Bull Market for Real Estate Secondaries

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Stewart: Hey, welcome back to another edition of the InsuranceAUM Podcast. My name's Stewart Foley. I'll be your host. And today we're talking about what might be a particularly interesting moment in real estate. The reset in interest rates put an enormous amount of pressure on valuations, leverage, liquidity, and transaction activity, but those same pressures are now creating a very different opportunity set for investors with capital, patience, and the ability to provide solutions, which brings me to today's topic: why this may be a bull market for real estate secondaries. And I'm joined today by Brendan MacDonald and Margaret McKnight of StepStone Real Estate.

Brendan is a Partner and Chief Operating Officer of StepStone Real Estate. He has a deep background in the space, having been a founding partner of Clearview Capital Partners, which was integrated into StepStone, which established StepStone Real Estate.

Margaret is a Partner and Head of Portfolio Solutions for StepStone Real Estate. Prior to joining StepStone, she spent more than a decade at Carlyle's Metropolitan Real Estate, where she served as co-chief investment officer. So both of these folks have spent a lot of time in real estate and know it well. Welcome to the show. We're thrilled to have you both.

Brendan: Thanks, Stewart. Thrilled to be here.

Margaret: Likewise.

Stewart: Good. Yeah. So before we get into real estate, we always like to get to know our guests a little bit. So I want to start with you, Margaret. Where'd you grow up and what's a fun fact that your colleagues at StepStone, maybe Erin or Jason, would want to know about you?

Margaret: So I grew up in Philly, and somebody recently complimented my accent who was not from America, and it gave me a good laugh because that's not common when you come from Philly.

Stewart: That's funny. I'm from Missouri, and I've never been complimented on my accent either.

Margaret: Yeah. Well, there you go. I'm with you.

Stewart: It's hilarious.

Margaret: I actually, outside of work, love to be creative, and I make jewelry as a hobby.

Stewart: Oh, do you really? Oh, we got to talk about that offline. Okay, good. I'm sure my wife would be interested in knowing that. How about you, Brendan? Where did you grow up and what's a fun fact that your colleagues would want to know?

Brendan: I was born in Ottawa, Canada, but moved to Bloomington, Indiana when I was in the fourth grade. So I spent most of my formative years in the Midwest. Bloomington's a great town, a college town, a lot of great basketball history, and also the national champion college football team. Fun facts. I was prepared, Stewart, to tell you about my first job, so I guess I'm going to roll with that.

Stewart: There you go. That works.

Brendan: As a Canadian that moved to the Midwest in the '90s, I knew how to ice skate. And so as rollerblades were coming on the scene, because I knew how to skate, I ended up getting a job teaching people how to rollerblade, which doesn't have quite the sex appeal today that it did in the '90s. But like real estate, these things tend to be cyclical. So maybe it'll come back one of these days. I think they're still in the closet.

Stewart: I remember those days very well. I lived in Imperial, Missouri, and we had an asphalt driveway, and I bought a pair of rollerblades and I was miserable on them. I mean beyond. I'm a motorcycle guy, my balance is okay, but skiing and when you put something on my feet that's not directly touching the ground, everything starts going wrong quickly. So I have a lot of respect for your proficiency in skating and rollerblading. You got a lot of friends in Canada. And like you said, I don't know if you skate or walk first up there, but it's definitely part of the program.

Brendan: You just needed a better teacher, Stewart.

Stewart: That's right. That's what I needed. Hopefully I found you. So Margaret, let's start with the underlying asset class. Real estate has gone through a significant repricing since rates began to move higher in 2022. StepStone's view, as I understand it, is that the trading prices are now near the bottom of a cycle while the outlook for property income is actually pretty constructive. Can you make the case for real estate today and why does the asset class look attractive from where you sit?

Margaret: Well, you hit a couple of the points. First of all, real estate has price corrected, is near the bottom of the cycle. We did just have a jump in interest rates, but apart from that, it was pretty fairly priced. That is not the case for other asset classes, which either quickly rebounded or didn't really correct. So from a pricing perspective, it makes sense. Although when you look in the rear-view mirror, returns were weak as prices fell, which is what the historical figures show. So that's actually a signal that you should invest. Also, when you look around, there's a lot of disarray, and we're going to talk about this, but when interest rates jumped and the cost of borrowing went up, the loans became too big for the actual income streams. So there's a lot of balance sheet problems. Only 17% of the loans that came due last year in the U.S. were completely resolved. $800 million got deferred.

