Private equity real estate funds have stepped up to be a major source of financing for the commercial real estate industry—and a bigger allocation for investors. However, fund managers may face a tougher road ahead for fundraising in the near term as capital flows to the sector slow.
Debt strategies have moved from the fringe to a more established and accepted part of the commercial real estate investment universe over the past several years. That shift has generated a significant wave of capital. According to London-based research firm Preqin, global private equity real estate debt funds have raised about $165.6 billion since 2013.
“Over the last three years in particular we’ve seen a massive amount of capital allocated to debt funds,” says Todd Sammann, executive managing director and head of credit strategies at CBRE Global Investors. The vast majority of that capital is targeting double-digit returns and is almost entirely allocated to closed-end funds. “The industry has seen fundraising trail off a little bit in 2019, which is not particularly surprising given the amount of capital that was formed,” says Sammann.
According to Preqin, the volume of capital raised by debt funds appears to have peaked at $33.7 billion in 2017. Fundraising edged lower to $29.4 billion in 2018 and has dropped more sharply in 2019, with fundraising through Nov. 7th totaling $15.6 billion.
That decline comes even as the broader private equity real estate fund market is enjoying robust capital flows. As of Nov. 7th, that global market had raised $138.2 billion year-to-date, which puts it on track to exceed the $146.1 billion raised in 2018 and likely to break the record of $147.5 billion raised in 2008, according to Preqin’s Q3 real estate report.
“There is no doubt that what Preqin is reporting, to a certain extent is true, that the appetite may not be there. But I also think that will rebound,” says Zac Barnett, co-founder of Fund Finance Partners, a debt advisory firm for private equity fund sponsors. “Private equity real estate debt doesn’t seem to be going anywhere. It fills a need, particularly when crossing over to the infrastructure space where there are very few banks that are able to play.”
Allocations, hedging costs drag on investment
Investors that have met allocation targets to debt likely account for some of the recent decline in fundraising. Although debt investment strategies have been popular in recent years, investors tend to allocate only a relatively small portion of their overall portfolios towards debt. Given the rapid growth of fundraising in the past few years, it is not surprising to see a dip while investors wait for their initial commitments to be realized, says Luke Alexander, real estate research manager at Preqin.
Fundraising has eased back, but it has not plummeted. That pause likely represents more of a “hiatus” rather than a diminished appetite for debt, says Alexander. In addition, it is not accurate to say that there is a significant shift in appetite, he notes. In fact, the $29.4 billion that global debt funds raised in 2018 was the second highest amount on record, according to Preqin.
Part of this is an investment allocation issue, agrees Barnett. “The whole universe of private credit, not just private real estate debt, has really exploded over the last five to seven years. So, investor allocations will take time to right-size to the opportunities and it results in periods of choppy fundraising,” he says. Investors have varying allocation buckets and sometimes private equity real estate debt does not fit neatly into any of them, he adds. For example, there are a number of real estate debt funds that invest heavily in infrastructure. The question is whether to classify that as a real estate investment, a private credit investment, a real estate debt investment or an infrastructure investment? “This will be figured out in time, but I think those decisions can materially impact investment decisions,” notes Barnett.
Higher hedging costs have also weighed on investment from European and Asian investors. During the first half of the year, those investors pulled back significantly due to the disparity in currency valuations between the U.S. and their home countries. In some cases, hedging costs for some foreign investors were approaching 3 to 4 percent, which was eating into too much of the returns available to credit vehicles, notes Sammann.
Action by the Federal Reserve to lower rates in the second half of the year has reduced hedging costs materially in recent months. “That has created a catalyst for much more participation from those cohorts,” says Sammann. It is likely that renewed investment activity will start showing up in the data in early 2020. “Our expectation is that there will be tepid demand from U.S. institutions (due to capital already committed), while the majority of demand in the next year or two will come from Europe and Asia,” he adds.
Fund managers face near-term challenges
The dip in fundraising could result in longer fundraising times and consolidation over the next few years in what has become a highly competitive sector. “As in other real estate sectors, the crowded fundraising market will make it more challenging for fund managers to stand out and attract capital, leading to more time spent on the road—especially for smaller fund managers,” says Alexander.
Some question whether debt funds are adopting riskier strategies as a means to hit higher target returns, especially as interest rates have dropped lower this year. Research firm Real Capital Analytics (RCA) recently noted a market trend where higher return requirements have pushed debt fund lenders into higher risk lending on value-add and opportunistic type projects. Specifically, debt funds now account for 22 percent of U.S. construction lending and 21 percent of value-add project lending as compared to 9 percent of the lending market on core assets, according to RCA.
Debt funds follow risk strategies similar to equity investment as it relates to core, core-plus, value-add and opportunistic bets. Additionally, there are a number of debt funds that invest specifically in infrastructure projects. The majority of debt funds are targeting double-digit returns, which has resulted in a focus on highly transitional value-add and opportunistic assets.
Spread compression is pushing some managers to take on more risk. For example, some debt funds are active in construction lending, land loans or condo inventory loans that have multiple layers of risk, such as execution risk and market risk, as well as no in-place cash flow. “Investors do have to think very carefully about whether those risks are being properly compensated,” notes Sammann.