CRE Debt Funds: Filling the Lending Gap
Capital market conditions over the last 18 to 24 months have been challenging for many in the commercial real estate (CRE) industry, but they have also presented an appealing opportunity for CRE-focused debt funds.
During the tightening cycle, markets have been shaken by rising financing costs and heightened anxiety about recession, inflation, and financial market stability. The CRE markets have not been immune, with investment volumes plummeting, price discovery disappearing, and pro forma returns dwindling.
The failure of three U.S. regional banks last year further muddled the outlook, as liquidity and funding challenges raised solvency concerns among those banks, which are a significant source of debt financing for CRE borrowers.
While elevated capital costs and lending alternatives are significant challenges for many CRE investors, this background is one of the reasons for increased interest in CRE debt funds. While debt funds account for a small portion of the overall CRE financing market, the current situation has allowed them to play a larger role.
“The 2008 crisis in essence created a funding gap that the private debt market readily stepped in to fill. And this was no different in the real estate market,” said Tamás Márk, global head of real assets at global investor service IQ-EQ. “Banks scaled back their lending in the face of plummeting property prices and increased regulatory scrutiny and, as a result, private real estate debt funds advanced to occupy the space that was being freed up.”
The result is a robust marketplace with over 2,000 real estate funds now operating globally, according to Preqin.
Furthermore, since 2020, nearly $111 billion in debt strategies has been raised across more than 330 closed-end funds, accounting for approximately 16% of CRE fundraising, according to Boston-based Jones Lang LaSalle’s (JLL) Global Capital Outlook report.
JLL examined the diversification benefits of debt strategies by comparing the differential between CRE cap rates and the U.S. commercial loan rate to the US 10-year Treasury yield.
“Since the onset of the Federal Reserve’s interest rate tightening cycle in the first half of 2022, credit strategies’ absolute yield has outperformed by 15 basis points,” the firm noted. “This compares to equity strategies’ yield outperforming by 220 basis points on average during much of the past cycle when interest rates were lower, speaking to the relative favorability of credit strategies.”
JLL predicts that $3.1 trillion in global real estate assets will have maturing debt by the end of 2025. Based on average loan-to-value rates across global markets, these loans are projected to be worth $2.1 trillion.
“Loan maturities will catalyze transactions activity and, in some cases, distress,” JJL warned. “This will result in pressure in a multitude of situations, along with a significant opportunity for investors to deploy across the capital stack and risk spectrum through mezzanine financing, rescue capital or other structures, giving them exposure to new property sectors and geographies.”
Recent advancements in industry reporting and benchmarking are providing additional support for growing debt funds. Institutional investors and their fiduciaries demand an index or tool to compare investment performance across asset classes.
There is presently no industry-wide standard investment performance index for private equity real estate credit. However, the industry body National Council of Real Estate Investment Fiduciaries (NCREIF) is creating a relative performance metric for its members.
Currently, NCREIF’s open-end credit fund aggregate includes 13 funds that contribute data to the new index, and these funds are well-diversified in terms of the industries to which they lend.
Some of the globe’s largest investors are making greater forays into commercial property loans, capturing market share from shrinking banks and betting on an end to the significant slump in real estate values.
U.S. firms PGIM, LaSalle, and Nuveen, Brookfield and QuadReal in Canada, M&G, Schroders, and Aviva in the U.K., and AXA in France have all informed Reuters that they intend to raise their property credit exposure, with most focusing logistics, data centers, multi-family rentals and the high-end office market.
“Many private pools of capital, such as debt funds, have significant “dry powder,” or capital available to make additional investments, and they can carefully select among borrowers and properties to invest at lender-friendly terms with high yields, low leverage, and strong covenants,” said Andrew Rubin, institutional portfolio manager, Fidelity Investments.
The fund management arms of major banks are also targeting the market. Goldman Sachs Asset Management closed its largest real estate credit fund to date, with over $7 billion of lending capacity, last month, including some of the firm’s own capital and leverage.
“More properties could come to market as owners begin to accept current pricing and lending terms and lenders hold the line on loan extensions and force borrowers’ hands,” added Rubin. “While this could add further pressure to property values in certain segments, it could create attractive potential upside for real estate debt investors with the opportunity to lend against reset property values and earn high yields with low leverage.
Market conditions have made CRE-focused debt funds an increasingly feasible alternative to traditional financing, and it is expected to take on a more considerable role in filling the widening lending gap.
