Bifurcated Market Squeezes Debt Funds

Calmwater Capital

Debt funds have been attracting a lot of attention—and capital—due to their ability to deliver equity-like returns. But can they deliver on what they’ve promised?

“It has been a very buzzy sector, for sure, but I think [that’s] for good reason,” says Andrew Janko, managing director, investments at RCLCO Fund Advisors. Real estate private credit fund managers and their investors are enjoying a fairly novel environment. They’re able to invest into a market where there are still solid underlying real estate fundamentals in numerous property types during a time when capital markets are more challenged. In addition, higher base rates have improved the overall profitability of the types of loans that they make, with less competition from commercial banks, he notes.

Base borrowing rates that have moved from near zero to 5 percent have increased the overall profitability of a loan for those lenders that have the capacity to lend. “The opportunity itself is broad-based,” said Kirloes Gerges, managing director of portfolio management at Principal Asset Management. The secured overnight financing rate (SOFR) will affect any floating-rate deals tied to it, no matter where the investment lies in the capital stack, whether it is a senior loan or mezzanine debt.

Preferred equity pricing, which is usually fixed, also has drifted slightly higher. As such, debt fund managers have been allocating in all of these spaces, as well as looking at opportunities where they can acquire distressed loans or assets at a discount, Gerges says.

Debt funds are definitely an active part of the market, according to Wally Reid, senior managing director, debt platform leader at JLL Capital Markets. JLL is doing 25 percent to 35 percent of its business with debt funds every week.

“Everybody has good loans for the most part. There’s not a ton of turmoil in the debt fund space,” Reid says. Yet debt funds are not unscathed by the challenges in the market in terms of higher cost of their capital, tighter liquidity for ones that use leverage, and stressed loans within portfolios. Combined, these factors are affecting profitability and the capacity for some debt funds to make new loans.

Haves and have-nots

Like many lenders, debt fund managers face the prospect of appropriately marking down valuations on loans in existing portfolios to account for changes in interest rates, if not for outright credit issues. Debt funds likewise have not been immune from troubled loans, especially ones with exposure to the office sector.

“Valuation declines, if not outright losses associated with defaulted loans, have greatly impacted legacy portfolios. In many cases, values have moved inside of the senior mortgage where the senior mortgage is impaired, and the mezzanine loan, if any, is wiped out,” Gerges says.

“I think you need to look at the fund series by vintage for any given manager,” Janko adds. Funds that were investing heavily during the two years immediately preceding the onset of the pandemic are likely to undergo some challenges, particularly if they were investing in office.

The industry was pretty quick to recognize the shift in valuations, however, and newer vintage loans have significantly better equity capitalization in front of the debt. So, performance has held up pretty well, and fund managers are continuing to focus on lending on assets with solid underlying fundamentals, such as multifamily, logistics, and other specialized property types that are continuing to generate demand from users, Janko notes.

Calmwater Capital

Those debt funds that are well capitalized and have less exposure to problem loans are keeping their foot on the gas. For example, Calmwater Capital recently provided Irvine-based West Hive Capital with a $12.25 million first mortgage for the purchase of Western Plaza in Rancho Palos Verdes. The owners plan an extensive renovation of the 1950s-era property.

“We have capital, and we’re excited about the opportunity right now. Values have declined, and we are positioned to do what we did in the GFC, which was to take advantage of the retrenchment where we can deploy capital to sponsors buying assets at a reset basis on a risk-adjusted perspective,” says Larry Grantham, managing principal of Calmwater Capital, a direct commercial real estate bridge lender based in Los Angeles. Last year the firm announced that it had raised $372 million for its fourth real estate private debt fund.

Finding opportunities to deploy capital

Real estate debt funds have a history of riding to the rescue in times of tighter liquidity, and that’s certainly the case in the current market. “There appears to be more than enough opportunity for the real estate private credit space because of the retreat of a number of other lenders from the market and just the general higher needs for capital to backfill some of the capital structures,” Janko says. So, debt funds are finding plenty of opportunities to deploy capital that has been raised across different strategies, he explains.

The relative scarcity of debt capital in the market has also shifted the balance of power in favor of the lender and allowed for tighter underwriting across the board. Debt fund loans, in particular, tend to have more structure, such as stricter covenants that give fund managers more control and insight into what’s going on in a loan.

Yet deploying capital has been trickier in a market where there’s less transaction activity and new construction has slowed. From a competitive standpoint, the best deals from the best sponsors where the risk-adjusted returns look the strongest are getting the most attention.

“The market has moved from a point where these strong deals may have had two or three bidders to the bidder pool potentially doubling and spreads actually compressing for a deal to be won,” Gerges says. “Moving up the risk spectrum and capital stack likely reduces the feeding frenzy, but there are fund investors operating up and down the risk-return spectrum.”

MCSI

Grabbing more market share

Although debt funds have a well-deserved reputation as a more expensive capital source, they have experienced significant growth since the GFC fueled by steady fundraising activity. Globally, private real estate debt funds have raised roughly $289 billion over the past decade, according to Preqin.

“Debt funds are indeed growing and continuing to take up market share,” Gerges says. According to Principal, debt fund AUM has grown approximately fivefold since 2013, and the firm expects that trend to continue and probably to increase. One catalyst to fostering growth could be the onset of increased regulation of the regional banks. Another could be that more and more borrowers are becoming accustomed to working with debt funds.

Prequin

“The debt isn’t cheap, [but] the appetite and willingness to lend to non-core deals where a bank may not be interested does exist, so that the debt funds serve a specific purpose and a specific segment of the market,” Gerges adds.

It’s tough to gauge just how big a share of the commercial real estate financing market that debt funds are consuming. According to MSCI Real Assets, investor-driven lenders (including debt funds) represented 10 percent of commercial real estate lending in 2023. Although that may seem like a relatively small slice of the overall pie, it is important to note that the MSCI data is counting only first mortgages or senior debt, and doesn’t account for subordinate debt where debt funds also play a big role.

Calmwater Capital is in the camp where it sees an opportunity for real estate private debt funds to gain more market share. “We are excited to see private debt come out on the other side of this cycle stronger and more resilient, and, frankly, more tested, because it is a new, institutionally recognized asset class,” Grantham says.