Well, we can talk more about this. There's a lot of pent-up need to sell and a need for structured solutions that avoid taking losses. A lot of managers feel like if they just had more time, they can grow out a lot of these problems. So they’re really interested, on the pricing side, in buying time. So the bad news and the disarray also make it a good opportunity.

As you pointed out, we've got inflation and higher interest rates make it more expensive to build. So new starts and deliveries are really finally starting to slow, and the outlook for income growth is decent, despite the weaker economic position that you may be worried about, hasn't quite happened yet. And that's the average. Real estate is a big, diverse market, and we play globally. There's a lot of opportunity where there's pockets of strength and outperformance if you know how to find them.

So that's the sort of cyclic position. And then just generically, real estate is really useful to portfolios. It provides a lot of current income. It can provide, depending on the strategy, a lot of current income, which either can be used for distributions or is just risk mitigation. It has demonstrably provided protection from inflationary shocks that have really devastated financial assets. And then finally, it has very low correlation to stocks and bonds. So if you're worried about an overvalued stock market, this is a great thing to have in your portfolio.

Brendan: And Stewart, the only thing I would add is just that while real estate is a global asset class, the dynamics tend to be very local. And so a given property type can be underperforming in one market because of an imbalance of supply and demand and outperforming in others. And so that's really when or why StepStone's global team and platform and footprint, which allows us to identify similarities and differences across markets in terms of the outlook for sectors and markets.

Stewart: Yeah, it's interesting. Can you comment on real estate as an inflation hedge? And here's why I ask. The insurance industry faces claims liabilities and they price in an inflation assumption. And I'm talking in particular about long-dated workers’ comp liabilities or long-dated medical malpractice where they're exposed to inflation and inflation is a kryptonite to their bond portfolios. So that's the source of the question.

Margaret: Yeah. So there's really two kinds of inflation to think about, and one is the sort of garden-variety CPI inflation. Real estate does a fine job of keeping up with that. Actually, so do stocks. On the other hand, the thing to worry about and the thing that has been so devastating to financial assets is unanticipated inflation. So that's what we experienced in the '70s and again in the immediate post-COVID period. So from 1973 to 1981, the average inflation rate was 9%. So that's exactly the problem you're worried about. Real estate, and this is really core real estate with no bells and whistles and mostly unlevered, delivered a 13.6% while the S&P delivered a 5%, but that 5% was after net of a pretty serious fall that not all organizations and corpuses made it through there. And we have a chart in our house views, which we're happy to share. We saw a very similar dynamic in the immediate post-COVID period.

Stewart: Yeah, it's interesting. I mean, some inflation is driven by macroeconomics right now, but some decisions or some of this inflation is based on decisions we've made. And so it's not easy to forecast things like that, that I think the fancy economic term is “exogenous shocks.”

Margaret: Exactly.

Stewart: So Brendan, here's what I find interesting about StepStone's thesis. Asset values have adjusted, but you've made the point that many real estate balance sheets still haven't fully adjusted to the 2022 rate shock. So we have assets that may be approaching clearing prices, but owners and funds that can still be overleveraged, overmarked, or in need of a capital solution. Can you talk about what that adjustment is going to look like and why? I think I know why it's taken so long to adjust. Folks are not wanting to deal with reality, but can you talk a little bit about that?

Brendan: Yeah. Real estate funds are broadly marked based on third-party appraisal activity and appraisers like to have transaction activity and data to support the changes in the assumptions that go into these valuations. So one of the challenges that you have during a market dislocation is because there tends to be this slowdown in the volume of trades, there's just fewer data points to go off of to support changes in assumptions. There's also, there just tends to be sort of a lag in real estate between what happens in the real spot market and where marks tend to be carried on funds’ books.

Stewart: And so Margaret, it's funny because there are asset classes that everyone knows doesn't have a lot of liquidity, and inevitably there are people who own those assets and need liquidity, which creates opportunities for those who have liquidity. And so we've got LPs, some LPs looking for liquidity, GPs looking for time and capital, assets that aren't necessarily reaching their natural exit. Can you talk a little bit about why this particular combination creates an attractive opportunity set for real estate secondaries?

