Does Private Equity’s Capital Overhang Matter for CRE?
Raising billions of dollars of capital for real estate investments and not spending it causes some people a lot of anxiety. And, that’s happening right now.
Today’s market is prime territory for growing capital overhangs. The strong fundraising environment of the past few years has built up capital in private equity GPs’ coffers. Aggregate capital raised has gradually increased each year since the lows of 2010, when 96 funds collected $26.3 billion.
Last year 134 commercial real estate funds raised a total of $59.3 billion, compared to 119 funds that raised $56.6 billion in 2013, according to alternative assets data provider Preqin.
Why is this making some people nervous?
In strong fundraising environments, like that of the past few years, private equity real estate firms are able to raise capital in relatively quick time as long as they have half-decent performance. The strongest performers will raise progressively larger funds over time.
Strong markets also correspond with rising asset prices, too. So GPs with large pools of capital may be moving slowly in deploying their capital to avoid high prices. This is prudent, and what any investor in a private real estate fund would expect. But, private funds have their 3-5 year deadline to deploy capital before investors might be forced to “give back” the money.
As capital overhangs build, the concern among the LP community is that GPs will be tempted to spend the money before the deadline, flooding the market with capital, further driving up prices and ultimately ensuring depressed performance.
These are fears that don’t necessarily play out. In fact, LPs usually would rather grant a GP an extension of the investment period, understanding that it’s better to give the manager more time to invest rather than pressuring them to deploy capital. Nor does an LP want their capital returned un-invested after having paid fees on the commitment.
Shifting investments in today’s capital overhang
The CRE-specific capital overhang hit $251 billion at the end of the third quarter, according to Preqin. “The first three quarters of 2015 have seen more capital raised for opportunistic real estate funds than in any full year since the Global Financial Crisis,” said Andrew Moylan, head of real assets products at Preqin.
This, and the fact we’re in a more mature phase of the real estate cycle, is causing shifts in how capital gets invested, according to Jerry Gates, managing director in real estate at Hamilton Lane, which advises LPs.
In the current real estate cycle, core asset prices in primary markets like New York, Boston and San Francisco have exceeded previous peak prices, he said. Managers have to look down market toward secondary cities for deals to achieve return targets.
The “low-hanging fruit” that drove real estate returns after the financial crisis — like distressed sales from banks — are not as prevalent today, he said. “Managers are having to pay more for properties, which makes it harder for them to hit targeted returns. So it’s taking them longer to find investments they’re comfortable making.”
Steven Roth, chairman and CEO of Vornado, in a recent earnings conference call, said that “The easy money has clearly been made and pricing is very aggressive. I don't know which way interest rates are going, but people think that they are going up. I don't know which way cap rates are going, but 50% [say] they can't go much lower. So it seems that this is the time to begin to think about preparing for the next cycle." Perhaps 2016 is the start of that new cycle.
Or some funds might look to strategic acquisitions and pick up some REITs.
The cycle inevitably will shift, but for now GPs must tread carefully to find the right deals at the right prices.