Private equity, real estate share similar set of concerns in 2018​

The role of private equity and real estate in investor portfolios may differ, but the outlook for both asset classes in 2018 continues to have much in common: too much money, too high prices and lower returns.

At the same time, the economy is a wild card. Nine years after the last recession, real estate and private equity investors continue to expect a downturn but have no clue as to what could rain on their parade. And they have been expecting the downturn for the past few years.

Real estate funds have a combined $244 billion in dry powder as of Sept. 30, up from $223 billion nine months earlier, according to London-based alternative investment research firm Preqin. Private equity managers are sitting on $954 billion in dry powder, up from $826 billion, Preqin data show.

There is a 1-in-4 chance the economy will hit a speed bump in 2018, said Andrea Auerbach, managing director, Menlo Park, Calif.-based head of global private investment research at Cambridge Associates LLC.

Private equity investors have a diversified array of options, including private credit, growth equity and sector-focused funds. In the 1990s, the only option was "heavily leveraged buyouts," Ms. Auerbach said.

And, with the exception of 2008, every recession has had "a smaller blast radius" with only a few sectors of the economy being affected, she said.

Since the 2008 recession, certain sectors have been affected by "rolling blackouts" including retail and oil and gas, she said.

Investors can benefit by going into those sectors if they stick with managers experienced in that industry, Ms. Auerbach said.

"I think the challenge for investors going forward as the private equity industry continues to specialize and fragment … is to find areas that are less trampled by capital and take advantage of those," Ms. Auerbach said.

Some asset owners are considering such specialized areas as royalties, settlements and litigation claims, she said.

Real estate insiders are also keeping the economic cycle top of mind but agree that the asset class is in better shape than it was before the Great Recession. "Broadly speaking, we are in a maturing economic cycle, but it's pretty healthy," said Russ Devlin, Boston-based director of the research group at real estate manager AEW Capital Management LP. "The last downturn was caused by supply being out of whack."

Industry executives have been waiting for a recession and/or a spike in interest rates that never arrived — "although we are keeping our eyes on it," Mr. Devlin said.

Property supply is trending up and that's expected to continue to edge up, though more modestly than in prior cycles, he said.

"Vacancy rates are moving sideways, with no upward movement in office, industrial and multifamily sectors," Mr. Devlin said. "Even retail, it went down a tick or two but it is not what you would have thought. We think the death of the mall is exaggerated."

Scott Davies, a principal on the Bala Cynwyd, Pa.-based Hamilton Lane Inc.'s real assets team, also feels fairly positive about real estate in 2018. "Real estate continues on solid footing, with healthy demand across the board from both investors and users," he said in an email.

Even so, investors should expect lower returns, he said.

"According to the (NCREIF Property index), quarter-over-quarter real estate returns have trended downward from 2015 highs, yet look to have stabilized at near the 10-year average of 2% in the past several quarters," he said. "We believe this trend will continue in the near term; however, we see a growing dispersion among manager performance as the industry reacts to slowing rent growth, softer absorption and increasing financing costs."

Hamilton Lane executives continue to advise clients to invest defensively through tactical, offense-oriented strategies, he said. "We favor best-in-class managers, which includes large diversified platforms and specialist operators; a combined strategy of equity and debt investments; and opportunities that don't run from cyclical headwinds but rather seek attractive investments that are created in times of volatility," Mr. Davies said.

In 2018, real estate managers will have to work harder to get returns, said Joseph Sumberg, New York-based managing director and co-head of Goldman Sachs Asset Management Private Real Estate.

"We are very focused on something we call the Great Rotation. Millennials have supplanted the baby boomers in total population. … They are marrying and having kids later. They are in the early stages of beginning to age out of urban (central business district properties) and they want more space and in most CBDs in America, the schools are not as good as suburban areas," Mr. Sumberg said.

While millennials do not value home ownership as much as baby boomers did, they do value great public schools, he said. Properties located near strong public schools will be in high demand, he said.

Meanwhile, baby boomers are selling the homes they raised their now-grown children in and are moving to central business districts, he said.

"Appreciation will be more difficult to come by with cash-flowing real estate. The market won't create it for you. We have to create it ourselves," he said.

Private equity is also expected to produce lower returns. Indeed, newer private equity funds are returning less than older vintage funds, according to performance data from PitchBook Benchmarks, a performance report issued by alternative investment research firm PitchBook.

Private equity funds raised in 2015 are producing a 4.8% median net internal rate of return vs. 8.4% for 2014 vintage funds and 12.01% for 2011 vintage funds, PitchBook data show. (PitchBook Benchmarks does not yet include 2016 and 2017 vintage funds.)

"There's continuing to be pressure on private equity returns," said Nizar Tarhuni, Seattle-based analyst manager at PitchBook.

Even so, capital is expected to continue to flow into private equity in part due to investors moving their stock exposure to passive strategies and investing in private equity to gain active exposure, said Cambridge's Ms. Auerbach.

This new capital will go to the larger private equity funds because such funds can accommodate larger investments, she said.

All this capital into larger funds will hurt returns.

"Larger fund returns are already less dispersed than smaller fund returns and they will get even less dispersed as more capital move into larger fund families," Ms. Auerbach said. "Their (larger funds') ability to provide compelling returns will be challenged."

The median for private equity is an 11% net internal rate of return, "and you are paying 2 (percent management fees) and 20 (percent carried interest) for that," she said.

Private equity fund fee structures will continue to change and evolve, Ms. Auerbach said. Two and 20 made more sense in the 1990s when private equity's median return was a 20% IRR, she added.

An increasing number of managers are expected to offer a sliding scale for carried interest, Ms. Auerbach said. A few managers are charging 10% carried interest when they produce a 10% return, 20% carry when they earn a 20% return and 30% carried interest when they produce a 30% IRR, Ms. Auerbach said.

Private equity fees even could more closely resemble private credit fees as private equity returns migrate down to credit returns, she added. The median net return for credit is 9%, two percentage points lower than private equity. Credit managers generally charge a 1% management fee on invested capital and 15% carried interest.

"The big elephant in the room are valuations," said Anthony D. Tutrone, New York-based managing director, global head of the alternatives business at Neuberger Berman.

"The concern for the future is that there is a lot of capital coming in, valuations are high and capital structures are aggressive," Mr. Tutrone said.

Even so, investors are maintaining or increasing their allocations to private equity, he said. "They see private equity valuations are more favorable than the public markets," Mr. Tutrone said. And fundraising should remain very robust unless something changes in the marketplace, he added.

Although managers are increasing the amount of debt they are using in deals, the level of debt is not nearly as high as it was in 2006 and 2007, he said.

"Additionally, since interest rates are very low and there is more equity in deals, the risk to the capital structure is much less," he said.

T. Ritson Ferguson, Philadelphia-based CEO of real estate manager CBRE Global Investors, said low interest rates keep the cost of investment capital low. And since interest rates are expected to increase slowly rather spike up sharply, increases in the next year or so should not negatively affect real estate.

Even so, CBRE Investors' executives are "wary after an extended period of good returns, which we have clearly enjoyed," Mr. Ferguson said.​