Real estate debt funds became more popular after the global financial crash (GFC) as traditional sources of financing dwindled due to a combination of increased regulatory scrutiny and a crash in property values. At the time, several real estate managers expanded into debt, particularly in the US as property values suffered more compared to Europe. From 2007 to 2009 US commercial property prices declined by almost 40% compared to 20% in Europe1. During this three-year period, at least 13 new US real estate debt managers emerged including Blackstone, Apollo, and CBRE, compared to only three in Europe2. Since then, the percentage of real estate managers that have a debt strategy has steadily increased and currently 60 of the top 100 US real estate managers have a real estate debt fund versus 36 in Europe (including the UK).
The expansion from real estate into real estate debt appears to have been more natural than the expansion of private debt into real estate debt – out of the top 100 US private debt managers only 25 have a real estate debt fund. Additionally, only eight of those 25 managers did not have a real estate equity fund prior to launching into real estate debt.
Source: Preqin Ltd as of November 2023.
This can be attributed to the specialisation that is required when underwriting real estate loans – managers with real estate equity practices can benefit from in-house valuation and asset management expertise, which may allow them to better appraise assets and manage downside scenarios if they need to take control of the assets. The pace of regulatory change in real estate also adds significant risk to the asset class, managers without sufficient expertise may underestimate the potential impact this has on the underlying asset.
Additionally, most pure-play private debt managers operate diversified strategies and do not have sufficient in-house resources to create a dedicated real estate debt fund. Still, there are some examples of private debt managers expanding into this strategy.
Note: Macfarlanes analysis of Preqin data, based on the top 100 private debt managers in the US by funds raised in the asset class.
Source: Preqin Ltd as of November 2023.
Currently, we are seeing a resurgence in real estate debt funds to take advantage of favourable market conditions that have not been experienced in the last 10 years. In 2023, at least 10 fund managers launched their first real estate debt fund including Bain Capital, Tikehau and TPG. Existing managers are also contributing to this growth with several announcing new fund launches in 2023. In fact, the number of real estate debt fund launches grew three times from 2022 to 2023.
Note: For closed end comingled funds.
Source: Preqin Ltd as of November 2023.
However, AUM data does not yet reflect the growth in this strategy. When looking at the past five years, the AUM growth for real estate debt funds pales in comparison to that of real estate equity or private debt funds.
A possible explanation is that several funds are still currently fundraising – fundraising in in the past year has been challenging across asset classes, leading to fundraising periods becoming more prolonged.
Still, several sources expect debt strategies to play an increasingly larger role in real estate – according to PERE’s fundraising data, in Q1 2023 debt represented 24% of capital raised across real estate strategies, up from 15% in Q1 2021.
Real estate debt funds
Real estate equity funds
Corporate direct lending funds
Source: Prequin Ltd as of November 2023.
Managers launching their first real estate debt fund in 2023
Note: This list is not exhaustive.
Source: Company announcments.
Although many managers, particularly in Europe, have not yet created dedicated real estate debt funds, that does not mean they are not still able to take advantage of opportunities in the space. Tikehau for example, prior to launching its first real estate debt fund in 2023, already had a track record in this strategy of €500m3 through its special opportunities strategy.
As mentioned previously, private debt funds tend to be diversified with little concentration restrictions on sectors. This means that most funds have flexibility in their mandates to invest in real estate. Given the returns currently achievable within real estate debt, more deals are becoming suitable for the return profile of private debt funds, particularly for more opportunistic funds where managers have the flexibility to move around the capital stack in pursuit of opportunities.
Fund managers opting to invest through existing vehicles should be cautious about investor sentiment as some investors may not wish to increase their exposure to real estate through a private debt fund, given the impact on their portfolio-level target allocations and diversification goals. Some investors may have included concentration limits in their side letters and therefore may be excluded from investments that surpass that limit, but the majority typically do not have this protection.
Source: Pitchbook LCD – Morningstar European Leveraged Loan Index.
In the past year, great emphasis has been put on the size of the “maturity wall” that will hit the US and Europe by 2025 i.e. the value of existing debt that will mature by that date, most of which will look to be refinanced. For commercial real estate (CRE) this is estimated as €150bn in Europe4 and $1.5tn in the US5. High interest rates and supply-side retrenchment have transferred more power to remaining lenders. This is leading to a tightening of terms and superior risk-adjusted returns.
