With inflation forecast to continue to fall (albeit gradually) and the Federal Reserve predicted to begin cutting interest rates in the second half of the year, investors are mulling whether now is the time to invest in real estate and if debt, equity, or both is the best option.

Regarding real estate debt, the current risk-adjusted return profile is appealing to debt providers. Rising interest rates have positively impacted the investment returns, and the thresholds for granting new loans are generally decreasing. This is especially true when borrowers demonstrate their commitment to the underlying assets and contribute additional funds to the transaction.

“We expect to see robust demand for debt financing solutions provided by real estate investment funds,” said David White, head of real estate debt strategies, Europe at LaSalle Investment Management. “This is due to both recent market developments and longer-term structural trends. In the shorter term, borrowers have begun to adapt to a higher cost of financing.”

Last year, U.S. government agencies, insurance companies and select private debt funds were able to provide most of the market’s financing requirements. But that may not be possible when transaction volumes increase, especially as traditional banks remain hesitant to return to their past lending practices.

Moreover, following last year’s regional bank failures and decline in property values, banks’ liquidity and commercial real estate portfolios, particularly their office exposure, continue to be closely scrutinized.

Given these circumstances, global investment management giant KKR is equally enthusiastic about alternate providers of real estate debt, highlighting that the credit gap will become more apparent as transaction volumes increase this year.

“We expect alternate providers of capital to have a significant opportunity to lend on high-quality, well-located real estate at attractive yields and terms,” noted Matt Salem, partner and head of real estate credit at KKR.

Despite Federal Reserve Chair Jay Powell’s dovish policy pivot in December, some analysts expect interest rates to remain higher for longer, lengthening the opportunity to offer funding for property acquisitions and refinancings.

“We believe that today’s market landscape characterized by high base interest rates, widening credit spreads, lender friendly loan structures, and the ability to drive terms in a constrained market has created an attractive risk-return proposition for privately originated real estate loans,” wrote Scott Weiner and Ben Eppley, partners at Apollo Global Management, in “Mind the (Funding) Gap: Finding Opportunities in Real Estate Debt Amid Dislocation.”

“There is a large need for capital on the horizon as significant amounts of real estate loans are expected to mature over the next few years. And funding gaps from declining property values and stricter loan standards need to be closed, offering another area to provide capital,” Weiner and Eppley wrote. Apollo sees attractive opportunities in both the US and Europe.

Also, lenders’ protection from loan structuring and terms has improved, added Apollo. Lenders can now reduce their risk by offering debt financing with lower loan-to-value (LTV) ratios than identical loans from a few years ago. The firm highlighted that the average LTV ratio on new deals after the Silicon Valley Bank collapse has “declined to 51%, down from the post-Covid average of 60%,” citing Trepp and Goldman Sachs data.

KKR, meanwhile, noted that activity in its real estate credit pipeline is gathering momentum, highlighting that there are currently about $15 billion of loans, up from an average of $10 billion to $12 billion in 2023. It expects there will be significant opportunities to lend as both refinancings and acquisitions increase.

“Across the market, we are finding that it is possible to lend at a significant discount to replacement cost and often at 50% of peak valuations, while earning low-to-mid teens gross returns on mezzanine-like exposure at loan-to-value ratios near 65%,” said Salem. “In other words, it is possible to earn equity-like returns at a favorable position in the capital structure, and the scarcity of debt capital in the market means that these conditions should persist.”

Global real estate manager CenterSquare Investment Management shared comments about its positive sentiment on the real estate debt markets, noting that “our optimism…remain unwavering.” The firm cited elevated credit demand, limited credit supply from traditional lenders, and a reconstitution of the capital stack as reasons to be bullish.

“…we had never been more enthusiastic about the opportunities available to generate equity-like returns through debt investments,” wrote CenterSquare in Navigating a Lender’s Market: 2024 Real Estate Debt Outlook.

“…while over $700 billion in loans were set to mature in 2023, many of those loans have been modified through a ‘blend and extend’ strategy, whereby lenders asked for additional collateral from the sponsor, adjusted the interest rate, and provided short-term modifications to the loan. This has pushed more of these maturities into 2024 and 2025 with the hopes of a friendlier refinancing environment.”

As a result, private funds and other specialty lenders are capturing a growing share of CRE debt capital commitments. Capital is responding to this opportunity set, with pension funds allocating roughly $6 billion to CRE loan vehicles through the first nine months of 2023.

“Prevailing market dynamics, defined by heightened demand and limited supply for credit, as well as mounting real estate debt maturities will present a compelling opportunity for real estate debt investors to generate attractive risk-adjusted returns in the coming year,” noted CenterSquare.