STATESIDE: Debt ceiling

Don’t count on The Blackstone Group’s current real estate debt fund aping the fundraising strategy of its most-recent real estate opportunity fund, Blackstone Real Estate Partners (BREP) VII, for which the firm increased the hard cap.

During an earnings call in early April, Blackstone’s chairman and chief executive Steve Schwarzman revealed that the firm had raised $2 billion for the first close of Blackstone Real Estate Debt Strategies (BREDS) II and intended to hold a final close at the fund’s $3 billion hard cap, despite that limit being far below investor demand. “We capped the fund at this amount in order to match its size with the current market opportunity,” he explained. 

Considering that BREDS II is one of the largest real estate debt funds currently in the market, the limited opportunity to which Schwarzman alluded is all relative, of course. Still, it can’t be denied that it is more challenging today to achieve higher returns on debt than it was just a few years ago.

“It’s not the big opportunity it was several years ago, when there was a real dearth of lenders,” said one consultant. “Before, there was no competition and it was all low-hanging fruit. If you could raise money, you could make money.”

One major reason for this change is the return of more lending sources to the market, from traditional banks to life insurance companies to the commercial mortgage-backed securities market. “The debt markets are close to fully functioning once again,” noted Prudential Real Estate Investors in its US Quarterly Outlook in April. “Spreads will remain tight and loan standards will get looser as the competition among lenders remains fierce.” 

In fact, lending institutions increased their mortgage holdings by $23 billion to $3.1 trillion during the fourth quarter. That was the first increase in 14 consecutive quarters, the report noted. 

Narrowing spreads translates to lower returns, which has led some debt fund managers to take on greater risk to achieve higher yields either by pursuing transactions in secondary US locations or by going outside of the country entirely. Indeed, Europe has been an area of growing interest for real estate debt because of the lack of active lenders in the region. Mezzanine real estate debt strategies generate an average return of 14 percent in Europe, compared with approximately 10 percent in the US, according to CBRE Global Investors.

Perhaps then it’s not surprising that the number of real estate debt funds in the market has declined over the past five years. Cleveland, Ohio-based consultant The Townsend Group tracked 108 real estate debt funds in the market as of February of this year, down from 145 funds between 2008 and 2009.

Still, investors have been flocking to debt funds because they offer both current income and returns that still are attractive relative to Treasuries or investment-grade bonds despite now being in the high single digits. “Today’s high property valuations have caused investors to become extremely cautious about equity positions in commercial real estate,” said Mark Zytko, co-founder and co-chief executive at Mesa West Capital, a Los Angeles-based real estate debt fund manager. “Investors have come to realize that debt provides access to the same assets but at a much safer position in the capital stack.” 

That said, far fewer general partners in real estate debt have long track records and strong platforms and teams than those on the equity side. Indeed, many debt vehicles raised over the past few years were first-time offerings and therefore haven’t yet seen realizations. For this reason, Blackstone has a clear advantage in raising its new fund, as its real estate debt strategies business has generated net returns of approximately 12 percent since its launch in 2008. 

In noting the demand and opportunity imbalance in real estate debt, Schwarzman seems to have been making a firm-specific statement, rather than one that applied to the overall market. “Other than Blackstone, everyone’s taking what they can get,” the consultant said. “I don’t think anyone but Blackstone is worried about sizing their funds.” 

The good news, however, is that as yields have come down, so have investors’ yield expectations. Zytko also expects an upcoming wave of recapitalization and direct lending opportunities, as more than $1 trillion of commercial real estate loans are due to mature over the next three to four years. “There’s more opportunity ahead of us than behind us,” he added.

It’s interesting to note that the pipeline of distressed, high-return real estate debt opportunities that was anticipated in 2009 and 2010 was much less than people originally had thought. What materialized instead was a fair amount of lower-yielding investments. 

Therefore, given current interest rate levels and the economic environment, it’s wise to play it safer on debt. After all, many investors became risk-averse following the global financial crisis and would rather opt for lower yields than take on too much risk. Broadening the definition of what’s considered an “attractive” debt investment also allows the window of opportunity to be opened wider. 

That said, there will be no repeat of what Blackstone did with BREP VII, where it raised the fund’s hard cap from $13 billion to $13.3 billion after having originally set out for $10 billion. This time, it appears the firm will stick to its self-imposed limits.