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More Foreign Capital Flowing to Real Estate Debt Funds

Foreign capital is following the broader market shift that has investors allocating more capital to commercial real estate debt.

Foreign investors still have a hefty appetite for U.S. commercial real estate, and now many are expanding their focus to include debt.

“Anecdotally, we have been seeing a fairly dramatic uptick in interest from foreign investors into the U.S. lending space over the last 12 to 24 months,” says Ryan Krauch, a principal at Mesa West Capital, a dedicated commercial real estate lender that provides mezzanine and first loans for properties across the country. The South Koreans were on the front edge of that trend two or three years ago, and that interest has since expanded broadly to include Asian, European and even Canadian investors, he adds.

Foreign capital is following the broader market shift that has investors allocating more capital to commercial real estate debt. According to London-based research firm Preqin, North America-focused private equity real estate debt funds have seen fundraising surging higher over the past three years. Last year, that segment of the private equity market raised $18.3 billion, which is nearly double the $9.9 billion raised in 2015 and marks a new 10-year high.

The same factors that have been attracting foreign capital to the U.S. real estate market for decades are still in play in terms of transparency, liquidity, quality assets and stable fundamentals. Foreign investors spent a total of $44.7 billion in acquisitions across property types in 2017, according to real estate services firm JLL. Although that volume is down compared to the prior year, foreign investment still accounted for a sizable chunk of total transaction volume at 11.2 percent.

Searching for alternatives

Premium pricing in equity markets is one of the reasons pushing investors to consider alternatives. The bid-ask spread, high values and cap rate compression in many markets are slowing acquisition activity. “I think people are trying to find alternatives to equity investments where that risk might be elevated right now,” says Krauch. And that shift is not unique to foreign capital, he adds.

There is still a lot of dry powder that has yet to be deployed and considerable interest in U.S. real estate, agrees Bob O’Brien, Deloitte’s global real estate & construction sector leader. “The issue recently has been concern over pricing. We’ve seen the pricing for commercial real estate getting very high, in part because of the length of the recovery cycle and in part because there is a lot of equity money out there looking for yield,” he says. Another advantage to debt investing for foreign investors is that interest income is treated more favorably than equity income from a U.S. tax standpoint, adds O’Brien.

Foreign investor debt strategies are a mixed bag that include higher-yielding mezzanine and bridge lending funds and more conservative senior loans. “Mezz was the choice du jour, specifically for Asian investors over the last five-plus years. But in the last year or two, there has been far more interest in some of the more conservative lending strategies,” says Krauch.

Investors like debt as a fixed-income alternative, especially because many countries have low 10-year benchmarks in their home countries. For example, current central bank interest rates for Eurozone countries is at zero, Norway and the U.K. are both at 0.5 percent; South Korea at 1.25 percent and China at 1.75 percent. “Looking at U.S. fixed-income alternatives like real estate debt provides a very, very significant alternative to their local risk-free rates,” says Krauch. At the same time, the debt is secured by high-quality U.S. real assets, which remains a very attractive asset class for many foreign investors, he adds.

Foreign capital increases liquidity

The foreign capital flowing into the debt sector is contributing to an increasingly competitive lending market. “It certainly adds some competition, but I think there is plenty of room to grow in some of those areas for new products and new participants,” says Krauch.

One of the dynamics of the current debt market is that availability of capital is bifurcated, notes Krauch. For example, there is an abundant supply of capital for properties in Midtown Manhattan looking for a 10-year loan, while there is a void in other areas of the lending market where banks and life companies are less active, particularly higher risk deals, such as shorter-term bridge and construction loans. So there are still plenty of opportunities for private capital to step into that lending space, he adds.

The pullback from bank lending due to more stringent regulatory requirements has created some dislocation in the market, agrees O’Brien. That is creating more opportunities for debt funds to act as subordinate lenders on acquisitions and development. “Consequently, I think you are seeing foreign investors taking a look at that part of commercial real estate investing world and seeing some interesting opportunities from a risk-reward standpoint,” he says.

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