Real estate debt fund managers touting a once-in-a-decade opportunity to lend to a finance-starved commercial real estate market face parallel fundraising challenges that limit their ability to raise dry powder.
Institutional investor appetite for private credit has grown in recent months, but the real estate debt subcategory drew just $7.68 billion from investors in 24 fund closings between Jan. 1 and July 24, according to Preqin. With a broader slowdown in alternative asset fundraising, real estate debt funds are on a trajectory for their worst annual fundraising performance in at least a decade. That could still change; Preqin was tracking 268 real estate debt funds in market targeting an aggregate fundraising total of $90.2 billion.
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Those funds are aiming to fill what Joseph Rubin, an EisnerAmper real estate consultant, described as a "huge void" in the commercial real estate (CRE) loan market. The void opened when traditional lenders — i.e., banks — shrank the size of the loans they are willing to offer CRE property owners, a more cautious approach inspired by stress in the US regional banking system and concerns over falling property values, particularly in the US office and retail sectors.
"There's lots of ways these debt funds can play, and there's a great opportunity for them now. The main thing is, because they’re the only game in town right now, they’re charging enormous rates," Rubin said.
A wave of refinancings
A stubborn bid-ask spread slowed transaction activity in the CRE market, but there are other opportunities for real estate debt funds to deploy the $71 billion in dry powder they held at the close of 2022, according to Preqin data.
Elizabeth Bell, a principal on the Hamilton Lane real assets team, said the funds were positioned to participate in the massive wave of CRE loan refinancings expected over the next three to four years.
"I think a lot of these debt funds are gearing up for the roughly $1 trillion of real estate maturities coming due in 2023 and '24, and then another $1.5 trillion coming due by 2027," Bell said.
That confluence of factors — a pullback by traditional lenders ahead of a tidal wave of maturities — prompted Ralph Rosenberg, global head of real estate for KKR & Co. Inc., to announce a "once-in-a-decade real estate investing opportunity" for real estate debt funds in a second-quarter market report. Even if it's not showing up in the fundraising data, fund managers insist their limited partners (LPs) are angling to get in on the action.
"We continue to see strong institutional demand for real estate debt due to the general risk-off sentiment in the banking sector and the outsized return opportunities to inject capital at conservative levels with reset valuations," said Michael Arougheti, CEO of Ares Management Corp., on the firm’s Aug. 1 earnings call, adding that Ares "raised nearly $500 million" for a real estate debt fund in the second quarter.
In an email, Bryan Donohoe, co-head of US real estate for Ares, described a "generational opportunity to invest in both real estate debt and equity," adding that the firm "focused on educating our clients on the current market environment and merits of adding real estate debt to portfolios."
"We believe that as [limited partner] allocations return to normal, commercial real estate debt will be a beneficiary," Donohoe wrote, noting that LPs, in general, "are looking to add or increase their exposure to the asset class."
Fundraising constraints
Fundraising for real estate debt peaked in 2021, when funds collectively raised $41.34 billion, according to Preqin. That aggregate total declined 27.8% year over year to $29.84 billion in 2022, and slower fundraising appears to have carried over into 2023.
Bell said institutional investors are constrained in their ability to commit to real estate debt funds because of the denominator effect, a portfolio imbalance that has also dragged on private equity fundraising. Institutional investors like public pension funds have strict allocation targets for each asset class in their portfolio, but they were pushed off those targets when 2022 stock market declines shrank the value of their public equity holdings relative to private markets investments.
In other cases, investors may be pausing new commitments to real estate debt funds because the capital they committed in previous years has not been called yet, she added.
"The money hasn’t been called yet because there aren't transactions, and that's a good thing. We're OK with our managers being patient right now. We don't want them deploying capital at values that just don’t make sense," Bell said.
Understanding the market
Alternative asset manager Blackstone Inc., owner of the world's largest commercial real estate portfolio, is the sponsor behind three of the 10 largest real estate debt funds ever raised. Like other large multi-asset managers with a toe in both strategies, the firm can leverage intelligence from its real estate equity investments to inform its strategy as a lender to the CRE market, Rubin said.
"They know the pulse of the market in terms of rents, investor appetite, what's going on in sales prices. They know large trends,” he said, adding that the experience may prepare them for a moment of elevated risk in CRE lending.
Other funds operate with a "loan-to-own strategy" and are willing to take risky bets on CRE loans because they ultimately want the deed.
"That would be what we call in real estate a very opportunistic play, because it's going to require a very long time," he said, adding that it may require investing in property improvements or finding new tenants before the property is resold.
Ticking clock
The clock is ticking for real estate debt funds, whatever their strategy. Rubin predicted "a very difficult turnaround period" for commercial real estate, particularly the US office sector, which remains troubled by a very sticky remote work trend. He said the window for real estate debt funds to deploy capital may only stay open "a few years."
"Ultimately, things will settle out. Property values will stabilize. Equity capital will come back into the market in force," he said. "The money is there. My metaphor has been that it's just waiting for the fog to clear."
Bell agreed that cyclicality is inherent to real estate debt funds.
"When the liquidity comes in and you’ve got lower costs of borrowing elsewhere, you're going to go there," she said.