Valuations and the impact of fund structure

Industry experts take a closer look at closed-end commercial real estate funds

Fund managers that are working to recalibrate portfolio values and accurately price new investment opportunities are continuing to search for reliable information and best practices in what remains an opaque marketplace.

Portfolio managers and investors alike are frustrated with a disconnect between property trading prices and appraisal-based valuations. According to the latest Green Street CPPI, the all-property index is down 16% from its March 2022 peak, whereas trailing 18-month data on the NCREIF ODCE index is down 4%. “The numbers don't look right, and they do not look reliable. That’s a real pain point because it puts clients in an over-allocated position, and it exacerbates the bid-ask spread if sellers think their basis is something that it's not,” says Margaret McKnight, a partner at the StepStone Group.

McKnight was one of four industry experts who recently participated in an Altus Group webinar on “Valuations and the impact of fund structure”. Panelists discussed investor demand for market information, strategies they are using to assess portfolio values and cap rates, and how current challenges are likely to drive more evolution in valuation practices.

The huge run-up in interest rates has had a direct impact on values, and fund managers are taking the initiative to write down values within their own respective portfolios. “Whether we were getting an appraisal or not, we internally valued the assets and generally wrote our portfolios down,” says Adam Vanni, portfolio manager at Fairfield. Closed-ended funds that have a fee structure based on GAV/NAV must align with market pricing to make sure that funds are not over-inflating their numbers. Fairfield focuses on both multifamily development and acquisitions, including develop to core and merchant build, as well as core-plus, value-add and affordable housing acquisitions.

Because the firm wrote values down late last year, the appraisals done in Q2 2023 have remained relatively flat. “Where we saw the disconnect was on assets that we had on the market to sell, usually due to fund life expiring or debt maturing, those values were substantially below the appraisals and BOVs (broker opinion of value),” says Vanni. Typically, in closed-end funds, most buyers have debt. So, the minute the cost of debt changes, the values change, he adds. “So, there's this continued pressure as rates are going up on cap rates and I believe that they're poorly reflected in the ODCE market,” says Vanni.

Searching for clues on values

In the current markets where trading volume is depressed but cap rates are clearly moving upwards due to rising interest rates, fund managers are leaning on different tools to price assets. One key focus is on the current income stream. StepStone is actively underwriting secondaries and co-investments, and its investment committee conversations often focus on the odds of achieving certain rental outcomes and assumptions for rental rate growth and exit caps. “The exit cap is a big conversation that we're having with a lot of GPs because we're trying to figure out what is the future of interest rates,” says McKnight.

It's not that hard to look at the relationships between what you're trading and the treasuries and the spreads. The real variable is what's going to happen with interest rates, adds McKnight. “There is a ton of discussion around that by the more sophisticated buyers in the industry. We can't wait for comp transactions to come around, because by then we may have missed a spectacular, once in a 20-year buying opportunity,” she says.

Because transactions have dried up there are fewer comps in general, and the comps that fund managers do see may have more of a story behind them. “You have to really try to figure out how useful they might be either on a good or a bad side,” says Christopher Lennon, executive vice president, NorthPoint Development.

Although the bid-ask gap is still very real, those bids also are providing nuggets of information. Properties are not trading because sellers are not getting the bids that they want. So, while there are not always transactions that appraisers can rely on, fund managers are having discussions around what they’re bidding on and having discussions with brokers on their BOV to try to get to a more realistic perspective of where cap rates are based on underwriting. Fairfield is gathering data on its own bids, as well as what others are bidding. “In some cases, somebody's willing to pay more, but we can still get a better gauge of what they're trying to do,” says Vanni.

To hear more from our panelists, watch the webinar on demand:

Raising the bar on reporting

Investors are continuing to raise the bar on reporting with demand for more accurate, granular, real-time data. “When you talk to an asset allocator and asset owner, there's just more people that are interested in what's going on in real estate and so the managers are pushing up more information and the valuers are trying to grab more information and trying to be more consistent,” says James Harkness, Senior Director and Strategic Client Partner at Altus Group. There is an opportunity for the industry to use this current environment to make changes, and fund managers may not have a choice if investors are demanding it, he adds.

Fund managers are building systems and processes to the highest spec or highest investor requirement. That provides best practices that can then be passed along to other investors. “We're not all at the bleeding edge, but there's been an evolution that is sweeping industry wide. So, the tide is rising,” says Lennon. “As we have instituted some of these newer procedures for certain existing clients, it's become an easy choice to extend those practices across the client base with limited additional cost.”

The U.S. pensions, global pensions and sovereign wealth funds are mainly defined benefit pension plans with an emphasis on quality quarterly valuations in particular, whereas defined contribution plans are more focused on daily valuations. Ultimately, that is drafting off the whole appraisal process, notes McKnight. “That being said, the revolution that's happening in computer technology is not about new math. We know how to do daily valuations. It happens in the U.K. regularly and thoroughly. It’s about gathering and handling more and more data,” she says. As that becomes more and more possible, more people are going to want that daily valuation data, which will drive improvement and greater transparency, she adds.

Investors want information that allows them to understand whether a fund’s current valuation reasonable, as well as the forward outlook and risk profile for the future. Investors also want to see where a fund’s current cap rates are compared with exit cap rates. “We always try to be transparent, but we're trying to be more forthright with what we're showing them all the time and giving them that perspective, so they know where we're sitting today, and where we expect things to go for their comfort level and ours,” says Vanni.

A lot of closed-end funds generally do appraisals once a year, and internally each quarter. Historically that has worked because real estate values don’t move very fast. But when debt markets are extremely volatile, that's creating more and more volatility on the asset valuation side. Especially in markets such as the current environment, fund managers are clearly working harder to stay on top of internal valuations and respond to investor questions. “I do think that we're going to continue to see technology evolve to get more data points for people, especially when we're in markets that are very volatile,” adds Vanni.