Real estate debt funds are on track for a third consecutive annual drop in fundraising, even as a bottoming commercial real estate market and cautious banking sector improve the outlook for lending.

These funds, which offer an alternative to bank loans for property owners and acquirers, raised $12.3 billion this year globally through Oct. 15, less than half the full-year 2023 total of $26.25 billion, according to S&P Global Market Intelligence's analysis of Preqin data.

Global fundraising totals for real estate debt funds have declined annually every year since peaking at $41.96 billion in 2021, a year that set the high-water mark for commitments to alternative assets.

Banks' retreat from commercial real estate lending creates an opening for the funds to meet the capital needs of a market that, outside of trouble spots such as US office, appears to be turning a corner. But the asset class tends to "fall through the cracks" of institutional investor portfolios, overlooked in favor of private real estate funds that make equity investments or other flavors of private credit, such as direct lending, said Liz Bell, managing director and co-head of real estate on Hamilton Lane's real assets team.

"That has limited the capital that wants to go into those funds," Bell said.

Deployment opportunities

As fundraising for real estate debt funds slowed, uncommitted capital fell to its lowest level in seven years. Dry powder for loans or debt refinancings totaled $76.4 billion globally as of March 1, down 5.4% from December 2023 and 27.6% from its 2021 peak, according to Preqin's latest data.

Opportunities to deploy shrinking dry powder appear to be picking up. The buyer-seller divide is narrowing as property owners reset their expectations on value, a shift reflected in signs of reviving transaction activity, Bell said.

"Whether it's a new mindset or sellers finally have to get their real estate moving, we're seeing transactions pick up," Bell said.

Blackstone Inc., the world’s largest commercial real estate owner and manager of two of the 10 largest real estate debt funds, declared in January that the real estate sector's post-pandemic decline had bottomed out. By the firm's third-quarter earnings call, Blackstone President Jonathan Gray upgraded his assessment to "a broad-based recovery in real estate."

Refinancing wave

Current deployment of real estate debt funds is not driven by transaction activity. Although higher, it remains well below pre-pandemic levels, said David White, head of LaSalle Investment Management Inc.'s real estate debt strategies in Europe.

Instead, loans for property improvements and refinancings are driving deal flow. White's US-based colleague, fund manager Craig Oram, compared the looming influx of commercial real estate loan maturities to "a wave crashing over a wall."

"Whether that comes to us in the form of refinances or a purchase and sale transaction ... it will be spread out over a couple of years," Oram said.

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With banks constrained by regulation and tighter lending standards, debt funds can expand their market share, he added.

"Even a 10% reduction in bank activity would be a big boost for the alternative lender space," Oram said.

Outlook

Bell said a rebounding commercial real estate market is not entirely positive for real estate debt funds. They may have to fight harder for institutional investor attention.

Investors turn to debt funds for safety during market downturns. Loan recipients must make debt payments, even if property values decline. But when the market rebounds, rising asset values benefit equity investors.

"I'd rather go to the equity side right now, as an allocator, and get the upside," Bell said.