The Gravitation Toward CRE Debt Funds 

Amid declining real estate valuations and elevated financing costs for direct acquisitions, real estate debt has emerged as a crucial investment target for investors, owing to its potential to yield equity-like returns. 

KKR observed a rise in commercial real estate transaction volumes over the past six months, emphasizing that the scarcity of bank capital should maintain favorable yields and elevated spreads compared to corporate credit. 

“The scarcity of capital and increase in volume is creating opportunities both in the near term and long term to earn equity-like returns on real estate debt, wrote Matt Salem, partner and head of real estate credit, and Dakota Sagnelli, a member of the real estate strategies team within global client solutions. “All told, we believe this will be an attractive vintage for real estate credit.” 

The global investment giant sees real estate credit as a “compelling, evergreen opportunity” to diversify both tangible secured equity investments and the credit aspect of a portfolio with a high-yield asset secured by real estate, while capitalizing on a structural reduction in capital availability. 

Valuations Hit a Low 

Real estate private credit fund managers and their investors are in an unusual environment. They can invest in a market with robust underlying real estate fundamentals across several property types, even amid challenging capital markets. 

“Investors are increasingly looking to reallocate some of the capital towards debt investing to seek diversification and stability as debt strategy is a lower risk alternative to shield them from market volatility and provide downside protection, said Neil Brookes, global head, capital markets, at KnightFrank. 

KKR believe real estate valuations have hit a low point, noting that capitalization rates in the U.S. and Europe have begun to decline. After reaching their highest level since 2012 at 6.8% earlier this year, U.S. cap rates have been heading lower. Meanwhile, cap rates in Europe, which also reached their highest level since 2012 at 5.2% earlier this year, have been declining as well. 

“We are also seeing signs of a bottom in the prices of publicly traded REITs, which have either stabilized or are increasing since year-end 2022,” wrote KKR. “Office remains an outlier, but even there we are seeing signs of stabilization by way of higher leasing activity.” 

Transaction Volume on the Rise 

KKR said its direct lending pipeline increased to $20 billion a week in August from $14.5 billion in January 2024. Evidence of the transition is seen in publicly traded CMBS markets, with some projections estimating issuance will hit $80 billion in 2024. This would represent the highest level since 2021, a notably active year, said the firm. 

The firm identified several variables fueling the rise in transactions, including the impending maturities of outstanding debt and the expiration of numerous interest rate caps, which the authors described as a potential “soft maturity date.”   

A significant portion of the loans maturing were for deals executed during 2021 and 2022, characterized by elevated property values and lower interest rates. As owners seek to refinance, they will encounter a rising interest rate environment and diminished valuations, which exerts pressure to sell. 

“We think this will be an attractive vintage for real estate credit. For one, we believe it will be lower risk than previous vintages,” KKR said. “As valuations have reset, loan-to-value ratios for new originations have come down.”   

This is partly due to a dip in overall property values, but also because loan revenues, or the actual amount owed by a borrower, have decreased by around 30% since the first quarter of 2022, when property values were at their greatest. For lenders, this signifies an increased equity buffer and a reduced total debt obligation, the authors added. 

KKR believes forecasts for inflation to continue to decline and additional global interest rate cuts are contributing to the rise in transactions, which has given “potential buyers more confidence in their investment assumptions.”  

The firm does not believe that lower interest rates mean a weaker outlook for real estate credit returns. “As rates remain elevated compared to history, the lack of available capital should put a floor under borrowing costs, and more transactions will mean more opportunities to lend.”