In September 2020, private equity giant Blackstone announced the closure of its most recent real estate debt fund, Blackstone Real Estate Debt Strategies IV, which raised a stunning $8 billion in total capital commitments.
At the time, it was the largest real estate credit fund ever raised, according to Blackstone. The firm said the fundraise reflected “significant demand for capital in the real estate debt markets and the continued confidence in our business from our limited partners.”
Since then, investment managers in the U.S. and abroad have been raising commercial real estate debt funds at a frenetic pace. The funds come in all shapes, sizes and flavors. Some buy pools of loans, some originate loans for borrowers, either for acquisitions or refinancing and some have a hybrid strategy.
While these debt funds focus on different property types, regions and types of sponsors, they
have one thing in common: they’re all cashing in on institutions’ insatiable desire for yield and taking advantage of pent-up demand from borrowers and owners who postponed property acquisitions and refis during the worst of the COVID-19 crisis.
“Institutional investors across the globe are either allocating to, or exploring, private real estate debt as a complement to their existing fixed income or real estate allocations,” says Bryan Donohoe, partner in the Ares Real Estate Group and head of real estate debt.
Last month, Ares closed its fifth commingled European direct lending fund, Ares Capital Europe V, at €11.0 billion ($13.3 billion), representing the largest European direct lending fund raised to date. The fund surpassed its €9.0 billion target eight months after its launch and closed oversubscribed at its €11 billion hard cap.
ACE V attracted strong backing from a diverse group of nearly 180 investors, including 65 limited partners new to Ares Management, according to the firm. The fund’s global investor base includes pension funds, insurance companies, sovereign wealth funds, endowments, asset managers and family offices.
“Ultimately, we believe that what’s driving demand from institutional investors is a combination of: 1) seeking investment strategies that offer a reliable income stream, 2) portfolio diversification, and 3) increased recognition of the asset class as a complement to fixed income,” Donohoe notes.
Debt for distress
Several private debt funds launched in 2020 and early 2021 to take advantage of anticipated distressed opportunities due to the pandemic. As of January 2021, there were 63 distressed debt funds in the market, looking to raise a total of $63.8 billion, according to London-based research firm Preqin. In comparison, there were 45 funds in the market in January 2020, targeting a total fundraise of $25.8 billion.
Miami-based Safe Harbor Equity, for example, is currently raising a $500 million fund to invest in distressed commercial real estate debt. To date, the private equity firm has launched three funds, including Safe Harbor Equity Distressed Debt Fund 3, which had an offering size of $350 million.
In 2020, Fund 3 evaluated over $700 million of non-performing loans and loan originations, according to Rafael Serrano, founder and managing director of Safe Harbor Equity. As of September 2020, the firm had deployed $59 million of capital in 22 investments and liquidated $5 million of investments with an average IRR of 30 percent.
Serrano notes that distressed opportunities have been slow to emerge during this economic downturn. The inability to deploy capital into distressed assets has forced some funds to return investment money or pivot to alternative strategies.
“While the pandemic has had profound effects on our economy, commercial asset valuations have fallen in only a few asset classes and have actually increased rapidly in other sectors,” Serrano says. “This dislocation has resulted in more and more investors seeking out opportunities in the commercial real estate space, including debt funds.”
Backlog of borrower demand
Experts say the U.S. commercial mortgage market can provide the level of depth, long-term liquidity and price stability required for a long-lived strategic allocation. There are $4.7 trillion of commercial mortgages outstanding, making it one of the largest fixed income asset classes, according to the Federal Reserve.
In terms of size, commercial mortgages stand between U.S. investment grade corporate bonds and municipal bonds. But less than 10 percent of private mortgages are held by institutional investors, highlighting an opportunity to address underserved borrower demand.
Research firm Trepp LLC estimates that $2.3 trillion of real estate mortgages will mature from 2022 through 2026, but current debt fund dry powder amounts to only 1 percent of that total, according to Donohoe. That’s why Ares anticipates “significant demand for first mortgage debt to continue.”
Moreover, there’s a significant backlog of borrower demand that was built up from slower lending activity in 2020,” says Matthew Koelliker, president of California-based investment management company M360 Advisors. “Most of the new funds are capitalizing on this demand coming out of COVID.”
For example, Canyon Partners Real Estate LLC announced the final close of Canyon Laurel Fund II just last month. The $650-million fund, which targets senior and subordinate debt investments in the top U.S. markets spanning all major property types, is Canyon’s largest U.S. real estate debt vehicle to date.
The Canyon Laurel Fund II investor base spans the U.S., Japan, Korea and Australia and includes public and corporate pensions, endowments, financial institutions and family offices. Around 70 percent of investors in Canyon’s predecessor fund re-upped into the Canyon Laurel Fund II, according to Robin Potts, Canyon’s co-head of real estate.
“The COVID-19 pandemic has created an even more compelling environment for real estate debt as lenders, owners and developers have been faced with increasing liquidity needs, while Canyon’s positioning coming into the crisis allowed us to move quickly and capitalize on the growing opportunity set,” Potts said in a statement.
Boon to borrowers
Private debt funds tend to be providers of more “flexible” capital, according to Ares’ Donohoe. They can offer a faster loan approval process, as well as loans customized to a borrower’s needs. “Borrowers can benefit from being able to access this source, especially for properties with more complex business plan execution,” Donohoe points out.
As these private debt funds deploy capital, borrowers will have more options, and traditional lenders will face more competition. Pricing, LTVs and other terms will move as a result of debt funds being active in the market.
“The biggest impact will be on loan spreads,” says Koelliker. “We are seeing tighter loan spreads today as a result of the higher capital volume. The competition is fiercest for the higher quality loan assets—those borrowers who were able to navigate the COVID environment well and have cash flowed or executed on business plans.”
M360 Advisors has ramped up its lending activity since the end of last year and has built a healthy pipeline of deal flow, according to Koelliker. The firm continues to focus on its core lending program, which is small-to-mid-balanced transitional lending opportunities across the commercial property types.
“Strong borrower demand has allowed us to be very selective in the loan assets we add to the portfolio,” Koelliker says. “We feel this is a very attractive lending environment and are raising capital to scale up origination volume.”