Margaret: Yeah, so LPs are very hungry for liquidity because distributions have been running, since 2022, about half of normal. So they're not getting money back, which means they can't give it back. They can't write new checks for new primaries. So the GPs are getting it, and they're very frustrated. So the question is, why aren't they selling? Well, the crux of the problem really does go to this valuation issue because their marks are through a fair process for valuing opaque, and my favorite word, non-fungible assets. Everyone is different. Their marks are often quite a bit higher than where properties are trading. So if they sell, they have to recognize a loss. And the sales last year, again, were low, distributions were low, but the average loss on the sale is 25% out of a non-core fund, which is not at all surprising to us when we look at how much those have dropped in value versus asset prices.

So they do not want to sell and/or they're overleveraged and they need to work down some debt to get some runway. And usually, in this case, the kind of stuff we're looking at, there are a lot of high-quality GPs with quality assets that they have now just paid too much for because the interest rate shifted since they bought them, and they really do have a credible case that with income growth and maybe some residual improvement at the asset that they really can substantially grow their way out of the problem if only they could have more time. And that's where Brendan and the crew come in to structure solutions that buy out the LPs who want out, that provide new capital to solve some of these funding gaps and restructure the loans and recaps the whole thing so that it works, reset the GP comp, give them the runway that they need.

And they're actually willing to pay a lot for that effectively through the structure of the deal because it keeps them from having to sell at a loss and it lets them find liquidity for their LPs, but also lets them keep control of the assets.

Brendan: But Stewart, I think that the key is that you need a catalyst in order to clear this logjam of assets that are being held in closed-end vehicles. Now, one of those catalysts is simply the end of funds’ lives. And based on our research today, there's more than $250 billion of net asset value being held in closed-end funds that are beyond their 10-year life. There's more than $1 trillion of net asset value held in real estate funds that have been held for more than five years. So at a stage that they should be starting to realize these assets. But those funds reaching the ends of their lives, the legal obligation on the managers to begin liquidating assets and funds is one of the catalysts that is driving transaction activity and really driving the opportunity set in the GP-led secondaries side of the market.

The other catalyst is debt maturities. And there's been much that's been said about and written about the wall of debt maturities. And over the last several years, rather than those maturities forcing asset sales, instead there has been a tendency to kick the can along the road and extend or forbear and modify. But as we look at our pipeline today, the primary driver of deal flow is balance sheet issues and owners that require new injections of fresh equity in order to deleverage assets so that they can get a refinancing done. And so that's another important catalyst that's really driving the opportunity set for recaps and secondaries today.

Stewart: And this is a topic that we've covered prior, but it's a really important one, which is GP-led secondaries. And one of the things I think that there are fixed income people in this world and they have their own language and they have their own knowledge base, and there are direct lenders and the same thing. Real estate people tend to be all their own, and they don't really cross over and do other stuff. You need a lot of expertise to be effective and successful in this market. So for folks who don't live in this market every day, can you talk a little bit about how GP-led secondaries work and why that structure is particularly interesting right now?

Brendan: Sure. Yeah. So first, I mean, I'll contrast a GP-led secondary with what is referred to as an LP secondary. I'd say in a traditional sense, an LP secondary is you have an investor in a fund, a closed-end fund whose capital tends to be locked up for a period of time, and they are looking to get liquidity for one reason or another prior to just the natural liquidation of the assets in that fund. And in most areas of the private markets, real estate included, there's an active marketplace of buyers and sellers to buy these indirect limited partnership positions in closed-end funds on the secondary market. Contrasting that with a GP-led transaction, in a GP-led deal, rather than the investor being the protagonist in a GP-led deal, it's actually the manager of the assets that is looking to facilitate some sort of a liquidity solution for assets within its portfolio.

Sometimes that's because there's assets at the tail end of the fund that require more time and more capital in order to optimize value, and they're looking to transfer those assets into a new vehicle with a new set of investors and reconstitute the timeline, the capital structure on a go-forward basis to provide that time and capital to maximize value. The other, I'd say, unique sort of nuance in real estate is unlike say private equity, I think there's a much wider range of structures that institutional investors and managers hold real estate through. So the GP-led secondary space in real estate, it's not just commingled fund structures, it's joint ventures, it's private REITs, it's real estate operating companies, separate accounts. Any one of these formats that you have institutional assets and managers can be conduits for secondary as well as recap transactions as liquidity needs arise.

