Figures recently released by Cass Business School as part of its biannual treatise on the UK commercial property market showed ‘other non-bank lenders’ – not including insurers, but mainly comprised of debt fund managers – accounted for 11 percent of the country’s loan book at mid-2018, up from 4 percent in 2013, PERE sister publication Real Estate Capital has reported.

In the grand scheme of things, Europe’s private real estate debt fund universe is small – far smaller than that of the US. While 2017 was a bumper year for fundraising – with around $10 billion raised for Europe-focused strategies, according to our research – many of the established managers are now deploying that capital. In theory, 2018’s fundraising will be lower.

While the European debt fund scene has its limits, it is almost impossible to imagine the market reverting back to one almost entirely bank-dominated. However, remember that most debt fund managers launched their businesses in response to the 2008 crash; theirs is a model yet untested through an entire cycle.

Already, changing market conditions are testing them. In the early part of this decade, managers could provide loans in situations where banks were entirely absent, earning juicy returns in the process. Today, banks are far more active, debt markets are more liquid, and competition has driven returns to less juicy levels.

The current benign credit conditions will not last, so Europe’s real estate debt fund managers must be ready to raise, and to deploy, in a downturn. That means ensuring investors’ return expectations are realistic.

So far this cycle, debt funds have typically been raised on an absolute-return basis, with managers expected to achieve a predetermined target in a set time frame. While debt funds could deliver IRRs of 8 to 9 percent on senior lending in 2012, equivalent figures are more like 3 to 5 percent today. Mid-teen mezzanine returns at the start of the decade are more likely now in the high-single digits. The problem is, in a market with dwindling returns, managers can be forced to take on additional risk to meet their promises to investors.

Now is the time to work more flexibility into fund structures to allow managers to lend sensibly through turbulent periods of the cycle. One answer might be raising capital on a relative-return basis, with targets pinned to an index such as a swap curve.

At this point, it is difficult to predict how debt fund managers might fare in a real estate downturn. Some fear risky lending is building up in real estate’s ‘shadow banking’ world. Indeed, it is likely there are managers taking risks which will eventually bite them.

However, there are tailwinds behind private real estate debt which suggest the model will remain relevant in future. Investors are today more educated about the asset class and see it as a viable alternative to fixed income and property equity. Indeed, the downside protection debt offers should appeal to many investors in a downturn. Once the cycle turns, debt funds should be the obvious port of call for borrowers struggling to refinance with a bank.

By the nature of the capital they serve, debt fund managers naturally take more risk than banks or insurance company lenders. However, it is important they adapt their businesses to allow them to become true through-cycle players, rather than being forced to chase outsized returns in unsuitable market conditions.

Keep an eye out for Real Estate Capital‘s upcoming special report on debt fundraising, in which we explore the challenges facing managers in today’s market, and how they are overcoming them.

Email the author: daniel.c@peimedia.com