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Resilience in real estate debt: behind the headlines

12 Dec 2023

Given the challenging conditions in the commercial real estate space brought on by higher interest rates, property funds have been making headlines in recent months. With investors pulling their money out of open-ended property vehicles, several major asset managers including M&G Investments and Canada Life have been forced to close down funds.

However, not all commercial property funds are created equal, and while real estate equity funds have struggled lately, real estate debt funds have been more resilient. With that in mind, here are some insights from a panel discussion on real estate debt I moderated at the 4th Annual Real Estate Europe Forum in October.

It’s a good time to be a lender

While there was plenty of debate throughout the panel discussion, one thing the panellists agreed on is that it’s a good time to be a lender right now.

This year, banks have been backing away from the commercial real estate market due to concerns over falling property values. And this retrenchment is creating opportunities for real estate debt funds. In this environment, borrowers are increasingly turning to alternative lenders to make acquisitions and handle loan maturities.

Meanwhile, higher interest rates are also creating opportunities for lenders as the elevated rates are increasing returns. Previously, commercial real estate debt investors could expect to achieve returns of around 6% to 8% per year. However, in the current environment, returns of above 10% are achievable due to the fact that lenders are now able to charge significantly higher interest rates. Additionally, lenders can insist on greater downside protection from borrowers.

Looking ahead, there is a huge wave of commercial real estate loan refinancing expected over the next three to four years. According to PIMCO, around $2.4 trillion in U.S. commercial real estate loans are scheduled to mature between 2023 and 2027.

This confluence of factors – a pullback by traditional lenders ahead of a wave of maturities, as well as a sharp rise in interest rates – has led to some market participants, such as Bryan Donohoe, co-head of U.S. real estate for Ares Management, describing the current real estate debt setup as a ‘generational’ investment opportunity.

Mixed market dynamics

In terms of the commercial real estate market itself, the takeaway from the panel discussion was that while valuations have come down as interest rates have risen, some areas of the market have fared better than others.

One area of the market that has held up quite well this year is logistics, which has continued to benefit from the growth of the e-commerce industry and seen investment from both online retailers and traditional retailers looking to ramp up their online sales. It’s worth noting that after a post-pandemic slowdown, the e-commerce industry is now reaccelerating and is on track to account for more than 23% of U.S. retail goods sold this year, up 100 basis points year-over-year.

This area of the commercial real estate market has also benefitted from the de-globalisation trend. With companies shifting from a ‘just-in-time’ approach to manufacturing to a ‘just-in-case’ model, demand for high-quality warehouse space has increased. As the de-globalisation trend continues to reshape the global economy going forward, logistics warehouses are likely to play an increasingly important role in supply chains.

Prime office property has also performed well lately due to supply and demand imbalances. This market has been boosted by banking and finance tenants, who are bringing employees back to the office after the coronavirus pandemic. According to BNP Paribas Real Estate, super prime office rents in London’s West End could hit £300 per square foot by December 2024 as the battle for space becomes more competitive.

On the downside, there have been some signs of stress in the development finance space, particularly where development costs have skyrocketed and where developers have suffered a parallel drop in estimated valuations. Yet refinancing is still taking place, and not just loan extensions, which implies that the can is not simply being kicked down the road. Regional office property has been another weak spot lately. Here, the market has been negatively impacted by higher interest rates and hybrid working arrangements.

Debt markets are coping well

As for how debt markets are coping with the recent developments in the real estate sector, the consensus from the panel was that they are coping quite well.

However, panellists agreed that it is crucial that a debt fund has the necessary scale, operational infrastructure, and certainty of execution when lending in the current environment. These resources are particularly important when operating in local markets. To operate effectively in local markets, funds need to have operational teams that have the ability to resolve regulatory/legal hurdles as they occur. This is where newer managers have struggled at times, as they have been unable to provide the same certainty of execution as larger, more established players.

Stay tuned for part two of this article, where I will discuss the panel’s views on how ESG is impacting the commercial real estate industry, how effective new real estate debt funds have been in lending to the market, and where interest rates are going from here.

Read Part II – Resilience in real estate debt: who’s responsible for ESG?

About the event

The Resilience in Real Estate Debt panel discussion took place at the 4th Annual Real Estate Europe Forum in October. During the panel discussion, panellists shared their perspectives on the state of the real estate debt markets and discussed the value of investing in debt given the current state of the global economy. The panellists were: David White, Head of LaSalle Real Estate Debt Strategies, Europe, LaSalle; Omega Poole, Head of Funds Management, LendInvest; David Renshaw, Managing Director & Co-Head, Fiera Real Estate Debt Strategies (Europe); and Justin Fiaz, Partner, Pluto Finance.

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