Stewart: And one of the things, I mean, I've had the privilege of working with StepStone for a number of years, and one of the things that folks might not know is StepStone's commitment to technology and data. And so StepStone's model at that point creates an interesting information advantage. I mean, you're a large global allocator to real estate managers and you're also active in secondaries and co-investments. So how does being active across all those places make you a better secondary investor? And I suspect that both of you are going to have something to. I didn't mean to say one or the other. You're both welcome here.

Brendan: Well, I'll jump in, and Margaret, please feel free to hop in as well. But just quickly, I mean, StepStone across its primaries investment business, we are committing roughly $15 billion of primary capital each year to private real estate. That tends to be across 60 to 70 distinct funds or vehicles that we're underwriting each year. And to do that, we're having over a thousand manager meetings around the world with GPs, and every one of those interactions is a chance to learn what are they buying, what are they selling, what liquidity needs they may be seeing across their client base, what vehicles within their portfolio may be due for some sort of a windup or continuation fund opportunity. And so the level of interaction that we have with the GP community, the amount of data that we collect on the portfolio that we're then monitoring post-investment does give us a true edge, both from a sourcing of new secondary and recap opportunities as well as a treasure trove of data to inform our underwriting and diligence on investments.

Margaret: We are part of an effort called REDI, Real Estate Data Initiative, across the real estate industry to take the reporting on closed-end funds, which is really opaque, and provide GPs with a standard template collecting asset-level data, which is absolutely critical for understanding what's in there and underwriting. We report, we work across about $200 billion of assets under management and advisement. We report for a lot of those clients. We collect the REDI data. We're starting to collect, we have now a couple years of data on about 3,000 different properties, and so that becomes a tremendous source of underwriting information as well as we're starting to think about how to mine the database to go back to the GPs and say, "Hey, wow, this fits all the criteria we'd like. Let's have a conversation about how we can help each other."

Stewart: So once in a while, the CIO folks let me try on the CIO hat. It's not a real one, but it kind of looks like a real one. So if I'm looking to access this opportunity, StepStone works with insurance companies in a variety of structures. You've got a big commitment with Aaron Driscoll in this space. Without getting into anything that you're actively fundraising for right now, how should an investor think about accessing this opportunity set?

Margaret: Come talk to us. We are very flexible. We are active also across the risk spectrum, debt and equity. We can work on everything from tailored SMAs to evergreen vehicles, to dedicated insurance funds. We are very skilled at structuring on capital side as well and are happy to work with people to provide solutions for their specific needs.

Stewart: Yeah, it's interesting. I mean, even if you had two assets that were identical from an underlying collateral perspective, the structure of the deal has significant impact on the capital treatment for insurance companies. So the way that the thing is structured, I've often said, and I think I'm exaggerating a little bit, but the structure's about as important as the underlying. I want to leave our audience with two takeaways. First, I'll come to you, Margaret, and then I'll go to you, Brendan. What would you want our audience to take away from today's podcast? And then I've got a fun one for you on the way out.

Margaret: I mean, first of all, this is a really interesting time to invest in real estate, and it's kind of hard to get excited about it because you have to be contrarian. But if you're smart about being contrarian and respect the fact that it's a really cyclic asset class, all the signs are that this is a great time to go in and to go in with somebody who's really good at finding or has experience at finding the granular opportunities, the property types that actually have more demand than supply or the locations that are appealing or the structures, it's better. They can be better than average. There's room for alpha right now in probably what's going to be some very good vintage years.

Stewart: Yeah, it's interesting. A lot of the insurance CIOs have a fixed income background and there's no shortage of contrarians there. Brendan, how about you? Let's take it to you. The second takeaway.

