Commercial real estate debt funds that thrive on disruption in capital markets are finding plenty of opportunities in the current environment as liquidity tightens.
Banks have pulled back significantly over the past 12 months for a multitude of reasons. Their diminished appetite to lend has been further exacerbated by bank failures at Silicon Valley Bank, Signature Bank, and more recently, First Republic. Banks across the board are reserving capital for existing customers, and when they do make loans, they’re lending at a lower leverage point.
“When the economy is accelerating, they open the credit taps, and when the storm clouds are circling, they tighten credit,” says Andrew Korz, director, CRE investment research at FS Investments. Some industry experts expect bank lending to tighten further in the coming months, especially for construction loans. Generally, banks are increasing reserves and preparing for a more challenging environment.
“Although this liquidity crunch affects bank lending, it obviously creates opportunities for debt funds,” says Paul Rahimian, CEO and Founder of Los Angeles-based Parkview Financial, a private lender that provides short-term bridge and construction loans. Parkview Financial is now fielding roughly 200 loan requests per week. “When banks scale back, borrowers have no choice really but to go to debt funds, and I think that might continue for several quarters,” he says.
Demand for construction financing
High volatility (HVCRE) lending regulations put in place for banks are another constraint that is tempering the ability for banks to originate construction loans, and debt funds are stepping into that void. “We’re taking on a lot of construction assignments, and we’re having to go to almost 100 lenders to get five quotes,” says Dan Rosenberg, executive vice president in the Chicago office of Bellwether Enterprise Real Estate Capital LLC (BWE), a national commercial and multifamily mortgage banking company.
BWE is continuing to knock on all of the usual doors at banks, life insurance companies and debt funds. Although the lender willing to offer the loan at the best terms depends on the individual transaction, debt funds are grabbing more market share and picking up slack created by the bank pullback, adds Rosenberg.
Debt funds also are charging a premium for that money. For example, a bank might offer a spread on a multifamily construction loan that is in the 250-to-325 basis point range compared to debt funds that might charge 400 to 550 basis points over SOFR, the most common benchmark rate for short-term floating rate debt. In addition, banks have generally pared down leverage on construction loans to 50% to 55% loan-to-cost, whereas debt funds are willing to go up to 75% in some instances, notes Rosenberg.
According to MSCI Real Assets’ Capital Trends Report, investor-driven lenders, including debt funds, have taken a bigger slice of the construction financing market share over the past two years. The average of 13% annually between 2015-2019 jumped to 24% in 2021 and 23% in 2022. In comparison, market share held by the regional and local banks shrunk from an average of 63% in the 2015-2019 period to 55% in 2021 and 51% last year. That market share could slide further this year.
Some debt funds made a strategic pivot to construction financing necessitated by the higher interest rate environment. Before the Fed started raising its target rate, debt funds were active in the bridge lending space and viewed as a cost-efficient source of capital. Borrowers could borrow up to 80% loan-to-cost at a spread of 300 basis points over SOFR, which was around 0.1% prior to when the Fed began raising its target rate. However, rising rates have put a damper on demand. SOFR has climbed to nearly 5% and spreads have slightly widened as well. Borrowers are now looking at rates on a short-term bridge loan in the range of 8% to 10%.
“Nobody wants to pay for that cost of capital unless they are buying an asset very cheaply and know that they can add value. Most borrowers are seeking shorter term fixed rate loans on assets in their existing portfolio as the cost of capital is lower than that of debt fund floating rate loans,” says Rosenberg.
Investor appetite for debt
Although fundraising has slowed across the commercial real estate industry amid market uncertainty, capital inflows to debt funds and other private lenders have continued, albeit at a slower pace. “We are doing our best to educate investors on the difference between equity and debt and the very different risk profile,” says Korz. The firm manages the FS Credit Real Estate Income Trust, a non-listed REIT, and also the FS Credit Income Fund, which is an interval fund.
Debt platforms have raised a significant amount of money over the past five to seven years and still have ample dry powder to deploy. According to Preqin, real estate debt funds focused on North America have raised over $111 billion since 2018. However annual fundraising totals have been a bit choppy with highs of $27.7 billion in 2021 compared to lows that dipped below $19 billion in 2019 and 2022.
Interest in real estate debt strategies often spikes during market disruption because debt is considered safer than equity due to its position in the capital stack. Part of the appeal for debt strategies is that making a loan on good quality real estate is akin to a bond because the cash flow is strong, and ideally, there is strong credit behind that cash flow. “Right now when we speak to our investors, the overwhelming concern is the safety and security of their investment. It’s really a preservation of capital mentality,” says Rahimian.
Investors have traditionally been attracted to the risk-adjusted returns of debt funds. However, headlines are constantly talking about commercial real estate values dropping, which is making some investors nervous about downside risk and how their investment might be affected. Investors are more concerned about the type of loans being made and what the loan to value parameters are on deals, notes Rahimian.
FS Investments has seen a slight shift in investor expectations over the past three months. According to Korz, its investors still want above-market returns, but there is greater focus on downside protection. “The risk-return tradeoff has changed, and I think people are a little more concerned with defensiveness and stability,” he says. In particular, investors are attracted to credit strategies that can offer both high single digit returns of 7% to 8%, as well as the risk protection of a senior loan that has 35% to 40% of equity above it.
Good runway ahead
Debt funds do see a good runway ahead for placing capital across a variety of different strategies. Avrio Management launched a joint venture debt fund, Avrio Real Estate Credit, earlier this year, with an expectation that it will originate about $500 million in commercial real estate financing this year. The fund provides senior mortgages, B-notes, bridge loans, mezzanine debt, construction financing and preferred equity.
“The fund is really focused on going into areas of the market where capital is scarce,” says Vicky Schiff, CEO of Avrio Management. One area that Avrio Credit Real Estate is targeting is existing floating rate bridge loans where either a borrower didn’t have an interest rate cap, or existing rate caps are expiring. “That is where borrowers are really starting to suffer,” she says.
Banks are asking borrowers to pay down the loan, because the loan is either coming due or is outside its DSCR covenants. For example, if a property is making $1.2 million in NOI and it needs to cover at 1.2x DSCR but their rate has moved from 4% to 7%, it means they have dropped below their required DSCR. There were a number of new players that entered the market in this last cycle with a business plan to go out and buy a property and raise capital through a syndication. It’s difficult to go back to that well to raise more capital. So, they either have to sell the asset, which is difficult right now without a lot of price discovery, or raise fresh capital to restructure the loan, notes Schiff. “So, there is a requirement for that type of capital in the current market,” she says.
In addition to financing new construction loans, Schiff also sees an opportunity to step in where a bank wants to be taken out of an existing construction loan where there are issues, such as cost overruns or delays. “I think there is a lot of demand for what we do, which is evident by how many loan requests we get every day,” says Schiff. In the last month, weekly inbounds have quadrupled, she adds.
Right now, the power in the relationship between the debt funds and the borrowers has shifted to the debt funds, notes Rahimian. “There is such a lack of liquidity. Banks have scaled back and even a lot of the debt funds are not lending,” he says. “That’s created this shift away from what had been a race to the bottom on rate for years. Now it’s the opposite.” Borrowers are just working to find a lender who can finance their loan at terms that make sense for the deal that they’re doing, he adds.