For borrowers, debt funds ‘are not going to change the market’

Real estate debt fund managers have been piling into the market, seeing an opportunity to help property owners bridge the widening debt funding gap.

Despite an overall challenging fundraising year, real estate debt funds raised a total of more than $41 billion across 62 funds in 2022, according to PERE data. This was the second highest real estate debt fundraising total in the 15 years PERE has been tracking fundraising data. The fundraising volume for the strategy peaked in 2017, when $46.3 billion was gathered across 113 funds, PERE data showed.

However, not every borrower is openly embracing debt funds as a refinancing option. “Many managers are now trying to raise new funds to invest in debt, anticipating that the companies are going to have issues with refinancing using traditional financing, bank financing,” says Antonio López Bodas, head of capital markets at pan-European manager Azora. “And they will need these alternative lenders.”

Debt funds generally charge higher spreads than banks, but these higher spreads can be compensated in term of IRR, he notes. Property owners can borrow at higher loan-to-value ratios with debt funds than banks, with higher LTV making a deal even more profitable being financed from debt funds than from a banks, the executive adds.

But López Bodas believes debt funds can only be used in a limited number of refinancings. The issue today is that the higher interest rates in the Euribor and LIBOR indices are making the total cost of debt very expensive because of the higher rates and higher spreads, he says. Debt funds therefore are affordable only for high-yielding assets, because these are the only assets able to bear the higher cost of debt, López Bodas remarks.

“When you had rates at 1 percent or 0 percent, you were talking only about the spread the bank was charging you, compared with the spread the alternative lender was charging you,” he explains. “But now you need to add an additional 400 basis points or 500 basis points of the Euribor or LIBOR. Then if you charge another 400 basis points or 500 basis points, or six or seven or eight [hundred bps] that these types of alternative lenders are charging, you are ending up financing at 10 or 11 percent. And there are not many assets that can be financed at 10 percent.”

He adds: “The new lenders are coming to market, they are increasing their market share. But I don’t think this is going to be a very big movement that is going to change the market.”

Limited usage

London-based manager NW1 Partners, for example, favors insurance capital over debt funds. “Clearly, there’s money with debt funds, but that money is usually more expensive and shorter term,” says co-founder and managing partner David Boyle, referring to debt funds of all types. “But we are now focusing a lot more on the life insurance company space. And life companies won’t be the answer for everybody because they have a certain kind of debt that they use, but we’re finding that they’re still lending and active.”

With the refinancing of a mixed-use portfolio in Washington DC, the firm was able to secure fixed rate financing at 250 basis points over treasuries from an insurance lender. “I thought there was a chance we’d have to borrow a lot higher,” Boyle says. “If we couldn’t find an insurance company or a bank, we might have [had] to go to a debt fund, and that would have been a lot more expensive.”

Azora will only look at alternative lenders in very specific instances. The firm’s own borrowing activity from debt funds is primarily restricted to those funds providing whole loans. “It would be very limited for those cases where the traditional lenders are not willing to provide us with financing,” López Bodas says. For example, with an asset that is currently generating a 20 percent internal rate of return, alternative lenders can provide a 65 percent loan-to-cost, five-year bullet loan at a 5 percent interest rate. By comparison, a traditional bank would offer an amortized loan at an LTC of only 45 percent.

“If I translate these two alternatives into the IRR formula, the IRR with the alternative lender is much better,” he remarks. “But now we see that the new all-in cost is not going to be 5 or 6 or 7 percent. It’s 11 to 14 percent and at that cost, we don’t see many of our investments being able to be at that cost. So it will be specific cases.”

One key difference between the current market dislocation and prior periods of uncertainty is that although bank lenders are generally more conservative, none have pulled out of certain markets or sectors as they had done during previous crises, López Bodas notes.

However, he acknowledges “it is true that if you haven’t been able to increase your earnings or your cashflows with an interest [rate] increase, you are going to have some issues paying the debt service. And in this case, you will have to decrease the senior tranche and maybe create a second tranche with an alternative lender that allow you to continue operating your assets.”

For example, a bank that originally issued a mortgage with a 60 percent or higher LTV may now only refinance with a 40 percent LTV loan, while a debt fund would lend on the remaining 20 percent, allowing the borrower additional time with no amortization to align the asset’s cashflows with the debt service.

“Those types of restructuring will allow alternative lenders, all the lenders that are not traditional banks, to increase their market share, but I don’t see a huge movement from one side to the other side,” he says.