Real estate debt has been a growing area of investment for several years, even through the covid crisis, but has also been one of the sectors of private debt most acutely impacted by the pandemic.

One of the most immediate impacts when covid first hit in early 2020 was widespread government recommendations that people should work from home wherever possible. This was most feasible for office staff, many of whom found they were able to do much of their work at home with minimal disruption, needing just a laptop computer, internet connection and telephone.

Return to office?

But the key question for investors in office real estate is: will workers return to their offices when the pandemic subsides or is working from home here to stay? So far it seems the answer to this is mixed. Some workers may prefer or need to be office-based and will largely return to pre-pandemic working patterns when they can. Others may wish to adopt a hybrid approach, spending some time in the office and some working remotely, while a final group are likely to work entirely or mostly from home for the long term.

This is set to produce a change in demand for prime office space as firms may require less of it than they did previously and will look to reduce their rental costs by finding smaller facilities more suited to the new structure of their workforce.

Consultancy BDO UK believes that the London office market, one of Europe’s most active, will become two-tiered in the future.

“High-quality, well-located buildings with excellent environmental credentials, pleasant user experiences, wellness capabilities and great use of technology can be expected to become the subject of increasing demand,” says a recent report by the firm.

There are two key reasons for this change in demand; firstly that ‘enlightened corporates’ want to provide quality workspaces for their employees and clients to collaborate and network; secondly, ongoing recessionary pressure means that in the short to medium-term the supply of new, high-quality and well-located office buildings will be restricted.

It is expected this could push up rents and capital values for those offering office solutions likely to be in high demand at the expense of more old-fashioned office spaces that are less well located, leading to a two-tier market.

“Property owners and lenders alike will need to be receptive to changes to the business community’s office needs and wants and should be sufficiently ‘fleet of foot’,” BDO says. “We would advise all stakeholders to take another look at their office portfolios. The aim must be to understand which offices are, or could become, the desirable, high-quality offices of the future and to formulate a plan for dealing with those other office buildings that might be left behind.”

Flocking to residential

However, with more staff working from home, there could be increased opportunities in residential property as families seek larger accommodation to enable home working and other sectors which have been historically in demand, such as multifamily living or student accommodation which could provide a more stable investment option than office space or retail, both of which are going through significant changes.

In an unexpected development, the pandemic appears to have helped rejuvenate fundraising for real estate debt. According to Private Debt Investor’s own fundraising data, after falling between 2017 and 2019, fundraising began to increase again in 2020. While in 2019 only $27.5 billion was raised for funds focused on real estate debt, this increased slightly to $27.9 billion in 2020 despite the pandemic causing peak levels of disruption and has grown strongly in 2021 with PDI’s preliminary full-year figures showing $31.8 billion was raised for the strategy. Additionally, there are a number of funds that invest in real estate debt as well as other strategies such as opportunistic lending and direct lending which are not counted in these figures.

Before the pandemic, the real estate debt and equity markets had experienced a lull in activity due to a sense that property was becoming overvalued. With the rapid changes in the real estate market caused by covid prompting the market to reset, investors are once again seeking to increase their exposure to real estate assets and capitalise on opportunities created by the pandemic.

Through the past 12 months a number of multibillion-dollar vehicles have been raised indicating there is significant demand from investors and GPs who believe they can put large sums of money to work lending to real estate projects and acquisitions. Figures from affiliate title PERE show that Brookfield raised the largest fund in the past year with $4 billion for its Real Estate Finance Fund IV. In 2022 we have already seen the first real estate debt mega-fund close with Madison Realty Capital Debt Fund V on $2.08 billion after less than a year of fundraising.

Not only are real estate debt funds able to offer investors opportunities to gain exposure to new developments in real estate without having to take equity risk, they could also offer another major advantage in the coming years as the old enemy of inflation once again rears its head. With inflation rates spiking in a number of countries around the world as supply-chain disruption, energy costs, changes in labour markets and large swings in demand as lockdowns begin and end, all work together to push prices higher.

“The relative attractiveness of real estate looks set to grow, as in recent months the surge in CPI has re-invigorated the sector’s appeal as a potential source of diversification during periods of rising inflation expectations,” says Simon Martin, chief investment strategist and head of research and investment strategy at boutique London real estate investor Tristan Capital Partners.

In Europe, leases are generally index linked, creating a direct pass-through effect from CPI to rents. This means equity investors will be able to continue to see rising rental costs to compensate for inflation and ensure they are able to service their debts. In addition, for those investing in real estate debt, they are offered the inherent protection seen in most forms of private lending, which is floating-point interest rates. All this provides a comfortable cushion against inflation for investors that may not be as readily available in other sectors.

The pandemic threw a curveball at the previously fairly predictable and reliable real estate sector and while debt providers are more insulated against market disruption than equity, they will still need to carefully monitor portfolios to identify underperforming assets and ensure they can meet the new demands of office, commercial and living space that the post-pandemic era heralds. With investors keen to obtain the security offered by real assets, there could be significant opportunities for those who can get to grips with how this market is changing and back the projects best suited to this new world.