Private Equity Real Estate: Still Looking Up?

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An earlier article at Sophisticated Investor, “Dark Clouds Looming for Private Equity,” discussed prospects for an industry that makes money by acquiring and selling businesses, usually with the assistance of borrowed money. But there’s more to PE investing than buyouts (leveraged or otherwise). One specialty segment, private equity real estate, or PERE, relies on actively managed equity and debt investments in property to generate returns.

Like its company-oriented counterpart, PERE has fared well in recent years. According to Preqin, “North American funds that closed from January to November 2015 raised $61 billion in investor commitments—up 42 percent compared to the same period in 2014.” In its 2015 Global Alternatives Reports, published last January, the research firm reported that three-year annualized returns for private real estate funds were 16.7%.

A positive economic outlook

As with the PE sector, an impressive track record has played a key role in bolstering PERE. For the U.S. subsector, in particular, another driver has been strong interest from overseas. Of the $96 billion in capital raised globally during 2015’s first 11 months, North American funds accounted for approximately two-thirds of the total. Andrew Moylan, head of real assets products at Preqin, noted that investors worldwide have continued to focus on “‘more established markets,…notably the U.S., where the economic outlook remains positive and there are a wide range of opportunities.'”

That said, some recent developments, most notably the Federal Reserve’s efforts to normalize monetary policy, suggest the U.S. market could soon face trouble. First, rising interest rates and an associated decline in risk appetites could make it more difficult for managers to obtain the financing required to underwrite some deals, and may also sour attitudes toward real estate as an asset class. Second, while overseas investors might remain keen on the U.S. because of the expected tailwind of a rising dollar–which stands to benefit from a widening of the gap between U.S. and foreign interest rates–global monetary policy divergence may well boost interest in overseas markets. Investors may view the still-accommodative policies in Europe, Japan and elsewhere as a more supportive backdrop for real estate than that of the U.S.

Could foreigners have a change of heart?

There is also the possibility that foreign investors may decide that the investing climate in the U.S. is less enticing than it has been until now, especially if, as some believe, the Fed’s move to raise interest rates turns out to have been a mistake that pushes the U.S. into recession. While it is possible that the central bank will be quick to reverse course, the damage to the economy and the resulting impact on investor attitudes could have long-range repercussions.

Even without any changes in economic fundamentals, regulatory concerns could lead some investors to reconsider their outlook for the U.S. PERE sector. The Wall Street Journal recently reported that the Fed had come away from “war game”-style exercises–designed to assess risks associated with a boom in commercial real estate (CRE) markets–feeling worried, and were reportedly contemplating what steps they might need to take to rein in what some believe are brewing bubbles in various property markets.

In fact, a number of authorities have warned about rising risks in CRE lending, stemming in large measure from looser underwriting standards and rising concentration levels among lenders. According to the ABA Banking Journal, federal banking agencies issued a statement in mid-December warning about

eased commercial real estate loan underwriting and CRE risk management practices that cause “concern.” They added that supervisors will “continue to pay special attention” to CRE lending in exams in 2016 and reiterated existing interagency guidance on CRE concentration risk.

Under the regulatory microscope

The PERE industry itself is also seeing stepped-up regulatory scrutiny. In October, Bloomberg reported remarks by Securities and Exchange Commission Chair Mary Jo White that examiners were “looking into poorly disclosed business relationships that benefit advisers to private equity funds.” The agency questioned whether some firms were not being transparent enough about using affiliated entities to provide portfolio-related services.

Finally, broad shifts in Americans’ working, shopping and other habits may increase uncertainty and undermine operating models in some parts of the property market, potentially spurring investors to demand higher returns from CRE-related investments. Among other things, technological advances have helped eCommerce to gain at the expense of bricks-and-mortar counterparts, lessening the need for a physical store, while the growth of telecommuting and on-demand economy (e.g., Uber) has undermined demand for office space. Meanwhile, Millenials appear less keen on owning their own homes than their ancestors did.

To be sure, the combination of a solid track record and strong fundraising momentum makes it seem unlikely that the industry has anything to worry about, at least in the short run. But as is often the case with investments that appear to be firing on all cylinders, the outlook always seems brightest before the bottom falls out. Expectations for the IPO market, for example, were very high following the strong showing in 2014; and yet, 12 months later, the outlook–as noted in “Déjà Vu All Over Again in the IPO Market?“–is looking decidedly shaky.

With that in mind, caution, rather than confidence, remains the watchword.