Frozen Liquidity and the Secondaries Solution

In the aftermath of the COVID pandemic, global inflation skyrocketed as demand normalized, labor markets remained tight, and supply chains were constrained. In response, global central banks undertook an aggressive rate hike cycle that escalated the cost of debt to levels unseen in over a decade. The rise in interest rates cascaded into commercial real estate (CRE) pricing and created a downward adjustment, with indices like the NCREIF ODCE declining 18.5%(1) and the Green Street CPPI declining 21.6%(2) peak to trough. This sudden shift in the pricing landscape produced a bid-ask spread that still lingers over the market in 2025.

Unsurprisingly, with a reset in valuations across market participants and a constrained lending environment, private market CRE transaction volume has fallen significantly with no signs of meaningful recovery. US CRE deal volume totaled $420B in 2024, 52% below the peak in 2021 and 22% below the average observed during the pre-COVID cycle from 2014-19.3 Similarly in Europe and the UK, deal volume totaled $188B in 2024, 40% below the volumes observed during the 2014-19 period.(3) This liquidity reduction and valuation reset has trapped capital in assets and portfolios longer than expected, impacting distributions to LPs.

The disruption of these flows is apparent when looking at the J-curves investors have experienced in closed end real estate funds over the last decade. Data on Fund DPIs and net cash flows show that every vintage since 2014 has underperformed the post-GFC expansion vintages.(4) Fund vintages from 2015-17 are tracking worse from a capital return standpoint than the vintages of 2006-2007, which were saddled with pre-GFC valuation assets that took an elongated time to unwind at subpar return levels. The more recent 2018/19 vintages are even more challenged, essentially failing to transition from investment periods into harvesting as they have not started the appreciable return of capital to investors.

The lack of distributions has created a vicious capital formation cycle as investors are unable to redeploy capital. Closed-end CRE funds only raised $111B in 2024, a 32% drop from 2023, and a 58% drop from the 2022 peak.(5) Fundraising now takes an average of 23 months, nearly doubling the pre-COVID pace. Open-ended and non-traded REIT structures show a similar story of broken capital formation cycles, having seen net outflows for six consecutive quarters.(6)

For a while, CRE market participants accepted the popular parlance “Survive til ‘25” with the belief that the rate cycle would reverse, reigniting transaction volume, valuations, and capital markets. However, higher for longer appears to now be the case going forward and time is no longer an asset when it comes to investments return outlook. Further incentive to transact in the short-term is the $2T wall of debt maturities the US CRE sector faces over the next 3-5 years.(7) Higher interest rates may result in a significant need for equity recapitalization of property and portfolio balance sheets, helping catalyze transaction volume.

The current market conditions could offer a unique opportunity for direct secondaries as a liquidity solution for constrained LPs and GPs. Direct secondary transactions can provide LPs liquidity from previously frozen holdings in order to recycle or redeploy capital into new strategies at a new valuation basis. Secondaries can also be a solution to GPs who need equity recapitalization as debt maturities come to fruition or need to extend hold periods as they look to optimize the investments returns. Institutional investors should also consider how structurally secondaries could serve as a compliment to their existing holdings. Capital distributions and closed-end CRE fund J-curves have been lagging normalized flows for a decade of vintages, but given secondaries occur partway into the asset/portfolio investment horizon, they may experience shortened J-curves with distributions coming back to investors sooner.

Sources:

(1) Bloomberg, NCREIF ODCE, February 2025
(2) Green Street, February 2025
(3) MSCI Real Assets, Volume & Pricing, January 2025
(4) MSCI Real Capital Analytics Insights, February 2025. Pooled net cash flow calculated as distributions less contributions and expressed relative to the total capitalization of each vintage year. Data as of Q2 2024.
(5) Preqin, February 2025
(6) Green Street, February 2025
(7) MSCI Real Capital Analytics, February 2025

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