real estate over the last nine months or so, as investors seek higher yields,” says Ron Kravit, head of real estate investing and senior managing director at Cerberus Capital Management. New York City-based Cerberus is one of the world’s leading private investment firms with more than $25 billion under management.
The broader private equity sector saw a definite contraction during the peak of the recession as money moved to the sidelines or other safe havens. However, investors began returning in 2010 and annual capital flows into private equity investments have been creeping higher. Although fundraising is still well below the $874 billion high water mark that was achieved in 2007, annual fundraising did reach $426 billion in 2013, according to PitchBook, a data provider for the global private equity market.
Real estate represents a small fraction of the overall private equity market at about 4 percent. Yet real estate private equity investments are clearly following that same market trend. The total capital invested in real estate on behalf of private equity firms has more than doubled in the past five years, from $7.2 billion in 2008 to $17.1 billion in 2013, according to PitchBook.
“I think we are on a little bit of an upward trend. As long as the markets remain a little more stable, we may see greater levels of investment,” says Bronwyn Bailey, vice president of research at the Private Equity Growth Capital Council (PEGCC), an international private equity association.
That is creating an attractive environment for groups that are out fundraising. One of the most notable examples from 2013 is the $4.4 billion in capital that Brookfield Asset Management raised for its global real estate opportunity fund. The company exceeded its $3.5 million fundraising target and closed the fund last July.
What is even more notable is that more capital is flowing to private equity funds even as institutions are under-allocated in real estate. Not only are pension funds and life insurance companies working to hit previous allocation targets, but many companies are raising allocations even higher for 2014.
The under-allocations to real estate and capital flowing back to private equity funds has been well documented by a number of industry sources. For 2013, global institutions were, on average, 97 basis points below their targeted real estate investment allocations of 9.8 percent, according to the 2013 Institutional Real Estate Allocations Monitor survey conducted jointly by the Cornell University’s Baker Program in Real Estate and Hodes Weill & Associates LP. Despite the challenges investors have had in meeting current allocations, institutions are exhibiting a stronger appetite for real estate. Institutions surveyed are planning to increase allocations for 2014 with an average increase of 52 basis points.
The under-allocation can be attributed to a number of factors.
“I think part of what we’re seeing is being driven by a sense that there was a little bit of an over-reaction on the heels of 2007 and 2008 and folks became under-allocated to real estate,” says John Ferguson, a partner in the business law department and co-chair of the real estate private investment funds practice at Goodwin Procter in New York City. In addition, the strong performance among other asset classes, such as public equities, has lifted portfolio values.
It is notable that capital is once again flowing into funds with a myriad of investing strategies. Two to three years ago, funds were largely focused on core investment strategies that featured stabilized properties. Now more private equity funds are putting money into opportunistic and value-add strategies, as well as new development.
“One of the takeaways and lessons learned from 2007 and 2008 is that the closed end private equity style fund model for real estate, which is an illiquid asset class, is fundamentally sound,” says Ferguson.
Performance piques interest
The favorable performance of private equity has helped draw capital back to the sector. Private equity returns outperformed the S&P 500 for five- and 10-year horizons by 1 and 6 percentage points respectively, according to the PEGCC. Although private equity generated more than 15 percent annualized returns for the one- and three-year time horizons, private equity funds underperformed the S&P 500 during those periods as a result of the post-crisis public market rebound and last year’s rally.
Private equity also stacks up favorably compared to the long-term performance of publicly traded REITs. The 10-year annualized return for all private equity is 14.2 percent compared to 8.8 percent for the NAREIT Equity REITs Index.
Private equity has been less volatile than the performance of the public markets over the past decade, says Bailey. “If you are a long-term investor, like a pension fund or an endowment, those are aspects that are very attractive,” she adds.
Another factor that is funneling more capital to private equity funds is the record distributions in private equity over the past decade. Those distributions go back to limited partner (LP) investors, such as pension funds, insurance companies and endowments. Last year alone there was $120 billion distributed back to LP investors from private equity funds.
“A lot of these investors have specific allocation targets for private equity. So with these distributions, my expectation is that the LPs will reinvest that into the new funds that are coming on the market or are on the market,” says Bailey.