When PERE compiled the 2023 edition of our Real Estate Debt 50 ranking, which aggregates capital raised for real estate debt issuance by firms in the five years to end 2022, the results were intriguing.
After all, in a year of rising rates and tumbling valuations, the wider asset class recorded its lowest fundraising total in five years, according to PERE data. The RED 50, however, saw its aggregate capital increase 19 percent on last year’s total.
Reflecting a once-in-a-cycle opportunity emerging for credit investors, the ranking’s coffers have swelled to $267 billion. A combination of bank retrenchment and tighter lending conditions is tipping the scales from supply to demand. As evidenced by our ranking, this is opening the door for debt funds to take a bigger slice of the refinancing pie.
Investors recognize the return potential here, not least because the risk-free rate has risen to such a level that a debt investment can be more attractive relative to equity. Although fundraising on the whole is still down as per PERE’s Q1 2023 data, debt funds have raised 24 percent of the total for the quarter, behind only value-add strategies, representing their largest share since full-year 2017.
There is no doubt the risk-return potential of real estate debt is attracting increasing investor interest. However, this does not explain why several established names slid down the rankings, where others thrived. A closer look suggests there are risks lurking beneath the surface at the long-time lenders that are most exposed to existing loans.
The four firms in our league table that have seen the largest decline in aggregate fundraising – with totals for each down at least $1 billion compared with one year ago – are all big brands with a roster of large real estate debt funds to their names. Indeed, all featured in the RED 50 each year since its inception in 2019. The same can be said for a number of other managers that have dropped off entirely. In contrast, this year’s ranking contains eight entrants, six of which are new to the RED 50 – compared with just one last year.
Such findings point to the growing risk of legacy issues causing a headache for some debt providers. There is not much visible distress in the market – yet. But in its US Big Picture report published in February, research firm MSCI reports that of the almost $400 billion in US commercial real estate loans maturing in 2023, around 11 percent were issued by investor-driven lenders. Look ahead to 2024 and this proportion almost doubles, standing at around 20 percent of the almost $500 billion due, and increases further still in 2025.
Notably, while LTVs are coming down in the current environment, the report also stated the average LTV for loans issued in 2021 by investor-driven lenders was 71.7 percent, the second-highest figure among all lender types. That is foreboding.
Performance issues are, thus, likely to rear their heads in older vintages, particularly those in the one- to five-year catchment area based on average commercial real estate fixed-loan terms. Indeed, one market source PERE spoke with warned of peers that have “taken on too much risk” in terms of their position on the leverage curve, and face “big issues in the coming months” as a result.
There is also the question of back leverage. Debt providers that issued loan-on-loan finance in years when rates were low will be feeling the pressure, if the now sky-high rates were not priced into trajectories.
Few would dispute the potential for 2022 and 2023 to be stellar vintage years for debt funds. But when the conditions change as drastically and as rapidly as they have, there will undoubtedly be casualties where existing business plans are upended. And where there are legacy issues to work through, raising fresh capital moves to the back burner for some and is harder for others.
As the RED 50 indicates, the real estate debt market as a whole will survive and thrive, but those leading the charge may look a little different to before.