The rise of commercial real estate debt funds?

Current capital market conditions continue to challenge many in the commercial real estate (“CRE”) industry but could present an attractive opportunity for CRE-focused debt funds. Private debt fund managers, investors and industry watchers are creating a buzz about the investment return potential of debt funds. Recent industry events, such as the PREA Spring Conference in Seattle and the MIPIM Conference in Cannes hosted both formal and informal discussions centered around the credit markets.

A lot has changed in 14 months since many central banks, including the US Federal Reserve (“Fed”), began hiking interest rates in March 2022. During the tightening cycle, capital markets have been rocked by increased cost of financing and added uncertainty focused on recession, inflation, and financial market stability. CRE markets have not been spared – as investment volumes plummeted, price discovery evaporated, and pro forma returns thinned.

The failure of three mid-sized banks in the US during the first five months of 2023 only complicated the CRE outlook more, as liquidity and funding pressures drove up solvency concerns across many small and mid-sized banks – a primary source of debt financing for CRE borrowers across the US. Facing more headwinds, these lenders are expected to continue their pullback and be less quick to return to the market, even as other concerns subside.

Enter commercial real estate debt funds…

While rising costs of capital and the availability of lending options are concerning headwinds for many CRE investors, this backdrop is one of the reasons for the growing attention to CRE debt funds. Debt funds which often compete with other lenders, including banks, look to be in a good position to be able to step up their lending activity and generate attractive levels of return for their investors. While debt funds collectively account for a small part of the entire CRE financing market, the current environment may be an opportunity for them to play a bigger role.

Debt funds have been growing steadily over the past years as many institutional investors seek diversification across and within asset classes, such as CRE. The PERE Real Estate Debt 50 (RED 50), a cohort of the largest debt funds that PERE tracks, shows that debt fund allocations have grown since 2008. This growth was a result of the great financial crisis that caused non-bank sources of lending to be a key source of funding for real estate equity investors. The top 50 funds captured $244.3B in 2022 with a 20 percent growth from 2021. Similarly, recent Preqin data show that CRE debt funds had close to $77.4B in September 2022.

Figure 1 - Global Real Estate Debt Fund AUM ($bn)

Tracking the performance of commercial real estate debt funds

Recent developments in industry reporting and benchmarking are serving as additional tailwinds for the rising debt funds. Institutional investors and their fiduciaries require any asset class to have an index or a tool to determine relative investment performance. However, currently, there is no standard investment performance index that is widely accepted in the industry for private equity real estate debt. So, it is telling that NCREIF, a key industry association in the US, is in the process of launching an indicator of relative performance for its members. While best known for their private real estate equity indexes such as the widely tracked ODCE, NCREIF has recognized that having a quarterly source of comparative data for debt funds is within their mandate.

Currently, NCREIF’s open-end credit fund aggregate has 13 funds contributing data to the new index, and these funds are well-diversified in terms of the sectors to which they have lent. NCREIF’s efforts, on behalf of its members, are an important development as it will allow investors in debt funds to look at their investment’s relative performance.

The unique set of circumstances the market has found itself in has made CRE-focused debt funds an increasingly feasible alternative to traditional financing. Time and evolving conditions will tell whether debt funds will take on a more considerable role in filling the widening lending gap and becoming a part of more investor portfolios in 2023.

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