The global real estate division of financial consultancy Ernst & Young recently published a report on the private equity outlook in the real estate space.
As the head of the division, Mark Grinis, says in an introduction, the premise of the report is that success in this space requires managerial focus on fundamentals, including the ability to keep “one eye on international events and the impact they may have on their local investments.”
The report starts with interest rates, and especially with the policy of the U.S. Federal Reserve. EY expects that the Fed’s funds rate will increase, modestly, and this “may increase the expense of developing new projects and refinancing existing projects.” But it does not believe that this poses a grave threat to asset values.
Part of the reason it doesn’t pose such a threat is that the debt market is increasingly sophisticated, allowing real estate investors to “source debt packages that are not closely tied to rates in short-term markets.”
Volatility in and from China
Events in the People’s Republic of China are a little more worrying to EY than are probable deliberations at the Fed. China’s debt has quadrupled in the last decade, and is now at 282% of the country’s GDP. Half of all Chinese loans are linked, either directly or not-so-directly, to the real estate market of the country. If this situation leads to an increase in nonperforming loans, and if that in turn slows the construction industry as a whole: How will China’s policy makers react? That is a big question for the moment.
Overall, though, the investment thesis of this report is stated in a five-word subhead on page 5, “There is room to run.” Real estate globally is entering into a stable period. Stable isn’t the contrary of “volatile” here. The volatility, in China or elsewhere, which will continue to exist, will create opportunities,
“Yields may be squeezed,” the report says, “but the fundamentals of core real estate remain strong – at least over the medium term – as demand for prime property continues to be high, balanced by steady, rather than strong, supply. “ Meanwhile, millennials have entered the labor force, and they find that they like city life and are willing to pay to live there. This is what EY calls a “solid trend.”
What does the report have to say about the private equity pursuit of the value available through real estate?
EY observes that “a number of firms have raised secondary vehicles to buy up investor positions in real estate funds and a new fund has emerged to acquire stakes in real estate managers.” This is an important enhancement of liquidity driven by “an increasingly discerning investor base” and by the rising market itself.
The report recalls that in 2012, the Securities and Exchange Commissions’ Office of Compliance Inspections and Examinations launched a Presence Exam Initiative – an effort to establish a presence within the private fund industry and examine the qualifications of hundreds of newly registered advisers. The OCIE is expected soon to release a study that will, in the words of the EY paper, outline “the more common deficiencies, violations and risk areas” it has discovered there.
This is a sign that a “new era of regulatory examinations” is under way and that firms ought to expect more than the initial document request letter, they should expect follow-ups “that increasingly focus on the adviser’s weak compliance points.” EY is optimistic, though, that this will be healthy for the industry as a whole, increasing the confidence of investors and cutting back on systemic risks.
EY has a similar view of the regulatory changes underway in Europe - burdensome at the micro level, but probably healthy when seen from an industry-wide macro point of view.
Public to Private
EY also looks at the trends regarding listed property companies being taken private. This is a development that dates back at least to a Blackstone deal in late 2014 regarding REIT Excel Trust a deal that proved worth close to $2 billion. There were likewise a “clutch” of take-private deals during 2016, the report says, and there will be more. One can be confident that there will be more in part because “many REIT management teams are overcoming their historical reluctance to sell and are recognizing that a deal at today’s relatively high prices can produce a good outcome for their business and their shareholder base.”