After reaching a record deal volume of 47 transactions and a post-crisis high deal value of US$40 billion in 2017, real estate private equity’s bull run has continued right through 2018.

And the 37 deals announced globally in the first three quarters of 2018 is the highest figure on record for that period. Yet despite the flurry of transactions across the sector, deal value was down by 56% to US$12.28 billion when compared with the first nine months of 2017.

Private equity activity by volume Q1 2015 – Q3 2018Target location: Global Bidder location: Global Sectors: Real EstatePrivate equity deal type(s): Exit, Buyout and Secondary Buyout

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Record fundraising

PE activity has been underpinned by strong investor appetite for private real estate funds. According to research firm Preqin, dry powder in the sector rose to US$294 billion by the end of September—a new record. Large, high-profile managers have been among the main beneficiaries, with Blackstone and Starwood Capital raising US$14.6 billion between them in Q1, almost half of the overall takings for the quarter.

With the market appearing to bifurcate in favor of large managers, it comes as no surprise that Blackstone closed three of the ten largest private real estate deals in H1 2018, including the US$3.68 billion buyout of LaSalle Hotel Properties, the US$3.1 billion purchase of the Investa Office Fund in Australia and the US$732 million takeover of India’s Indiabulls Properties.

Other large financial sponsors also featured, with Starwood buying a stake in Victoria Park for US$255 million, Apollo acquiring Fair Value REIT for US$264 million and Oaktree taking on Indego for US$311 million.

Seeking value

High deal volumes have also been supported by attractive buying opportunities, with PE real estate dealmakers seeing good value in listed real estate investment trusts (REITs), which have underperformed equities for the last two years and are turning to M&A to boost shareholder value. This was a key factor in getting the Blackstone/LaSalle Hotel Properties deal over the line. With REITs continuing to trail the performance of equities, PE buyers are in a position to pay a premium on current share prices yet still buy at a discount to net asset value (NAV).

With regards to the real estate subsectors that PE real estate dealmakers have invested in, office space assets remained the primary targets. But Preqin figures show that dealmakers are diversifying into other real estate segments.

In Q2 2018, the share of aggregate deal value for office assets fell from 36% to 28% when compared to Q1 2017, with a larger proportion of capital directed into residential, operational and hotel property.

Apollo’s acquisition of Fair Value REIT in Germany, for example, will give the manager exposure to properties in in medium-sized towns and the outskirts of metropolitan areas in Germany, while Kildare’s acquisition of Lagoas Park in Portugal from Teixeira Duarte includes a portfolio of office space, hotels, restaurants, a college and parking space, among other assets.

Hunting for yield

PE real estate funds are also increasingly on the lookout for real estate deals offering growth upside in addition to yield, with many funds aiming to deliver net returns of around 15% and 1.6x money multiples for equity strategies.

One clear example of this is the investment of US$325 million in Open Door Labs by a consortium of venture investors led by General Atlantic, giving Open Door Labs unicorn status. The business operates across a number of major US cities, purchasing properties directly from homeowners for a fee, refurbishing them and then listing them as quickly as possible, with the aim of securing a quick sale. According to CB Insights, the business already accounts for 3% of home sales in Phoenix and Dallas and could achieve annual revenues of more than US$1 billion if it could win just a 1% market share of national home sales.

Within a low-yield environment, institutional investors are also showing greater interest in strategies beyond core real estate investments. According to Preqin, interest in core strategies is still strong, but there is growing appetite for other real estate plays, with 51% of investors polled by Preqin targeting value-added real estate strategies where managers reposition or redevelop properties to increase occupancy, and 45% interested in opportunistic strategies.

Potential pitfalls

After an active start to the year, the question now is how long buoyant PE real estate investment can continue. In the US, the Federal Reserve raised interest rates in June and signalled two further increases, while the Bank of England increased rates in August.

Rising rates could dilute returns, and firms will have to be more careful with their asset selection, focusing closely on cap rates (the rate of return on a real estate investment based on the income it is expected to generate) rather than banking on fair winds to drive appreciation in the value.

The market has also become more crowded, with institutions starting to invest directly in private real estate rather than through third-party managers, as demonstrated in deals like the US$1.1 billion acquisition of Harrison Street’s student housing portfolio by Scion Student Communities, a joint venture formed by Canada Pension Plan Investment Board (CPPIB) and Singaporean sovereign wealth fund GIC. Preqin estimates that there are now more than 600 managers in the market raising real estate funds, more than at any time in history.

Looking ahead

The rising number of new players entering the market, combined with the record amount of dry powder that that needs to be invested, will increase demand for assets and push up valuations, which will eventually put downward pressure on returns.

Although these dynamics will help to sustain private real estate deal volume and values, the challenge for dealmakers will be to find attractive real estate assets at reasonable valuations in an increasingly competitive space.