The Gates Come Crashing Down
This month, the largest two private real estate funds in the US surprised investors by bringing the gate crashing down, limiting withdrawals. Blackrock Real Estate Investment Trust (BREIT) and Starwood Real Estate Investment Trust (SREIT) have both told shareholders that they’ll need to wait to get their money out because requests for redemption have exceeded available liquidity. This is certainly eye-catching because it impacts many small investors: BREIT has a massive $69b in net assets, while SREIT weighs in at approximately $15b. Gates on mega-funds always raise eyebrows, but we shouldn’t feign surprise. This was bound to happen. Indeed, it will happen again in the future.
Real estate is an obviously illiquid asset. Yet these funds allow investors to redeem, pretty much at will - at least under normal circumstances. These two facts are not altogether compatible. In order to make it work, they use a variety of techniques. First, they net (or offset) subscriptions and redemptions. Minor net redemptions can be met with income from the portfolio and cash held in the portfolio specifically for that purpose. When outflows get more severe, debt facilities can be tapped to tide investors over in the short run. But when all else fails, they need to sell properties, and that’s when things can get tricky.
It takes time to sell real estate. If a large fund needs to sell quickly, potential buyers smell the figurative ‘blood in the water’. Forced selling of this kind almost always results in sale prices below the carrying value of the assets in the fund’s NAV. This can trigger downward revaluation of the rest of the portfolio, worsening performance and encouraging further redemptions, in a kind of ‘doom loop’. This obviously harms remaining investors in fund. Gates are meant to short-circuit this negative feedback loop; giving the fund manager time to liquidate in an orderly fashion and achieve the best possible sale prices. So far, so good.
The problem arrives at turning points for real estate markets; when fund NAVs can become wildly unrealistic. Portfolio assets are valued using appraisals, which are intrinsically subjective. But additionally, to the extent appraisals utilize comparable transactions (‘comps’), they’re inherently backwards looking. Combine this with the fact that not all portfolio assets are revalued at each portfolio revaluation point, and you can get a get an extremely ‘stale’ or out of date fund NAV. That’s ok, most of the time, when valuations are not changing too quickly. But when the reality on the ground has changed rapidly, and fund NAVs are unrealistically high, investors have an incentive to flee.
That’s just what’s happened in 2022. The liquid real estate market (publicly traded REITS) has tanked, while the NAVs of these private REITs have actually moved up. They can’t both be right. Investors have sniffed out this discrepancy. In redeeming their units in BREIT and SREIT, they’re saying that these fund’s NAVs are bogus. And they’re almost certainly right.
In light of these gates, it’s interesting to ask: why are these types of funds so popular? You have the risk of lockups to deal with, and running costs are huge. Moreover, their diversification value is overstated. In our experience advisers (and their clients) often desire the return smoothing and the appearance of lower risk that illiquidity brings. This is an illusion, but a soothing one.
In many cases advisors can afford to indulge this minor self-deception, as long as position sizes are kept reasonable. But we should be clear-eyed about how these funds really work and when to avoid them. You don’t want to be in one of these funds towards the end of a market cycle. The best time to use them (if use them you must) is when their portfolios are marked at a discount to the portfolio values implied by the prices on public REITS. We’re not there yet.