Supply-side retrenchment
Opportunities for alternative lenders
The banking sector has become more cautious due to the current market environment and the failure of four US banks since March this year6, one of them a major global player. Although US banks have been more impacted, these events have also led the UK and Europe to increase their focus on banking vulnerabilities. In the UK for example, regulators are taking a more hands-on approach to stress testing and will be conducting tests themselves based on banks’ balance sheets rather than leaving it to banks to self-report.
Increased caution by banks will further drive the market share of non-bank lenders in real estate financing, this has been compared by some managers to the trend seen in private debt, with some stating that real estate debt is approximately five years behind direct lending. In the UK, non-bank lenders already make up 30% of CRE origination, but this is still some way behind the US where this figure stands at 55%. If the UK evolves in the same way, this will represent an additional annual debt origination value of over £10bn for non-bank lenders.
The implementation of Basel IV could prove to be an important catalyst for the growth of European non-bank lenders. Basel IV introduces “output floors” that limit the minimum risk-weighting a bank can attribute to a loan, therefore requiring banks to increase their capital reserves. Previously, sophisticated banks, mainly in Germany and Scandinavia, could benefit from using internal models that ultimately attributed a lower risk-weighting to specialised loans, which include real estate.
Basel IV will have limited impact on UK banks. When first implementing the Basel reforms, the UK decided not to allow the use of internal models for calculating capital requirements, instead, the stricter “slotting approach” was implemented across the sector leading to, on average, higher risk weights on specialised loans. However, the UK real estate debt market is impacted given the presence of foreign lenders actively lending into the UK, particularly from Germany.
These output floors will gradually increase until 2027 thus continuing to move the dial on banks’ capital levels and limiting banks’ origination in real estate debt.
Note Basel IV is an informal name given to the final implementation of Basel III and is a set of international banking reforms that began implementation in January 2023, and are expected to take five years to fully implement.
Source: Bayes Business School, Cohen and Steers.
LTVs are derived at the time of loan origination by dividing the total committed credit amount by the total value of the property (plus any other collateral). Generally, the lower the LTV, the less risky the loan. The willingness to lend at different LTVs is a key differentiator between banks and non-bank lenders, with the latter accepting on average higher LTVs (although also charging a corresponding higher margin to recognise the increased risk). Initial LTVs above 60% make up less than 15% of UK banks’ loan books, whilst for debt funds they represent more than 55%7.
Since the GFC there has been a trend for CRE to become less leveraged. In 2019, the average initial LTV in the UK ranged between 55% and 60% across sectors, down from 75% pre-GFC. In 2023, LTVs on new transactions reached historically low values ranging from 53% to 56% across property types indicating that lenders became on average more risk averse. Borrowers are currently faced with two difficult and opposing issues on LTVs:
According to Green Street’s commercial property index, property prices declined c.10% in Europe from January 2023 to January 2024 and c.25% from their peak in April 20228. Debt issued at peak values could be greatly impacted when refinancing in 2025/2026 if property values do not recover. The bar chart on the right illustrates the impact that the decline of property prices has on LTV ratios. For example, a loan issued in Europe in 2019 with an LTV at origination of 58% would now have an LTV of 70%, based on the average decline in CRE prices. At this level, supply from banks is much more reduced leaving borrowers to look for more flexible lenders and/or finding different ways to increase capital for example through preferred equity. For lenders, this means that they can achieve higher returns at lower leverage points.
Note Trends in CRE prices vary significantly based on sector. Prices in the office sector for example have experienced a more significant decline in the last 12 months than stronger sectors such as industrial.
Based on average LTVs at time of origination and average decline of property values across sectors.
Source: Based on Bayes Business School data.
Indexed to 100 in September 2007
Source: Green Street’s Pan-European CPPI.
ICRs show a borrower’s ability to service the interest on their debt from the income received from the underlying property/ies. The figure is derived by dividing a property’s net rental income9, by the interest expense. Generally, the higher the ICR the less risky the loan.
Although ICRs have always been included in loan documentation, in the last 10 years, due to the low interest rate environment, LTV was often the key metric analysed. ICRs are now at the forefront of loan structuring considerations because LTV ratios do not convey the impact of interest rates or margin increases.
