The economic downturn and the global financial credit crisis have impacted asset classes in all regions of the world, and the real estate sector has not been immune. One of the consequences is the emergence of the real estate secondary market.

Despite the partial recovery since spring 2009, the value decline in public asset classes has left many institutional investors overexposed to real estate.

In addition, some general partners have accelerated capital calls and delayed distributions. The lack of a fully functioning credit market has caused these general partners to call for capital at an accelerated rate in order to bulk up their funds’ balance sheets to guard against the need for more equity to refinance transactions. Furthermore, many real estate funds have started using their ‘dry powder’ to make new acquisitions before their investment period ends. At the same time, distributions have been limited or absent as general partners have been holding off selling fund investments in the current market environment. So what should an investor do?

The prospect of limited partners defaulting on their financial commitments to private real estate funds is a reality today. As a consequence, we are seeing institutional investors that need to explore selling their interests via the secondary market.

While the secondary market for limited partnership interests in private equity funds is well established, the secondary market for limited partnership interests in real estate funds has been slow to take hold — until recently. The financial distress faced by struggling limited partners has been the catalyst to instigate the real estate secondary market.

Before 2008, secondary real estate transactions were few and far between, and such transactions often occurred at or above reported net asset value, so why would anyone invest in a secondary investment under such circumstances?

In early 2008, savvy limited partners sensed the changes about to occur and proactively sought to sell their limited partnership interests very selectively. Discounts to net asset value in early 2008 were at most around 20 per cent. By late 2008, some limited partners became acutely aware of their predicament and the floodgates opened, creating significant opportunities for buyers of secondary positions.

To provide some context to the scale of opportunity, we logged approximately $3.6bn (e2.4bn) of real estate secondary opportunities during 2008. Over the course of 2009, our deal sourcing team has already recorded over $18bn in real estate fund stakes for sale on the secondary market.

While there is clear recognition of the opportunity to invest in real estate secondary transactions, many institutional investors have questioned how sustainable the market opportunity is. It has been our experience that under normal market conditions, approximately 3 per cent to 5 per cent of the equity capitalisation of a fund comes back to the market as a secondary transaction over its lifecycle.

The actual secondary market volume should significantly exceed these thresholds as a result of the current economic turmoil and the liquidity needs faced by struggling institutional investors. According to a 2009 survey by Preqin, more than $400bn of equity capital was raised by private real estate funds during the past five years to invest in real estate, and in recognition of the position faced by distressed institutions, the real estate secondary market should grow to upward of $20bn-$40bn of transactions over the next several years.

Looking back over the past decade, the private equity secondary market has grown rapidly, providing liquidity options for owners of private market interests and attractive opportunities for investors. With general partners of real estate funds across the globe becoming accustomed to seeing stakes in their real estate funds trade on the secondary market, the real estate secondary market will experience a similar trajectory of sustainable growth.

While there are many sellers seeking liquidity, there are currently few buyers. This mismatch has created significant pricing power for buyers. That, combined with the fact that private market valuations still do not fully reflect public market valuations, has caused discounts to net asset value to rise from about 20 per cent in early 2008 to 50 per cent or more in 2009.

All too often, limited partners that attempt to  evaluate secondary investment opportunities do so only in investment funds in which they have already invested. While they may reduce their cost basis in a given fund, they will be increasing their concentration of risk. It therefore stands that institutional investors should pursue secondary investments via specialised fund managers that have the requisite experience and historical pricing perspective to

identify and price opportunities and deal with the necessary legal and tax considerations; speed and ease of execution often result in securing better pricing from the seller. As a result, not only will the investor achieve improved diversification by property type and geographic region, but they also will realise improved diversification by strategy and vintage year.

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