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Private real estate debt funds: growth of a bustling asset class

15 Apr 2024

Like the rest of the private debt market, private real estate debt funds really came into their own in the aftermath of the global financial crisis when mainstream banks hunkered down and reined in their lending activities in a move to protect and bolster their own financial health.

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. 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.

What has since been created is a bustling asset class that not only provides outsized returns and great diversification benefits for investors but also stable cash flows that derive from contractual income streams. The result is a thriving marketplace in which more than 2,000 real estate funds now operate globally, according to Preqin.

But despite the glut of interest in debt investments, alternative lenders at the recent MIPIM conference in March, the world’s largest property gathering, said that they felt the opportunities to deploy capital right now was limited, although they expect this to ease and for the situation to improve later this year and into 2025, especially if interest rates remain higher for longer.

So, what exactly are private real estate debt funds?

In short, they consist of credit extended by non-bank lenders to borrowers, often developers, for commercial real estate projects, such as multifamily buildings, shopping centres, and hotels. It is where private equity-backed capital lends money to prospective real estate buyers or current owners of real estate assets.

The majority of debt funds are centred on a specific loan strategy or investment concept. For example, some will concentrate on providing residential construction loans to apartment builders, while others might focus on financing shopping developments. Such funds can help borrowers that have less straightforward or complex financial situations or those that do not have easy access to traditional forms of credit.

And the asset class should not be confused with private real estate equity funds, with the all-important distinction between the two being that the debt investment – the underlying loan – is underpinned by a concrete asset that is used as collateral.

What are some of the strategies used?

Private real estate debt funds come in various shapes and sizes and have multiple strategies, with the most popular being direct lending: loans made by private lenders directly to borrowers. And, within that, real estate is the most popular type of collateral.

Direct lending funds make money on the interest rate or lending rate charged over the life of a loan. They also charge fees, which may include origination fees, exit fees and early termination fees, which investors have the ability to benefit from on top of the interest coupon.

Other strategies include mezzanine loans, which sit between senior debt and equity in the capital structure, and distressed debt, which in terms of real estate refers to an investment in a physical property that is priced lower than the market rate. This could be down to solvency or cash flow problems related to the operator, manager, or owner of the asset. During the Covid-19 pandemic, for example, many hotels temporarily lost their value as lock down restrictions were implemented and the tourism sector dried up.

In more detail, mezzanine debt offers higher returns than direct lending due to its lower seniority. They are subordinate to senior debt but receive priority over both preferred and common equity, and take their name from building mezzanines, which sit one level above the ground floor.

Distressed loans, meanwhile, have grown in popularity as rising interest rates and a fall in property prices have put downward pressure on owners, creating enticing opportunities for intrepid and sophisticated investors to step in. Indeed, as economic uncertainties persist and market dynamics evolve, distressed real estate debt has emerged as a key strategic avenue for investors seeking lucrative opportunities during current market volatility.

What are the risks and rewards?

Private real estate debt funds have the ability to provide excellent, sector-beating returns but this does not come without risk, and so it is always good for investors to know what those risks are.

The risks inherent within the asset class include both traditional real estate pitfalls, such as a drop in prices and tenant delinquency, and financial risks, including high loan-to-value ratios in deal financing and acute interest rate rises.

But, while the risks might be higher than in some other areas of finance, the returns are eye-catching. On top of this, private real estate debt offers significant diversification benefits when added to a portfolio of more traditional asset classes. It is not correlated with the stock market, meaning investment portfolios can become less risky and, importantly, real estate debt is also diversified from other alternatives by sector and size.

At the same time, the loans can also either pay a fixed-rate coupon or a margin over a floating reference interest rate, which reduces the exposure of a debt portfolio to interest rate movements.

All of this has helped the asset class to thrive, with a number of different sources predicting that debt strategies will play an ever larger role in real estate. According to PERE’s latest fundraising data, in the first quarter of last year debt represented almost a quarter of capital raised across real estate strategies, up from 15% in the previous year. And, based on data from Preqin, the assets under management from private real estate debt funds also jumped from $183bn in 2019 to a healthy $264bn at the end of last year.

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