The gating of withdrawals from some open-end funds in the commercial-property downturn introduces an element of risk for the U.S. private-equity real-estate model moving forward. The heart of the problem is uncertainty around asset valuation and the ability of limited partners (LPs) to get at their capital. Had all valuations been beyond reproach, redemption queues may not have gotten out of hand.[1]
Pressures in the great repricing
Every manager took hits to asset values at different times and speeds in the great repricing of U.S. commercial real estate (CRE) that began in 2022. In meetings with clients since then, a common question has been “Has this company or that company cut asset values as much as us?” The fact that some managers could move at a different pace raises an important question. How objective are these appraisal-based values when timing can be chosen selectively? (In the public markets, by contrast, pricing is what it is on the day of a transaction, not a target to move toward over time.) Furthermore, appraised values diverged the most from subsequent sale prices for the U.S. than for any other global region in our annual study of the topic.
US appraised values differed from sale prices
Objectivity in appraisals has been a problem for the business of real estate in the U.S. before. In decades past, there were fewer external appraisals conducted, with firms valuing their own assets. This approach created skewed incentives for managers to hide the fact that asset values were falling.[2] If you tell clients that values are holding up despite market challenges, and if you keep clients at bay long enough, perhaps values recover, and LPs can exit the fund without taking losses.
How can asset owners ensure that the same perverse motivations do not re-enter the industry now or into the future? Do asset owners have the tools available to challenge or test the appraisal assumptions delivered to them? Looking at the disconnect between what appraisals and transaction-market prices would suggest for investment returns does provide some support to the notion that motivations have been skewed.
Pain in CBD offices
Take the U.S. market for offices in central business districts (CBDs), which is going through the harshest downturn in performance since the development boom of the late 1980s and early 1990s.[3] And yet, total CBD-office returns for the MSCI U.S. Quarterly Property Index in 2023 and 2024 had still not fallen to the levels seen even during the 2008 global financial crisis (GFC).
Appraised values for CBD offices had fallen only 43% from the peak levels to midyear 2024, while the RCA commercial-property price index (CPPI) for CBD offices stood 51% lower than the peak at that time. Recalculating the performance index using CPPI trends — i.e., measuring changes in asset prices rather than appraisals — produces a different story on investment performance.
Appraisal-based returns for CBD offices did not fall as sharply as transaction-based returns
As shown in the exhibit, this recalculated index is a bit noisier than the officially published index, because the capital-value component of the official index is based on appraisals, which are notoriously smoother than market-based transactions. What the CPPI-based index demonstrates, though, is a trend that matches the generally accepted reality that the CBD-office market faced worse conditions in this downturn than during the aftermath of the GFC.
The recalculated index shows quarterly returns below -10% for a period in 2023, weaker even than the post-GFC returns of the officially published index. Annualizing the quarterly declines shows a return of -33% when the index is calculated from transaction prices and a -22% official total return based on appraisals.
Who knows? Maybe the managers who hold CBD offices that have not seen drastic cuts in asset values simply have better assets. Cap rates for the CBD office market overall increased 160 basis points from the end of 2021 to the second quarter of 2024. Perhaps managers who have not raised cap rates on their assets as much as the market are simply better managers. But without independent confirmation from third-party datasets, LP investors will never know. The opaque nature of the performance data in the commercial-property markets often keeps LP investors in the dark as to the reality of asset values.
The benefit of multiple measures
Open-end funds offer up returns tied to the predictability of CRE along with an element of liquidity. But if one cannot transact at the values at which the assets are carried in the fund, is that promise of liquidity real? Uncertainty around asset valuation can distort incentives for GP and LP participants in a fund. LP investors are going to look more favorably on the sector if performance measures are transparent and predictable. A simple way that LP investors can cut through the uncertainty is to look at multiple measures of performance to identify outliers that could be skewing performance overall.