Brendan: I would say that real estate can be a lot of things. It can deliver high-yield opportunistic returns, and there's certainly an opportunity today to help to capitalize on a fair amount of distress that exists within the sector given the interest rate increase and the pressure on balance sheets and the devaluation that has occurred. It can also be a great source of just stable current income at the more core and core-plus end of the risk-return spectrum. And for the reasons that Margaret just described, that's also a great opportunity today because as interest rates have increased, you can now buy these assets at higher going-in yields. And because of the slowdown of construction, the inflation of construction costs, there's a nice runway ahead of us where we should see growing income streams in markets and sectors where you continue to have growing demand and fixed supply. So real estate offers opportunities today really across that risk-return spectrum.

Stewart: All right, I'm going to stay with you, Brendan. We got a little bit different out-the-door question, just slightly different. So first of all, great education on real estate secondaries. Lots of good information here, super educational. I really appreciate you both. Fun one on the way out the door. Describe your — I'm kind of excited about this question because it's new. Describe your best real or fantasy dinner. Brendan, we'll start with you. Real or fantasy. So while you think I can fill some airtime here, and when I was teaching, I used to cue the Jeopardy music when my students were not answering.

Brendan: So I'm a tennis player, and I was watching the U.S. Open over the last couple weeks and was so impressed to see Ben Shelton's run in the U.S. Open. And as a dad to young athletes, I'd love to have 30 minutes to pick him and his dad's brain around just how to raise young athletes today and how to get them to focus on excellence while avoiding burnout in a single sport. I think what's interesting about Ben Shelton's story is he actually came to tennis, despite having a dad who was a professional tennis player and a college coach, he came to tennis late in life after focusing in football and really was a late bloomer and finally ending up in the finals of the U.S. Open. So that'd be my pick today.

Stewart: Okay, so it would be you, Ben Shelton, his dad, and your kids.

Brendan: You got it.

Stewart: Are you going anywhere? What's for dinner? What are we having? You think on that, we're going to go to Margaret. So Margaret, for you, what's your best real or fantasy dinner? Because Brendan's is pretty good, I got to say.

Margaret: Yes. So the real part, easy, is a handful of good friends and some really good high-quality California cuisine, fresh local ingredients. And the fantasy part is I would like to have my guest star be Dolly.

Brendan: Great answer.

Margaret: So much fun. And in addition to being a great entertainer, she is an amazing businesswoman, and I so respect the way she has found a way to give back and make the world a better place and not just work well.

Stewart: Yeah. I mean, it's interesting because I don't know if this is true, but it's my own perception. She was almost universally liked.

Margaret: Yeah, and that is not easy.

Stewart: In this country, are you kidding me?

Margaret: She always had good answers to hard, inappropriate questions that just, you left with a smile, right? Always.

Stewart: She's from very, very modest beginnings, but to your point, a really savvy businesswoman. So super cool answer, both of y'all. I just think it's great. I want to say thank you very much to both of you for being on.

Margaret: Thanks, Stewart.

Brendan: Thanks, Stewart. Really enjoyed it.

Stewart: We've been joined today by Margaret McKnight, who's a Partner and Head of Portfolio Solutions for StepStone Real Estate, and Brendan MacDonald, who's a Partner and Chief Operating Officer of StepStone Real Estate. Thanks for being with us today. If you like what we're doing, please rate us, review us. You can catch us on any podcast platform, as well as YouTube. We do video podcasts and this one is a video podcast, and it's going to be on YouTube at InsuranceAUM Community. My name's Stew Foley. I've been your host, and we'll see you on the next episode of the InsuranceAUM Podcast.

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Contacts

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StepStone

StepStone Group

StepStone Group (Nasdaq: STEP) is a global private markets investment firm focused on providing customized investment solutions and advisory and data services to our clients. StepStone’s clients include some of the world’s largest public and private defined benefit and defined contribution pension funds, sovereign wealth funds and insurance companies, as well as prominent endowments, foundations, family offices and private wealth clients, which include high-net-worth and mass affluent individuals. StepStone partners with its clients to develop and build private markets portfolios designed to meet their specific objectives across the private equity, infrastructure, private debt and real estate asset classes.

W. Casey Gildea 
Managing Director casey.gildea@stepstonegroup.com
+1.212.351.6114

Erin Driscoll
Managing Director - Global Head of Insurance Solutions erin.driscoll@stepstonegroup.com

Morgan Kennedy
Senior Associate morgan.kennedy@stepstonegroup.com

277 Park Ave, 45th Floor
New York, NY 10172

 

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