In 2023, deterioration of ICRs was more significant than the changes seen to LTV ratios. To illustrate the impact, we look at the ICR evolution of a CRE loan issued in 2020 in the UK, assuming a 2x ICR at origination, as it corresponds to 50% of net rental income being allocated for interest payment, and a 3%10 margin over the reference rate11.
During the period from October 2020 to October 2023, the rise in interest rates caused an increase of 166% in interest costs, while rents grew over that period by only 21%, thus explaining the sharp decline in this ratio. With base rates forecasted to decline in 2024 and 2025, some recovery is expected.
Note At current interest rate levels, many borrowers will struggle to refinance at an affordable cost. Banks will often not lend at lower ICRs creating opportunities for debt funds – ICRs below 1.4x make up over 50% of debt funds’ loan books compared to less than 10% for UK banks12. Similarly to LTVs, borrowers are facing pressure from both sides, ICRs are decreasing but lenders want to move towards safer assets and demand higher ICRs. The decline in ICR also emphasises the importance of hedging, a standard feature in loans that has become more lax in recent years. It is expected that lenders will look to insist that borrowers hedge in new loans, which can add an additional cost for borrowers. This is also renewing interest in fixed rates, which are now being provided by more debt funds.
Loan size 100mn, 3% fixed margin, growth in earnings is matched to inflation13
The initial real estate debt funds set up after the GFC were almost exclusively focused on mezzanine or other subordinated debt. As bank lending falls, fund managers are seeing opportunities further up the payment priority and are in theory able to negotiate better terms. Whilst previously more senior loans in real estate did not often meet the target returns of alternative lenders, the growth mainly in base rates but also in margins has made these safer loans more attractive. In 2018, the difference between the margins offered by banks and debt funds was on average 100 basis points across sectors, since then there has been a significant convergence.
Fund managers are now providing a similar price and more flexibility than banks, improving their competitive position. By way of a simple example, senior loans provided by a bank in 2019 would be priced at LIBOR (0.5–1%) plus a margin of 2–3%. Now with SONIA rates in excess of 5%, plus margins increasing to almost 4% for similar assets, funds can be competitive if they offer a fixed rate of 8% on their loan. Overall, several managers believe this has resulted in favourable risk-adjusted returns which, as mentioned previously, has led to a rapid increase in funds dedicated to this opportunity.
Source: Bayes Business School.
Although there is clear growth in real estate debt strategies, it is not without its challenges. Fund managers must navigate a fragmented and highly regulated sector where data can quickly feel out of date. Some of the key barriers include:
Fragmentation
Valuation uncertainty
Change in laws and regulation
Restructuring and defaults
Similarly to other alternative asset classes, fundraising for real estate debt is down as investors across the world take a step back on allocations. According to INREV’s investment survey14, 62% of European investors surveyed are looking to increase allocations to non-listed real estate debt15. This is a significant evolution from previous years when less than a third of investors reported an expected increase in allocations.
In Europe, according to INREV, insurers are the largest investors into non-listed real estate debt funds (40%), followed closely by pension funds (37%)16. One of the drivers behind insurers’ allocations may be the treatment of CRE debt under Solvency II. As with private debt, the solvency capital calculation for CRE falls under the spread risk module of Solvency II, however, because real estate debt loans are usually collateralised this can lead to a reduction in the solvency capital required (if certain criteria are met). Currently, the higher returns available in real estate debt at lower leverage points, paired with a potentially more favourable Solvency II treatment, make this strategy more efficient from a solvency perspective.
Several large investors in the US allocate to the asset class from their private debt programs, but some are investing through their real estate/real assets strategies, which is also more common in Europe. CalPERS and CalSTRS, the two largest investors in real estate debt in 2023, are a good example as the former allocates from its private credit program and the latter from real estate. This makes it more difficult to estimate how much headroom investors may have to allocate to the strategy, but it may also afford greater flexibility for investors looking to commit, depending on the return profile of the product and how it aligns to the different programs.
Note: Investment intentions survey: comparing year-on-year answers for non-listed real estate debt.
Source: INREV’s investment intentions survey.
Note From a portfolio construction perspective, real estate debt is more aligned to a private credit program than a real estate one. A possible explanation for those allocating through real estate/ real assets is the lack of a dedicated private debt program – until August this year CalSTRS did not have a dedicated private credit allocation. This may also explain why in Europe this is more common, as US investors have been generally quicker to implement dedicated private credit allocations.
