In 2017, closed-end private real estate funds invested US$287 billion and reached US$811 billion in assets under management, both record amounts. The net asset value of closed-end real estate funds has now increased for 30 consecutive quarters. The expansion of the real estate fund industry in recent years reflects a robust post-financial crisis real estate market that has resulted in increased portfolio values, strong performance results, and access to greater amounts of capital.
This market has also generated new challenges for real estate fund managers, who are seeking to source attractive investment opportunities in an environment where valuations are high and competition for assets is intense. Following years of successful fundraising, fund managers are under pressure to deploy capital and maintain strong returns. Although fundraising levels are still high, the amount raised by closed-end private real estate funds decreased from US$126 billion in 2016 to US$111 billion in 2017.
Investors seeking higher returns continued to direct the majority of capital raised by private real estate funds to opportunistic and value-add strategies in 2017. However, there has been an increased focus of fund managers and investors on debt-focused strategies, reflected in an increase in the amount of capital raised by private real estate debt funds from US$22 billion in 2016 to US$28 billion in 2017. This trend is expected to continue, as investors seek to diversify portfolios and protect against downside risk in the face of increased interest rates and cyclical economic factors.
New fund managers continue to face challenges as capital is concentrated in fewer, larger real estate funds. Nonetheless, emerging managers have produced strong returns, and many such managers have been successful in turning current market conditions to their advantage by focusing on assets outside of the scope of larger funds seeking to deploy capital through the acquisition of portfolios and other large investments. In addition, institutional investor interest in partnering with new managers in joint ventures or seeding arrangements has been strong (see “First-Time Fund Managers and Seeding Arrangements” above), balancing out some of the challenges that new emerging managers face.
Real estate fund managers are continuing to invest in new technology platforms that allow them to analyze diverse sets of real estate investment data more efficiently. For instance, fund managers are utilizing predictive analytics in making investment decisions and relying on improved performance data in managing retail, industrial, and multifamily properties. Fund managers are also using new technology systems to provide reporting and back office functions, resulting in significant cost savings.
Fund managers are also increasingly utilizing complex fund structures to hold real estate and related assets (including debt investments) in an effort to accommodate investors with diverse tax and regulatory concerns. This trend is expected to continue, in particular as non-U.S. investors seek to take advantage of changes implemented by the Tax Cuts and Jobs Act of 2017. Real estate fund structures often include parallel vehicle structures and the use of specialized investment vehicles such as REITs, leveraged corporate blockers, and Delaware statutory trusts. While these structures provide tax benefits to investors and have expanded the pool of investors able to invest in real estate funds, the associated costs can represent a significant hurdle for emerging fund managers and could increase pressure on fund managers generally to produce returns that justify such costs.
The Tax Cuts and Jobs Act of 2017 increased the holding period for long-term capital gains with respect to gains attributable to carried interest from one year to three years. While real estate funds typically hold assets for a period of three years or longer, this change will further incentivize fund managers to focus on assets that are expected to meet the holding period.