There is no doubt that commercial real estate fundraising has been changing in the past few years. Nowadays, there is much competition for high-quality assets, which makes capital distribution even more demanding. We wanted to see how fund managers should react given the circumstances, so we’ve asked Jason Burian, partner in CohnReznick’s Commercial Real Estate Industry practice, to give us a few insights.
First, he pointed out three main steps that fund managers should consider:
- Maximize alignment with investor preferences—While investors are reacting to increased political and economic uncertainty by shifting to core and core-plus investment strategies, most fund managers are still focused on value-add and opportunistic strategies. Additionally, while investor interest in multifamily and retail continues to dip, office, industrial and mixed-use properties are enjoying heightened attention. Given the increase in competition for capital, most funds have less leeway then they once did to chart their own course independent of prevailing investor desires.
- Have a clear macro-level view of the direction of the market—The situation is hardly helped by the influx of foreign investors, to whom U.S. compressed cap rates look solid compared with their home markets. Whether or not it makes sense to stay at the table depends on how much higher you think valuations can go.
- Manage and maximize operating income—Even if it appears that valuations will continue to rise, operating income plays an increasingly crucial role in achieving a 15 percent return on exit.
CPE: Could you provide some figures/data to show how the fundraising environment has changed over the past few years?
Jason Burian: The number of closed-end private real estate funds in the market raising capital over the past three years:
- January 2015 – 478
- January 2016 – 492
- January 2017 – 525 (record high)
Closed-end private real estate dry powder over the past three years:
- December 2015 – $229 billion
- December 2016 – $237 billion
- July 2017 – $255 billion (record high)
The two sets of data above support one of the biggest changes in the fundraising environment. We are at a level no one has seen before as it relates to competition and amounts of capital waiting to be deployed. Over the next few years, we will either see a drop off with those who are focused on real estate as an asset class or we will see everyone finding a portion of market share to support the continued success being sourced from this asset class.
CPE: Could investors being cautious, selective or patient explain the “too much money chasing too few deals” situation?
Burian: Investors are being patient and disciplined at this stage of the market, with plenty of high-quality assets on the market that fit each investor’s respective investment strategy. But there is so much competition for those high-quality assets that investors need to be disciplined to not overpay for a specific transaction and to stay the course on the investment strategy and returns which were promised to their investors. The deployment of capital has become more challenging given this competition and record amounts of capital chasing the same deals. Another macro factor that has reduced transactional activity in the first part of 2017 relates to the slight increase in interest rates in late 2016 combined with the uncertainty related to the new administration’s direction as it relates to certain policies affecting real estate.
CPE: What recommendations do you have for fund managers in the current fundraising environment?
Burian: This depends on the size of the fund manager. A trend we’ve seen the past few years is the capital concentration among the largest fund managers on the market. From the perspective of the larger fund managers, I’d recommend maintaining the course. Focus on your current relationships with investors who are committing those record amounts of capital. Maintain the strategy that got you to this point and focus on providing those consistent returns. Smaller fund managers need to get creative. Most are getting creative by changing their investment strategies which result in marketing different targeted returns, while looking at different property types. Another creative approach is focusing on different regions than their larger competition. Combined, this is a way to show investors some diversification and uniqueness to the product they are getting from the smaller fund managers.
CPE: Is the real estate crowdfunding industry a solution? What are the risks?
Burian: I see real estate crowdfunding as an alternative to traditional private equity real estate and an alternative source of investors and not as a solution to any problem. As we know, it is just an avenue for every day individual investors seeking exposure in their portfolios to real estate without acquiring shares of REIT’s.
The handful of risks associated with crowdfunding for real estate investment are well documented. There’s risk associated with the limitation on due diligence. The type of individual investor crowdfunding is targeting is most likely not a real estate professional and is not analyzing each investment. This is a process being trusted with the platform raising the capital. Another risk is that the investments in a real estate crowdfunding platform are typically unsecured. There have been recent discussions on how to change this within the industry so stay tuned. Government regulation is always a risk for this relatively new industry sector. There are questions about the amount of government regulation and whether there is enough to make it a safe playing field. Until crowdfunding matures, with the proper level of regulation, there is always a risk that someone is taking advantage of that gap that currently may exist.
CPE: What type of assets do domestic and foreign investors prefer? Is there a fundraising competition between them?
Burian: Investors look at markets and asset classes as risk buckets and each market or asset class has its own positives and negatives. Any given investment strategy could restrict an investor looking at a certain asset class due to it not fitting that investment strategy. For instance, with a core or core plus strategy, your focus as a fund manager would be on trophy office assets in core markets with minimal updates/value-add. The competition at the fundraising level would not be driven by the type of asset class being focused on by a fund manager, but more about the returns being provided through a solid investment strategy, risk and diversification being offered to the investor base. But I have not seen any specific trend related to asset class preference for either domestic or foreign investors.
CPE: What are your predictions regarding fundraising by the end of 2017?
Burian: We have seen a recent run of record-breaking fundraising resulting in record amounts of dry powder and that almost definitely will lead to a slow of fundraising activity. Many experts think it could take a few years to unload the current dry powder levels. Global private equity firms raised $108 billion in 2016, compared to $123 billion in 2015. We can expect to see that number drop again for 2017. While investors are certain to increase their target allocations over the long term, the immediate future will result in a noticeable slowdown. Another prediction is that we will continue to see through the end of 2017 a split of the fundraising market where the larger funds will see the most capital concentration, which has been a common trend the past few years. This will not hinder the market from continuing to expand over the long term, as most experts still think the industry will be larger in three years than it is today.
Image courtesy of CohnReznick