A $500B Opportunity
There has been a significant emergence of alternative lenders over the past 12-18 months as traditional banks continue to grapple with considerable challenges, including, but not limited to, a reduction in their deposit base, regulatory scrutiny, and potentially increased capital requirements.
A recent Morrison Foerster survey revealed that 62% of lenders have devoted more than 50% of their time to portfolio management and workouts, leaving limited capacity for engaging in new lending activities.
In addition, in a world where traditional banks play a central role in providing capital for over 50% of the roughly $6 trillion of commercial mortgages, lending activity declined by about 43% in 2023, as reported by the Mortgage Bankers Association.
With that in mind, there is a $500 billion opportunity in the commercial real estate debt market as banks scale back from lending, according to analysis by global investment firm KKR. Commercial mortgage-backed securities (CMBS) and debt funds will help to close this funding gap.
Concerns over U.S. regional banks, along with a drop in property values, banks’ liquidity and commercial real estate portfolios, particularly office exposure, have caused banks to withdraw from lending to the sector.
“Doing some back-of-the-envelope math, if bank lending recedes to 40% of the roughly $5.8 trillion commercial real estate debt market from 50%, it leaves a gap of over $500 billion,” said Matt Salem, head of real estate credit and partner at KKR.
“Who will be able to fill that gap? We do not think insurance companies or U.S. government agencies can allocate significantly more to commercial real estate given their existing exposure. That leaves CMBS and debt funds.”
KKR forecasts CMBS issuance to rise to $62 billion this year from $47 billion in 2023, and that the trend will persist over the next few years. It also stated that private debt funds hold $39 billion in dry powder.
“These are large numbers, but taken together, current non-bank financing remains insufficient to fill the void left behind by the pullback from banks,” Salem added.
Meanwhile, Nuveen, the investment manager of TIAA, believes real estate debt has the potential to provide greater returns than it has in a long time. “With higher credit spreads off higher interest rates and arguably with less risk, loans are being made with loan-to-value (LTV) ratios of already reset values,” wrote the authors of U.S. commercial real estate debt: Discovering beneficial routes of exposure.
Nuveen added, citing CBRE research, that standard LTVs in CRE loans in the second quarter of 2023 remained 4 to 5 percentage points lower their long-run average, “with the tightening more pronounced in multifamily than commercial.”
“This has left an emerging funding gap for viable lending opportunities in the mid-range of the lending risk spectrum, at 55% to 75% LTV.”
The decrease in real estate values is close to reaching a bottom, said KKR, and that the price difference between buyers and sellers should begin to narrow. As a result, the company expects more deal activity this year.
It noted that around $1.6 trillion of real estate debt is set to mature in the next three years, with owners likely to come under pressure as they would have purchased properties at peak valuations and financed their debt at low interest rates.
“Given the rapid rise in interest rates over the past 18 months, many of those capital structures are now highly levered or over-levered,” KKR’s Salem said. “While we think some loans will be modified, we also expect a significant number of owners will be forced to refinance or sell.”
Alternative lenders have a “unique” chance to provide capital at a higher return, potentially without increasing their lending risk, noted Nuveen. “If we consider a 55% to 75% senior loan over five years, the returns to investors could be boosted by a spread in the range of 275bps to 350bps delivering a coupon of 8% to 9%.
“At the same time, the 25% equity cushion embedded in the transaction will protect the returns to debt investors so long as the loan collateral avoids a value loss of more than 25%.”
Nuveen’s forecasts suggest the value can be derived by targeting loans collateralized by industrial, housing and alternative real estate, including manufactured housing, student housing and self-storage.
Given traditional bank lenders’ retrenchment, higher interest rates and the ability to limit risk through market selection, alternative CRE debt lenders may have an opportunity to achieve above-average returns.
“We expect this unique market environment to persist due to both structural and cyclical factors, allowing CRE debt investors to outperform in nominal terms as well as on a risk-adjusted basis,” noted Nuveen.
